Tuesday, December 11, 2012

Leveraging in real estate

Guest post by Samuel G. Njenga

Leverage (debt) magnifies outcomes. What does this mean?

To illustrate how leverage works in a real estate investment, we'll take the following investment parameters (The figures are hypothetical but not so far from reality, just to put the points across):

•Construct 5 units for sale each at construction cost of 5M (inclusive of land)
•Financing at 14% interest (service interest during construction) and repay loan on sale of units
• Sale price of 7M per unit for total sales of 35M

Let's look now at the ROI (Return on Cash Invested) with different options:
25M utilized by the developer from his/her pocket for all the construction costs:
Profit of 10M on 25M invested = 40% (return on cash invested)

50% (12.5M) cash from developer and 50% (12.5m) construction loan:
•cash out will include interest on loan (say 1M) and full loan repayment (principal) 12.5M for a total cash out of 13.5M
•Return = 35M – cash out (13.5m) – developers cash (12.5m) = 9m
•9m/cash invested (12.5m) = 72% return
30% (7.5M) cash from developer and 70% (17.5M) construction loan
•cash out will include interest on loan (say 2M) and full loan repayment (principal) 17.5M for a total cash out of 19.5M
•Return = 35M – cash out (19.5m) – developers cash (7.5m) = 8m
•8m/cash invested (7.5m) = 106% return
As you can see, even though your risk increases with leverage, especially if the sales are not made fast enough it might be a wise choice when you can increase your ROI by as much as the margins above. A seasoned investor will actually use OPM (Other People’s Money) as much as possible. Now this is good debt.

Assuming you got the 25M and as opposed to just utilizing the same for the 5 units…and do without a loan, suppose you put the entire amount as 30% (read last option above). This means, you can now get a loan of around 60M. In other words, you can now construct 17 units.

Sell the 17 units @ 7M for total sales of 119M. If you manage to sell the units within 1 year, then you’ll have paid an interest of around 7M (coz you’ll not draw the cash all at a go).

Cash out is now 7M (interest) + loan repayment (principal (60M))
Returns = 119M-67M = 52M/25M (cash invested) = 208% return……this one will drive someone crazy……or let’s say if I made this, then I’d be off to Benidorm for a month... and switch off my phone

The above figures paint a good picture about debt if well utilized. Take note that the above example(s) are purely driven by sales in good time. This is quite an assumption and a seasoned developer will tell you that without sales, then you are doomed. Notice how crazy it can turn out if you got a 60M loan and sales are not forthcoming…..you will cry in the toilet… But trust investors to take huge risks….after all what would be the worst case for this type of investments??? .....

Next post we shall think along this line.

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