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LEVERAGE is the quickest way to go bankrupt in Real Estate.
Buy a $10M property for $2M cash and you've just increased your chances of being unsuccessful in Real Estate.
Buy a $10M property for $2M cash and you've just increased your chances of being unsuccessful in Real Estate.
You find a deal at a 5 cap. The purchase price was $10M, so the NOI is $500k.
You put down $2M and you borrow the other $8M from the bank. The bank charges you 3%. To keep it simple, your mortgage payment is $240k per year ($8M * 3% interest)
You put down $2M and you borrow the other $8M from the bank. The bank charges you 3%. To keep it simple, your mortgage payment is $240k per year ($8M * 3% interest)
Your total Cash Flow is $360k ($500k NOI - $240k Mortgage). That means your cash on cash return is 13% ($240k Cash Flow / $2M Equity)
Unfortunately, Real Estate doesn't always go up! And in this situation a variety of factors have worked against you and the value of your property has decreased.
Your $500k in NOI has decreased drastically to $200k. A global pandemic hit and ppl decided to stop paying rent.
Your $500k in NOI has decreased drastically to $200k. A global pandemic hit and ppl decided to stop paying rent.
Our Mortgage of $240k hasn't changed. So cash flow is now NEGATIVE $40,000 ($200k NOI - $240k mortgage).
We pay $40k every year out of our own wallet to cover this cost. What if we don't have this cash? this is when we become a distressed seller. The worst position to be in.
We pay $40k every year out of our own wallet to cover this cost. What if we don't have this cash? this is when we become a distressed seller. The worst position to be in.
At the same time, how has our property value changed? We bought the property at a 5 cap. Our property value is calculated by taking NOI / Cap Rate.
To keep it simple let's say Cap Rate hasn't changed so it's $200k / 5% = $4M.
Our property value went from $10M to $4M.
To keep it simple let's say Cap Rate hasn't changed so it's $200k / 5% = $4M.
Our property value went from $10M to $4M.
That $2M of cash that we used to buy the property? That was originally $2M of equity we had in the property. Now, it's all gone. Because we owe the bank $8M on a property that's worth $4M.
In Real Estate we love talking about leverage.
But just remember, always forecast and protect the downside.
But just remember, always forecast and protect the downside.
Real Estate has ups and downs. You can't predict business cycles. You have to buy great assets, with smart leverage, and be a high-quality operator.
In the past decade, sometimes none of this mattered and you were saved by the market because of cap rate compression.
In the past decade, sometimes none of this mattered and you were saved by the market because of cap rate compression.
Avoid stupidity. Don't risk what you have for something you don't need. And lastly, keep a big reserve account.
