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Benefits of CRE Debt

5/6/2019 by Kevin Henderson

In the dynamic market that exists in commercial real estate, there lies opportunities, challenges, threats and the ability to categorically increase wealth. Real Estate is an asset class that is among the most secure and resilient methods to build generational prosperity and can act as a hedge against inflation while producing predictable cashflows. In the past decade, the commercial real estate industry in the United States has seen massive amounts of capital invested – both domestic and foreign, institutional and consumer - in all asset types and product classes. This influx of investment has spurned significant development, asset re-positioning and financial activity. This, consequently, has created an abundance of competition that has driven down investment returns.

One of the primary drivers of commercial real estate is debt, a financial instrument that, when used appropriately, can boost the returns of a real estate transaction and increase both the buyer pool and scope of work possible for a real estate project to be feasible. The availability of debt for a transaction is dependent on many factors – both on an overall market basis and an individual deal level. Financiers price loans and weigh risks based on property type, borrower experience, leverage level, business plan, geography, loan term, etc. Debt is often misunderstood and seen as a negative by a large segment of retail investors. An education on what is “good debt” versus “bad debt” is essential when contemplating a business plan.

Below are four reasons why applying debt to a commercial real estate property is worth considering:

Positive Arbitrage is the concept whereby a rate of return in an investment is increased due to the cost of borrowing money being less than the return being earned on the cashflow stream – in the case of CRE, Net Operating Income (NOI) and Net Cash Flow (NCF). To explain this more clearly, see the chart below illustrating a scenario where leverage (debt) is applied to a transaction and one where only cash is used.

All Cash

Positive Leverage

Negative Leverage

Cost of Property

$12,000,000

$12,000,000

$12,000,000

Net Operating Income

$960,000

$960,000

$960,000

Loan Amount

None

$9,000,000

$9,000,000

Interest Rate

N/A

7.0%

8.5%

Amortization Type

N/A

Interest Only

Interest Only

Debt Service

0

$630,000

$765,000

Net Cash Flow

$960,000

$330,000

$195,000

Cash on Cash Return

8.00%

11.00%

6.50%

Arbitrage

N/A

3.00%

-1.50%

In the chart above, the only variable applied in each leveraged scenario was interest rate charged on the debt in each column. If one were to apply 75% leverage on the same property, returns can be altered due to the cost of capital. Just a 1.5% increase in the cost of capital can have negative effects on returns as illustrated in the “Cash on Cash” row. Returns are 4.50% lower due to the cashflow being leveraged. It should be noted that the scenario described is a bit simplistic, with all points being equal except the interest rate – which is rarely the case in CRE debt. There are many other factors that a Borrower must consider when placing debt on a property including covenants within a loan, prepayment penalties, cost of loan origination, additional loan structure, etc. that will change the yield profile.

Principal Pay Down – In addition to potentially increasing returns on a commercial real estate investment on a cash-on-cash basis, yield on a property can be further boosted through principal reduction – in the case that a mortgage has an amortizing debt schedule. While it is not a true return in the traditional sense, whereby one receives monies directly from an initial investment; principal paydown allows for a Borrower to pay down his outstanding debt over time and further increase his equity through actual cash injection(s). This, coupled with the (hopeful) appreciation of an asset, increases the Borrower’s equity to be realized upon a capital event - either through a subsequent refinance or sale of a property. Amortization schedules are weighted towards lender’s receiving their interest payments in a higher proportion early on in the loan term relative to the principal pay down, meaning that the longer that a Borrower pays the more the loan will amortize in the later years of the loan term. Note that loans with amortization have payments that include both Principal and Interest whereby Interest-Only loans have payments on interest alone – therefore they have lower monthly payments. Below is an example of two amortization schedules over a 10-year period – one interest-only and one amortizing from the first payment.

Interest Only Loan

Amortizing Loan (30-year schedule)

Loan Amount

$10,000,000

$10,000,000

Interest Rate

7.0%

7.0%

Loan Payment

Balance

Loan Payment

Interest

Principal

Principal Balance

Year 1

$700,000

$10,000,000

$798,363

$101,581

$696,782

$9,898,419

Year 2

$700,000

$10,000,000

$798,363

$108,924

$689,439

$9,789,495

Year 3

$700,000

$10,000,000

$798,363

$116,798

$681,565

$9,672,696

Year 4

$700,000

$10,000,000

$798,363

$125,242

$673,121

$9,547,455

Year 5

$700,000

$10,000,000

$798,363

$134,296

$664,067

$9,413,159

Year 6

$700,000

$10,000,000

$798,363

$144,004

$654,359

$9,269,155

Year 7

$700,000

$10,000,000

$798,363

$154,414

$643,949

$9,114,741

Year 8

$700,000

$10,000,000

$798,363

$165,576

$632,787

$8,949,165

Year 9

$700,000

$10,000,000

$798,363

$177,546

$620,817

$8,771,619

Year 10

$700,000

$10,000,000

$798,363

$190,381

$607,982

$8,581,238

Total Payments

$7,000,000

$10,000,000

$7,983,630

$1,418,762

$6,564,868

$8,581,238

As you can see, over a 10-year hold, the difference in annual payments between an Interest-Only loan and an Amortizing loan is nearly $1 MM, however, the outstanding loan balance in the amortizing scenario is decreased by approximately $1.4 MM, thereby increasing the equity position in the loan and decreasing a lender’s basis/exposure. Both forms of debt are used on property types, however they have different effects on returns based upon the business plan, holding period and overall market.

Tax Free Cash – When a Borrower refinances a commercial real estate property, the proceeds that flow through to the Borrower are received without negative tax implications. By taking funds from a “cash out” refinance, a Borrower can reinvest proceeds back into the property through capital improvements and renovations – all without paying tax on monies received. The resulting improvements, when appropriately budgeted and implemented, will further increase returns on a property. Another benefit of a refinance is to further decrease a Borrower’s “basis” in the property whereby the actual cash invested, directly from the Borrower, decreases. Conversely, the funds obtained through a refinance may be allocated by a Borrower to purchase additional properties and thereby further increase portfolio holdings.

In short, debt is accretive to a CRE transaction when applied at prudent levels on a cashflow-producing asset. The proceeds can be used to improve the property and further increase rents and returns, allow a Borrower access to equity that is currently “locked up” in the asset, and earn a higher return.

When looking for debt on your next CRE transaction, consider District – the modern commercial real estate lender that is injecting technology into the commercial loan process. We’re providing borrowers a lower cost of capital, a high level of visibility into the funding process and ease of execution through automation.

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