Real estate is like a three course meal (TM). It has three profit centers: cash-flow (or the appetizer), mortgage paydown (the main course) and equity appreciation through asset improvements and inflationary rental upside (the dessert).

One key question is: how much cash to put down and how much leverage to apply via a mortgage. The more cash down, the higher the cash-flow.

Is this better though ?

REITs typically use 50% or less leverage and can be good investments or should one be higher levered with more equity upside, but little or no cash-flow ?

Let's look at three scenarios. What is a better investment of a

1) a $4M building with $1M invested with a $3M mortgage, or

2) a similar but smaller $2M asset with the same $1M invested, but only 50% levered, or

3) a mortgage free asset at $1M ?

Assumptions:

a) 6% asset yield, also referred to as a CAP rate,

b) 4% interest on the mortgage with 25 years amortization,

c) 0.5% annual overhead costs (really: a reduction in the CAP rate to 5.5%)

d) 1% annual investment into the asset for minor upgrades/repairs to yield an asset value growth of 2% over and above inflation, and

e) inflationary rental upside of 2%.

$1M invested, $4M asset, 6% CAP (yield), 75% LTV (loan-to-value) mortgage at $3M at 4%

$240,000 NOI (net operating income) minus

$180,000 mortgage payment (of which $60,000 is principal and $120,000 interest)

$60,000 `cash-flow` in theory .. Some of which will be asset management fees, annual accounting, tax filing costs, overhead (say $20,000) and rest upgrades (say $40,000) .. Thus NO CASH FLOW

20% value growth in 5 year to $4.8M due to inflation and upgrades/rental upside (4%/year on average)

Equity in 5 years: $800,000 gain plus $300,000 mortgage paydown = $1.1M =

But no cash-flow !!

$1M invested, $2M asset, 6% CAP (yield), 50% LTV mortgage for $1M at 4%

$120,000 NOI minus

$60,000 mortgage payment (of which $20,000 is principal and $40,000 interest)

$60,000 `cash-flow` in theory .. Let`s assume some of which will be asset management fees, annual accounting, tax filing costs, overhead and rest upgrades .. Say $30,000 - same ratio as scenario 1 .. So $30,000 cash flow (3% on the $1M invested)

20% value growth in 5 year to $2.4M - same as scenario 1

Equity in 5 years: $400,000 gain plus $100,000 mortgage paydown plus $150,000 in cash flow = $1.65M =

$1M invested, $1M asset, 6% CAP (yield), no mortgage

$60,000 NOI

$60,000 `cash-flow` in theory .. Let`s assume some of which will be asset management fees, annual accounting, tax filing costs, overhead and rest upgrades .. Say $15,000 .. So $45,000 cash flow (4.5% on the $1M invested)

20% value growth in 5 year to $1.2M

Equity in 5 years: $200,000 gain plus $225,000 in cash flow = $1.425M =

What is better: Scenario 1 ..

Or Scenario 2 ..

Or Scenario 3 ??

One key question is: how much cash to put down and how much leverage to apply via a mortgage. The more cash down, the higher the cash-flow.

Is this better though ?

REITs typically use 50% or less leverage and can be good investments or should one be higher levered with more equity upside, but little or no cash-flow ?

Let's look at three scenarios. What is a better investment of a

**hypothetical $1M**(say by the time you intend to retire or from an inheritance) ?:1) a $4M building with $1M invested with a $3M mortgage, or

2) a similar but smaller $2M asset with the same $1M invested, but only 50% levered, or

3) a mortgage free asset at $1M ?

Assumptions:

a) 6% asset yield, also referred to as a CAP rate,

b) 4% interest on the mortgage with 25 years amortization,

c) 0.5% annual overhead costs (really: a reduction in the CAP rate to 5.5%)

d) 1% annual investment into the asset for minor upgrades/repairs to yield an asset value growth of 2% over and above inflation, and

e) inflationary rental upside of 2%.

**Scenario 1:**$1M invested, $4M asset, 6% CAP (yield), 75% LTV (loan-to-value) mortgage at $3M at 4%

$240,000 NOI (net operating income) minus

$180,000 mortgage payment (of which $60,000 is principal and $120,000 interest)

$60,000 `cash-flow` in theory .. Some of which will be asset management fees, annual accounting, tax filing costs, overhead (say $20,000) and rest upgrades (say $40,000) .. Thus NO CASH FLOW

20% value growth in 5 year to $4.8M due to inflation and upgrades/rental upside (4%/year on average)

Equity in 5 years: $800,000 gain plus $300,000 mortgage paydown = $1.1M =

**110% ROI**(return on investment) in 5 years ..But no cash-flow !!

**Scenario 2:**$1M invested, $2M asset, 6% CAP (yield), 50% LTV mortgage for $1M at 4%

$120,000 NOI minus

$60,000 mortgage payment (of which $20,000 is principal and $40,000 interest)

$60,000 `cash-flow` in theory .. Let`s assume some of which will be asset management fees, annual accounting, tax filing costs, overhead and rest upgrades .. Say $30,000 - same ratio as scenario 1 .. So $30,000 cash flow (3% on the $1M invested)

20% value growth in 5 year to $2.4M - same as scenario 1

Equity in 5 years: $400,000 gain plus $100,000 mortgage paydown plus $150,000 in cash flow = $1.65M =

**65% ROI**in 5 years with some very modest 3% cash-flow !!**Scenario 3:**$1M invested, $1M asset, 6% CAP (yield), no mortgage

$60,000 NOI

$60,000 `cash-flow` in theory .. Let`s assume some of which will be asset management fees, annual accounting, tax filing costs, overhead and rest upgrades .. Say $15,000 .. So $45,000 cash flow (4.5% on the $1M invested)

20% value growth in 5 year to $1.2M

Equity in 5 years: $200,000 gain plus $225,000 in cash flow = $1.425M =

**42.5% ROI**in 5 years with some modest 4.5% cash-flow !!What is better: Scenario 1 ..

Or Scenario 2 ..

Or Scenario 3 ??

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