What is better: cash-flow ... or higher ROI ?

Matt Crowley

Senior Forum Member
REIN Member
Dear Thomas,



Thank you for the question. Many others have offered intelligent and insightful replies.



In my personal opinion, what I believe is trying to be demonstrated here is that investors have different levels of risk-aversion, or fear of losing money. What I hope all readers will ascertain from the example is that:



Scenario 1 = Scenario 2 = Scenario 3



Each asset in scenario 1, 2, and 3 offer a 6% net return on the asset before taxes or paying a mortgage.



Scenario 1

NOI = 240 k

Building = 4 M

cap rate = NOI/Building = 6%



Scenario 2

NOI = 120K

Building = 2 M

cap rate = NOI/Building = 6%



Scenario 3

NOI = 60 k

Building = 1 M

cap rate = NOI/Building = 6%



You can use any amount of leverage on any of the buildings to achieve whatever "ROI" you desire. But what Thomas is cleverly pointing out is that debt never changes the productive return of the asset!



When the question is simply: Which investment is better?

a) 100% ROI

b) 62.5% ROI

c) 42.5% ROI



Mathematical answer:



None of them is better than any other. If you are investing in exactly the same underlying asset, with exactly the same gross return (6%), they are all entirely equivalent assets. (In a universe where we can buy four assets of scenario #3 or two assets of scenario #1 to equal scenario #1)



A bit of interesting (and extremely useful) theory:



Let's ignore final appreciation for a moment because every building here appreciates by the exact same amount. This will allow us to examine the effects of leverage.



Ever wonder how leverage really works?



You have probably heard of "ROI" as "return on investment". ROI is



ROI = (return on asset) * (leverage)



Now what is leverage? Mathematically, we represent leverage as



Leverage = (building value)/(cash invested)



What is "return on asset"?



Return on Asset = ROA = (cash before tax)

building value today



An easy way to think about return on asset as that it is the cash you have in hand at the end of the day divided by the cost of the house today. On an asset without any debt, return on asset is simply the cap rate ie. net operating income divided by the value of the asset. As more debt is applied, the cash before tax decreases as we now have debt payments.



Under scenario 3
, our leverage
is equal to:



Leverage = 1M (building value) = 1

1M (cash invested)



Here, our leverage ratio is 1, or no leverage is used.



Return on Asset = ROA = (cash before tax) = 60K

building value today 1M



ROA = 6%



ong>ROI for scenario 3:



ROI = (return on asset) * (leverage)

ROI = 6% * 1

ROI = 6% / year

ROI (~ 5 year) = 6% * 5 years = 30% ROI



Now, lets add some leverage for scenario 3:



50% loan to value. That is we buy the building for $1 million and use a $500k mortgage. Using Thomas' numbers we have 30k mortgage payment and 10k principal pay down so net we lose 20k / year to interest payments.



return on asset = $60K (NOI) - $20K (interest payments)

1 million (building value today)



ROA = 4%



Leverage = 1M (building value) = 2

500 K (cash invested)





ROI = (return on asset) * (leverage)

ROI = 4% * 2

ROI = 8% / year

ROI (~ 5 year) = 8% * 5 years = 40% ROI



The relationship of leverage:

  • the higher the leverage applied, the lower
  • the return on asset
  • Each asset only has the productive capacity of offering a 6% total return on the asset.
  • Debt does not "enhance" the productive capacity of an asset. Taking on debt is ultimately an expression of your confidence in that asset.
    By the nature of leverage, we can turn a 6% cap rate asset into a 200% ROI or 300% or 4000%. None of these are better than the other, if the higher "ROI" is simply coming from leverage.
    As investors, we should search for higher ROA
  • .

That's just my two bits. (I have an honours degree in finance and work as a real estate analyst for what it's worth). This is generally how we think about asset valuation.



Thanks for the post, looking forward to more discussion.
 

KevinSolomon

Inspired Forum Member
Registered
[quote user=SweetZone]Debt does not "enhance" the productive capacity of an asset. Taking on debt is ultimately an expression of your confidence in that asset.


^ This.



[quote user=SweetZone]By the nature of leverage, we can turn a 6% cap rate asset into a 200% ROI or 300% or 4000%. None of these are better than the other,
if the higher "ROI" is simply coming from leverage.


^ This.



+1000 Great post and the reason I ignore individuals who throw around ROI numbers.



I also ignore people who throw around CAP numbers, but those are for different reasons.



Hopefully this post was obvious to most real estate investors.
 

RedlineBrett

Senior Forum Member
REIN Member
[quote user=SweetZone]You can use any amount of leverage on any of the buildings to achieve whatever "ROI" you desire. But what Thomas is cleverly pointing out is that debt never changes the productive return of the asset!


Leveraging the asset through debt does free up capital to be re-invested elsewhere, or to be used for consumption without requiring the sale of the asset... at a cost of the prevailing interest rate for debt secured against real property. (The cheapest there is). The opportunity cost of being completely un-levered is the productivity capacity you speak of. You would have to be ok with that 6% for all of your capital you have decided to invest in that property.



Markets do appreciate and property owners will see the value of their property increase even if they choose to keep their rents the same. Over time gross rents (productive capacity) do go up. So by levering an asset you can free up capital to turn around and buy something else... and ideally have a greater pool of assets maximizing their productive capacity. If you are not adverse to the risk and the obligation to one day pay off the debt!
 

Thomas Beyer

Senior Forum Member
REIN Member
[quote user=RedlineBrett]If you are not adverse to the risk and the obligation to one day pay off the debt!


or your (lucky) heirs ...
 

Colin Forrest

Investing with Integrity
REIN Member
Hi Sherilynn,

I know this thread was written years ago, but I stumbled on it today and would like to clarify something if I may. From my understanding with Thomas's 3 examples, the investor only had $1 mil to invest, is this not correct? If so, then doubling down with $2 million would not be accurate for the scenarios presented?

cheers,

Colin
 

Thomas Beyer

Senior Forum Member
REIN Member
[quote user="colinaforrest"]had $1 mil to invest, is this not correct? [/quote]
correct.

It assumed three scenarios: one asset worth $1M, all cash; or one asset for $2M with $1M mortgage (50% LTV); or one asset worth $4M wit a $3M mortgage (75% LTV)
 

Thomas Beyer

Senior Forum Member
REIN Member
Let's look at three scenarios for many towns in BC - THE NEW REALITY. What is a better investment of a hypothetical $1M (say by the time you intend to retire or from an inheritance) ?:

1) a $3M building with $1M invested with a $2M 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) 4% (vs. 6%) asset yield, also referred to as a CAP rate,
b) 2% (vs. 4%) interest on the mortgage with 25 years amortization,
c) 0.5% annual overhead costs (really: a reduction in the CAP rate to 3.5%)
d) 1% (vs. 2%) annual investment into the asset for minor upgrades/repairs to yield an asset value growth of 1% (vs. 2%) over and above inflation, and
e) inflationary rental upside of 1% (vs. 2%) %.


Scenario 1:

$1M invested, $3M asset, 4% CAP (yield), 66.67% LTV (loan-to-value) mortgage at $2M at 2%

$120,000 NOI (net operating income) minus

$100,000 mortgage payment (of which $60,000 is principal and $40,000 interest)

$20,000 `cash-flow` in theory .. Some of which will be asset management fees, annual accounting, tax filing costs, overhead (say $10,000) and rest upgrades (say $30,000 ie 1%) .. Thus NEGATIVE CASH FLOW of $20,000/year with 1/3 down !

10% value growth in 5 year or $300,000 to $3.3M due to inflation and upgrades/rental upside (2%/year on average)

Equity in 5 years: $300,000 gain plus $200,000 mortgage paydown minus $100,000 negative cash-flow = $0.4M = 40% ROI (return on investment) in 5 years ..

But negative slightly cash-flow !!


Scenario 2:

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

$80,000 NOI minus

$50,000 mortgage payment (of which $30,000 is principal and $20,000 interest)

$30,000 `cash-flow` in theory .. Let`s assume some of which will be asset management fees, annual accounting, tax filing costs, overhead ... say $10,000 and $20,000 upgrades .. - same ratio as scenario 1 .. So no cash-flow

10% value growth in 5 year to $2.2M - same as scenario 1

Equity in 5 years: $200,000 gain plus $100,000 mortgage paydown = $0.30M = 30% ROI in 5 years with no cash-flow !!


Scenario 3:

$1M invested, $1M asset, 4% CAP (yield), no mortgage

$40,000 NOI

$40,000 `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 $10,000 .. So $20,000 cash flow (2% on the $1M invested)

10% value growth in 5 year to $1.1M

Equity in 5 years: $100,000 gain plus $100,000 in cash flow = $1.2M = 20% ROI in 5 years with some modest 2% cash-flow !!


What is better: Scenario 1 ..

Or Scenario 2 ..

Or Scenario 3 ??
 
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TrevorW

Inspired Forum Member
Registered
I like this post. Thanks Thomas!

Which is better is a nuanced question and, in my opinion, likely depends how comfortable you are with debt and your ability to carry an investment w out any cash flow.

Personally, I would work with Scenario 1 and only enter the investment if there was an opportunity to increase rents and generate some honest positive cash flow.
 

Thomas Beyer

Senior Forum Member
REIN Member
Personally, I would work with Scenario 1 and only enter the investment if there was an opportunity to increase rents and generate some honest positive cash flow.

That is doable on turnover in most BC properties, but the rent levels have to be realistic, and as stated, it costs the same to fix a suite in Surrey or in Campbell River, say $10,000, but you might get $600 more in rent in Surrey but only $150 in Campbell River. Depending on price, LTV and upgrade cost $s for renovation may, or may not, come from operating cash-flow.
 
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24001

New Forum Member
Registered
How does this scenario affect new investors with respect to being approved for financing? I'm not ready to take other peoples money so I rely on conventional lending on my own. Should I take the cash flow? This will improve my debt ratios and give me a better chance at getting financing for the next investment.
 

Thomas Beyer

Senior Forum Member
REIN Member
I am a recent/ new person and have sent you an invite too. I would choose option # 2 as the equity in 5 years is highest (1.65M). Am I correct Thomas ?

The question was more rhetorical as it depends on your life situation, age, cash availability, risk tolerance and life goals.


Thomas Beyer, Asset Manager, Investor, Community Improver, Author, Father, Mentor www.prestprop.com
 

jay1214u

New Forum Member
Registered
Everything being equal and cash flow or cash is not a problem, Which scenario is preferred by you?
 

Rickson9

Senior Forum Member
Registered
It also depends on whether the individual is beholden to investors and the contract agreement between them.
 

jay1214u

New Forum Member
Registered
Thomas,


In the next 1-10 years , I want to move from residential to commercial investment in Toronto or surrounding area. Having said that, I plan to buy commercial property, set up the business, run it for 1-2 years and sell the business. Repeat the process every 2 years. Let the business pay my mortgage and other fixed expenses. Positive cash flow after the sale of the business will be preferred.

I do not know which business location will be more profitable among the several other locations. There are several locations which I have in mind, but how does a person judge which is better for the long run, given the variables and the trend/forecast. Should I go for a retail unit in residential tower / commercial tower or a strip center and other similar variables. The variables may be population growth, per capita income, crime, spending and demographics among others

This will be a learning curve for me.Take your time. No rush

Thanks
Jay
 
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