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[00:00:22] No Leverage. Return equals the Cap Rate
[00:00:45] 50% Leverage
[00:00:51] Loan Constant
[00:01:18] 75% Leverage
[00:02:04] Positive Leverage
[00:02:45] Neutral Leverage
[00:02:58] Negative Leverage
[00:03:13] How to Optimize Leverage

Leverage is the concept of using other people's money. Specifically when investing in real estate, leverage typically means using bank debt to reduce the amount of equity needed to buy an investment property. When utilized properly, leverage can help you acquire more units, scale your portfolio, and boost your annual ROI.

I'm going to show you three different examples of investing in the same $1 million asset at an 8% cap rate one with no leverage, one with 50% leverage, and one with 75% leverage to highlight the impact on the investor's returns.

With No Leverage, the Return is the Cap Rate
A good way to demonstrate this is to think of the cash that is generated by the property, in this case, the $80,000 of NOI going into a bucket.
With no leverage, the investor gets to keep all of the cash in the bucket. In this case, they invested $1 million and are getting a cash return of $80,000 each year, for an 8% cash on cash return.
50% Leverage

So when we think about leverage, think about it as partnering with the bank, but at a lower cost.

Loan Constant
In this case, with the 50% leverage, the debt service on a $500,000 loan would be $30,000 per year.

That equals a 6% cash return, the lender's loan constant. The lenders portion is only 30,000, the remainder goes to the investor. The investor keeps 50,000 of the 80,000, and since they invested $500,000 of their own cash that yields a 10% cash on cash return.
75% Leverage

In this last example at 75% leverage, the lender is putting up $750,000 of the capital in the form of debt. And the investor only puts up $250,000 in cash. At that same rate in terms, once again, that $45,000 divided by the $750k is a 6% cash return to the lender, the lender's loan constant.

That leaves $35,000 in the form of net cash flow leftover for the investor. The investor only puts up, in this case, $250,000 of their own cash. $35,000 divided by $250,000 investment is a 14% cash on cash return.

The investor is only putting up one fourth of the amount of capital and they're making a significantly higher return on that capital.

Positive Leverage
This is called "positive leverage". And effectively, positive leverage occurs when the cap rate is greater than the loan constant. Now the loan constant can change as you've seen in other lessons, depending on the interest rate and the amortization.

But whenever you have a spread between the cap rate and the loan constant, where the cap rate is higher, it's typically optimal to increase leverage in order to increase the investor's cashoncash return.

The example I just showed you was an instance of what we call "positive leverage", where the return to the lender or the loan constant is lower than the cap rate, allowing the investor to capture some of that net cashflow to increase their return.

Neutral Leverage
There's also, what's called "neutral leverage" where the lenders loan constant is the same as the cap rate. Therefore not providing any additional benefit to the investor for leveraging, other than reducing the amount of capital they need to invest to acquire the asset.

Negative Leverage
And then of course we have what's called negative leverage, and that's when the loan constant is higher than the cap rate. In that case, the investor needs to forfeit additional cash flow to service the debt, where the lender is making a higher return.
How to Optimize Leverage

In order to analyze the optimal amount of leverage to use, simply compare the loan constant and the cap rate.

If the cap rate is higher than the loan constant, then use more leverage to increase the cash on cash return.

If the loan constant is higher than the cap rate, then less leverage is better in order to optimize cash on cash return.

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