John was feeling entrepreneurial that day. He had always wanted to own a brewery, and by golly, he finally had saved enough to buy one. He bought the operations without a loan for $1,000,000, and with the $70,000 of net income the brewery was producing, he was earning 7% cash on cash every year. Plus he had his own happy hour whenever he wanted! What could be better, he thought… until his friend Paula got to talking about maximizing his cash on cash returns.
Paula explained that John could have invested less money upfront and earned an even better return than his 7% by simply taking out a loan. She explained: “if you had taken out a $500,000 loan at a 5% interest rate, you could have been making a 9% cash on cash return instead of only 7%. And you’d still have money left over to buy another brewery.” She walked through the math:
No Loan Scenario:
- $70,000 Earnings / $1,000,000 Equity = 7.0% Cash on Cash Return
- $500,000 Loan x 5.0% Interest Rate = $25,000 Interest Expense
- ($70,000 Earnings – $25,000 Interest Expense) = $45,000 Net Earnings
- $45,000 Net Earnings / $500,000 Equity = 9.0% Cash on Cash Return
Paula’s example illustrates the benefit of using a loan (also known as “leverage”) to acquire an asset, increasing the effective cash on cash return. Even a modest 50% loan increases John’s cash on cash a full 200 basis points (or 2%). And he’s putting less of his own money into the business!
The risk, naturally, is that leverage also amplifies the reduction in return if the earnings from the business were to decrease, because the interest expense is a fixed cost. So a cyclical business, such as a brewery, subject to significant ups and downs of the economy, may not be the ideal asset on which to use leverage.
That’s why real estate is a unique asset class when it comes to pairing leverage with income. Given that leases are long term contracts, and that 10-year loans are available on a routine basis, real estate assets can provide more certainty over the projected cash on cash returns over a longer time horizon. There is always the risk that rents could decline in the future, but pairing low, long term leverage with in-place lease contracts to solid tenants goes a long way to mitigating that risk.
These days, real estate investors are seeing a generational opportunity to benefit from low interest rates and lock in outsized cash on cash returns by utilizing leverage. Some investors may go too far and overleverage their properties, leaving little cushion in the event of reduced income. Others, like stREITwise, seek moderate leverage with long term debt, giving investors the best of both worlds: superior cash on cash returns AND downside protection.
Whatever you do with your hard-earned savings, make sure you’re maximizing your cash on cash returns. Your money can and should work harder for you, even if you don’t run the business!