Commentary: For Best Results, Leverage Credit Wisely

Photo by Len Villano.

Hi, my name is Caleb, and I’m a recovering banker. Just kidding. But seriously. Prior to my current post at Door County Economic Development Corporation, I worked for nine years in commercial real estate finance for two banks, M&I Bank (now BMO Harris) for four years and U.S. Bank for five, originating construction and acquisition loans that financed large-scale apartment complexes, office buildings, shopping malls, and distribution centers all across the country.

Fresh out of college when my personal budget sometimes hinged on tens of dollars, not hundreds and certainly not thousands, I was noticeably uneasy when I was given responsibility for underwriting and advocating for a loan portfolio totaling more than $300 million within my first few years on the job.

“Wait, you’re serious?” I’d ask as my heart rate elevated to Packers-lining-up-for-a-last-second-field-goal speed. “That ‘1’ has seven zeros after it. That’s not a typo?! Someone didn’t fall asleep with their thumb on the zero key?”

To my astonishment, my co-workers were serious and to my even greater disbelief, relatively nonchalant about the amount. “Yeah, dude, we’re serious,” they’d reply. “Now step away from the donuts and get back to work.”

During those initial months and years it became apparent that although those figures were staggeringly high to a person raised in a single-parent household who considered any salary above $60,000 as exorbitant, in-ground-pool-in-the-backyard kind of money, what mattered most to the bank were the loans’ ratios relating to the probability of timely repayment and the objective review of the loan’s risks and strength of mitigation.

Although I learned pretty quickly that commercial banking wasn’t where I wanted to spend the rest of my professional days (nine years doesn’t sound that quick in hindsight), working in finance was a tremendously valuable experience and one that I am grateful to have had. In addition to enjoying a stable, healthy work-life balance and working with some of the brightest and kindest people I’ve ever known, I gained a greater appreciation of the power of financial leverage, both in personal and professional contexts, as well as its many pitfalls.

As the father of a good friend of mine likes to say, “Debt is like fire – if you control it, it can be a great tool. If it gets out of control, it can be disastrous,” which seems apropos as Door County temperatures plummet and our fireplaces get more use, wildfires rage out west, holiday shopping shifts into manic mode, and our economy, housing and stock markets seethe and swell to previously unknown heights.

For the purposes of this month’s column, I will focus on the use of commercial debt and its applications. There are many qualified personal financial advisers in Door County that can explain the wise use of personal debt better than I can, so I’ll leave it to them (there are also many professionals who could explain commercial applications of debt better than I can, but I’m going to take a swing anyway).

Although not without increased risk, using leverage allows a commercial borrower to increase their return on investment by paying a fee (interest) to use other people’s money for a portion of the cost of an investment, whether that’s the construction or acquisition cost of real estate from which they will receive rental income and/or a premium above costs on sale, the purchase of new equipment needed to make widgets at a profit, or the rights to a new product whose marketability is expected to increase over time.

As a condition of issuing a loan, financiers almost always require the borrower to put in some amount of equity first, which will be accessible to the borrower only after the last dollar of debt is repaid to the bank. After considering the cost of the debt (the interest rate) during the life of the investment, it is most often worth the interest expense. This is because the bank only receives their original principal amount plus interest, whereas the borrower receives their original equity investment back, plus monthly cash flow over and above operating expenses and debt service payments, any upside on the sale of the asset, and/or continued cash flow after the loan is fully repaid. This is why a leveraged return, assuming a reasonable interest rate from the bank and normal economic conditions, is always higher than a non-leveraged return.

Let’s walk through a quick example. For simplicity’s sake and because the parameters are somewhat similar to using debt to purchase a home, let’s assume Jane buys an eight-unit apartment complex.

The complex is fully occupied, each unit charges $800 per month in rent, and expenses total 50 percent of income, which is typical for multifamily projects.

Jane agrees to pay $300,000 for the investment and secures a $240,000 (80 percent loan-to-value, or “LTV”) loan from the bank and contributes 20 percent of her own cash as equity ($60,000).

The bank offers a 5 percent interest rate, 30-year amortization, and a 30-year repayment term. Jane’s monthly income from these units is $6,400 ($800 per unit per month times 8 units), expenses are $3,200 (50 percent of $6,400), resulting in a monthly net income of $3,200 ($6,400 in rent minus $3,200 in expenses) from which to pay debt service, which is $1,288 ($240,000 loan at 5 percent interest at 30 years with mortgage-style amortization).

Her after-debt service monthly cash flow is $1,912 ($3,200 in net income, less $1,288 in debt service). Assuming equal rent and expense growth, but 2 percent annual appreciation on the complex, and a 10-year hold period, Jane sells the apartment for $365,698 in 2027. Her overall annual return on that complex (monthly income plus the increase in value, less repayment of the outstanding loan balance at the end of year 10) is 39.7 percent. Not bad.

Let’s see what happens if she pays all cash for this property. Her monthly net income would be the same since rents and expenses don’t change, but no debt service would be paid, so her monthly income after debt service is much higher. The full $3,200! That has to result in a higher return, right?

We assume the same amount of appreciation and thus the same sale price, but at the sale, her overall annual return drops to 13.8 percent. Why? Because the years of monthly cash flows plus the $65,698 in appreciation are divided by a much larger initial investment from which the return is derived ($300,000 in cash invested vs. $60,000), thus reducing the return.

How about if she only puts down 10 percent? Her annual return, with only $30,000 down, a higher loan of $270,000, and even with a higher interest rate of 6 percent due to the increased risk to the bank at 90 percent LTV, is nearly 64 percent.

What?! Even with smaller monthly cash flows and fewer net sales proceeds due to a higher loan amount?

Yes. With less of her own cash invested, the monthly cash flow and sales proceeds at the end of the hold period result in a higher cash-on-cash return (i.e. the decrease in the denominator [the initial investment] outpaces the decrease in the numerator [cash flows plus sales proceeds], increasing the return).

Obviously, earning a higher return is not the only reason businesses use debt. Among many other applications, companies also wisely use debt to bridge timing differences between when costs are incurred and when cash is available, prudently invest in new technologies for whose applications, delivered in the form of innovative products and services, there is ample demand resulting in projected profits, as well as appropriately conserving actual cash on the balance sheet for emergencies or future investments.

There are too many considerations to list when it comes to wisely using debt – interest rates, repayment periods, collateral, loan covenants, etc. (perhaps enough for another month’s column!) – but the examples above articulate how and why debt can be a useful tool in any business’s arsenal. And like fire, its power is not something to fear or avoid, but cautiously harness and monitor to enjoy its full benefits.

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