When apartment investors evaluate a potential new property, they have many points to consider. If their preliminary analysis looks promising, they’ll eventually start figuring how to finance the project.
At this point they will check with various lenders to discover their current loan parameters. What loan-to-value (LTV) percentage will they honor? What debt service coverage ratio do they look for? What interest rate do they offer, and for what length of time before the balloon? For how many years will they amortize the loan?
In addition to the debt side of the equation, the sponsor must look to his or her investors for equity to cover the down payment, loan and acquisition fees, and reserves for known or anticipated capital expenses. They will poll their potential investors to discover how much they might contribute, as well as their tolerance for risk. They might also ask if any of them need to do a 1031 exchange, or need help setting up a self-directed IRA.
Once all this is done, they calculate how much equity to raise to complete the purchase. Most often, a sponsor hopes to raise just enough capital to meet the target LTV their favored lender is looking for. Currently, most lenders require a minimum of 25-35% down. So for a million dollar purchase, an investor group might look at raising a minimum of $250,000 to $350,000 for the down payment. However, not all groups want to get in for the minimum amount down. For their own reasons, they may prefer to put half down, or even pay all cash. How do these decisions affect the bottom line return after the holding period and subsequent sale?
In order to determine the answer, we’ll compare the internal rate of return (IRR) for three different scenarios. The IRR reflects the total return on investment, taking into account annual cash flows and final profit at the sale. All the following numbers reflect pre-tax dollars.
- Purchase price (all-inclusive) = $1,000,000
- Buy at 8% cap rate ($80,000 net operating income first year)
- Vacancy rate = 7%
- Rent income escalators = 3% per year
- Expenses = 50% of gross operating income
- Expense escalators = 3% per year
- Expense of sale = 7%
- Loan interest rate = 6%
- Amortization period = 25 years
- Loan term = 7 years
- Sell at end of year 5
- Sell at 8 % cap rate
If you’d like to see how the following numbers were derived, the spreadsheets are included below.
|Year 1 cash flow||Year 5 cash flow||Sale @ 8 cap||Sales Proceeds||
$1,000,000 (all cash)
$500,000 (50% LTV)
|$250,000 (75% LTV)||$65,271||$75,899||$1,225,932||$915,287||
Upon close inspection, you will see that compared to putting 25% down, buying with all cash will give you better cash flow, but an overall smaller return. Putting in an intermediate amount gives intermediate results.
So why doesn’t everyone go for the maximum return? In these variations, putting in the smallest amount gives the biggest bang for the buck because you’re leveraging your money with the loan. It must be easier to raise $250,000 than a million dollars, so why do some folks buy for all cash?
One reason might be the ability to get a discount for an all cash purchase, where the seller doesn’t have to wait to see if your loan will go through in time, if at all.
It might also have to do with the mindset of the investors in the group putting up their cash. Younger investors with many years to go before retirement usually have a steady and growing income from their job and are often looking to work for a big payday down the road. Their risk tolerance may be relatively high since they have a long time to make up for any errors they make now.
People approaching retirement or already retired may place a higher value on a more robust cash flow today to supplement their fixed income. They may also be worried about that balloon payment a few years down the road when the loan term expires. They simply don’t have as high a tolerance for risk as they did in their younger years.
Many of the deals we see today are the result of projects not being valuable enough in the current market to refinance the loan to pay off that debt coming due. So, paying with cash means there is no loan, so there is no balloon. As with all investments, the greater the return, the greater the risk. Therefore, successful sponsors will match the equity required with the risk-tolerance of their investors.