Thursday, July 26, 2007

Inflating Leveraged ROI Can Ruin You

Previous: Leveraged Investments: High ROI Is Not Always Best

The previous leverage article covered how the common method for measuring leveraged Return on Investment (ROI) can mislead you by underestimating the work and risk. Add overly-optimistic “magic” numbers to inflate ROI and this article shows how the combination of rosy estimates and ignored risk can trick you into a bad investment.

We will start with the same example as last time:
$250k: invest 100% cash (unleveraged) or 10% cash with 90% loan (leveraged)?

$250,000 [100%] paid in full in cash:
--$26,400 in rents - $3300 expense = $23,100 NOI
--$23,100 / $250,000 = 9.2% ROI

$25,000 [10%] cash down payment [plus $225,000 mortgage]:
--$18,879 in mortgage payments + $3300 expense = $22,179
--$26,400 in rents - $22,179 = $4221 NOI
--$4221 / $25,000 cash in front = 16.9% ROI

example from: Using Financing for Real Estate Leverage

Debt makes you 80% richer?

The example author concluded:

“As you can see, even though your risk increases with leverage, it might be a wise choice when you can increase your ROI by as much as 80% (16.9% is 84% increase over 9.2%) over the full cash in front option.”

The promised 7.7% spread (16.9 over 9.2) was not impressive enough so the author used a percentage of a percentage to make the pro-leverage number 10-times bigger (80%--Who doesn't want to earn 80%?). Almost doubling your ROI would be a good thing but let’s not get carried away too soon.

The pro-leverage conclusion depends on magic numbers.

How many rental markets have perfect 100% occupancy rates, i.e. no vacancies at all between tenants, and no missed payments? Here are some real-world rental occupancy rates/vacancy rates that I quickly found to see how the examples perform with real-life inefficiencies:

(Sorry if a long space appears before the table)

© 2007 HFF

Occupancy Rate (%)Gross Rent Annual ($)ROI Unleveraged (%)ROI Leveraged (%)
2001 Northeast94.725,0018.711.3
2001 US urban (inside MSA)92.024,2888.48.4
2001 US non-urban89.623,6548.15.9
2004-Sep. Texas 6 major
2003-Oct. Texas 6 major

Sources: Statistical Abstract of the United States, 2002, Community Connections

  • In only one real-world occupancy rate did the leveraged ROI beat the unleveraged ROI.
  • In one other case, leveraged ROI broke even with unleveraged ROI.
  • In most cases, the leveraged ROI was worse than the unleveraged ROI.
  • In 2 cases, the leveraged ROI is losing your money while the unleveraged ROI is still providing almost 7%.
  • In the last case, the margin spread (+6.9% v. -6.9%) shows that it is the unleveraged ROI that is 13.8% points higher than the leveraged choice.

Can you feel that $225k of debt making you 80% richer yet?

No comments: