Use of debt financing is a standard practice in the real estate investing; and is often referred to as leveraging. Debt financing is used by the equity holders to enhance the equity return; however, debt financing can also magnify the severity of capital loss if the property value declines.
Let's look a case study to explore this further; we shall use simpler set of assumptions for the sake of ease.
Consider a property with an acquisition cost of $10,000,000. Property is assumed to yield $700,000 in annual rent throughout the holding duration (no escalation!). Assume the property is sold at the end of fifth year for a price of $14,000,000 i.e. 40% appreciation or capital gain.
Assume that the property acquisition is 100% funded by equity. The project IRR and equity IRR will same in this case; and it will be 13.2%. Cash flow for this case is given below:
Now assume that the property is financed 40% by debt and 60% by equity; the cost of debt is 6%. You can see below that the project IRR remains at 13.2% however the equity IRR shoots up to 15.4%.
Equity return is magnified by introducing debt financing!
Now consider an altogether different scenario. Assume 40% depreciation in the property price at exit. Keep debt at 40% and equity at 60%.
You can see the equity IRR is much lower than project IRR; debt financing has inflated the extent of capital loss as the property value declined.
I must stress here again that debt is a double-edged sword.
I did few simulations with various combination of debt:equity ratios and exit values, the graph is plotted below:
Hope you enjoyed this post, use the comment section below to let me know your thoughts on the use of debt financing in real estate investments.
You might like to refer the impact of cost of debt on the project and equity IRRs.
You can also download the interactive Excel spreadsheet containing this example of debt financing to explore it yourself.