Debt can be a Friend

Debit or CreditDebt is a four lettered word these days. Households are trying to get rid of it. Governments are effectively taking in more of it to try to save us from the excesses of households and of banks.

We should still not lose sight of the use of debt to invest however. Used in a measured way and understanding the risks debt can be useful.

Let us look at some very simple examples to demonstrate the power of debt, or leverage as it is often referred to. Let us say we have $1000 to invest and we choose an asset that produces cashflow of $100 per annum (with no growth).  We have a 10% gross return on our capital ($100x100/$1000).

If we replace $500 of capital with $500 of bank borrowing for the same asset our gross return becomes 20% ($100x100/$500). We have the same cashflow but we are employing only half the capital to produce it so we double our return.

If only life were that simple! The bank of course wants to be paid. And it will attach a range of conditions to its lending. In the above example if the bank interest is 8% this gives a cost of $40 to service the debt. Our return on capital now becomes 12% ($500x100/($100 - $40).

In our example by borrowing half the capital we have increased the return from 10% to 12%, a 20% increase. “That’s not bad,” you would say to yourself. “Having used only half the available capital I can go and do the same thing again”. And that is quite a valid thought until we begin to introduce a larger dose of reality to the point where the risk/return calculation does not look quite so attractive.

The simple examples above bear some similarity to investing in commercial property (just imagine another 3 zeros after the numbers!). As an asset class commercial property has the characteristics, among others, of good cash flow (often in a range of 7 – 12% p.a.) and it is something the banks are willing to lend against.

Let us say we have used the $1000 (half our capital and half from the bank) to purchase a commercial building that has 3 tenants with good leases. There is one anchor tenant that pays 50% of the rent with the remaining two tenants paying half the remaining rent each (ie: $25 each).

What if one of the smaller tenants moves on? Our return on capital equation becomes $500x100/($75 rent - $40 bank interest cost) = 7%. This is still a reasonably robust return while the property is re-tenanted. The bank is unlikely to be unduly concerned.

What if the biggest tenants moves on? Our return equation becomes $500x100/($50 rent - $40 bank interest cost) = 2%. The cashflow return now looks very weak and the bank is now likely to be concerned.

The bank’s lending will have come with a few conditions about loan to valuation ratios and coverage of interest, just to name a couple. Given that commercial property valuations are driven by expected cashflows the value of our property in this instance will, at least in the short term, have dropped in value in the bank’s eyes. They may well want to keep all the rent in order to reduce the loan. Your cashflow return is now nil.

The above scenarios are simple but the messages are clear. Debt can increase your returns but it also increases risk and can magnify losses. These forces have played out in many instances over recent times through listed and unlisted property funds to the great pain of investors. The professionals managing these vehicles should have known better but the investing public can be excused for having less expert knowledge.

Caution is still required by individual investors. We are seeing activity increasing among property syndicators again. Most of these, in an attempt to reduce their marketing effort and to lift returns to cover the syndicate establishment costs and make it a more attractive sell to investors, use 30-50% bank borrowings.

Investors need to be cautious and closely examine the effects of debt within these syndicates on a case by case basis. Furthermore the above examples do not examine the effects of rising and falling rents or of rising or falling debt costs over time. These issues can further magnify problems. And what happens if the bank decides not to refinance at all?

Having observed the great performance of direct property investment in client portfolios over the past 25 years I have formed the view that debt is best arranged and secured on the investor’s own balance sheet rather than on the syndicate’s. The investor has better control.

Debt can be your friend but that friendship can come with a price you need to be aware of.

Reproduced from NZIM article for December 2010

Debt

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