When apartment investors evaluate a potential new property, they have many things to consider. If their preliminary analysis looks promising, they will eventually start thinking about how to finance the project.
At this point, they will consult with various lenders to discover their current loan parameters. What percentage of loan to value (LTV) will they honor? What debt service coverage ratio are they looking for? What interest rate do they offer and for how long before the balloon? In how many years will the loan be amortized?
In addition to the debt side of the equation, the sponsor must look to its investors for equity capital to cover down payment, loan and acquisition fees, and reserves for known or anticipated capital expenditures. They will canvass their potential investors to find out how much they might contribute, as well as their tolerance for risk. They can 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 capital to raise to complete the purchase. Most of the time, a sponsor hopes to raise enough capital to meet the target LTV that their favored lender is seeking. Currently, most lenders require a minimum of 25-35% down payment. So for a million dollar purchase, a group of investors might consider raising a minimum of $250,000 to $350,000 for a down payment. However, not all groups want to enter for the minimum starting amount. For their own reasons, they may prefer to pay half or even pay all in cash. How do these decisions affect the final performance after the holding period and subsequent sale?
To determine the answer, we will compare the internal rate of return (IRR) for three different scenarios. The IRR reflects the total return on the investment, taking into account the annual cash flows and the final profit on the sale. All numbers below reflect dollars before taxes.
assumptions
- Purchase price (all inclusive) = $1,000,000
- Buy at 8% cap rate ($80,000 net operating income first year)
- Vacancy rate = 7%
- Rental income escalators = 3% per year
- Expenses = 50% of gross operating profit
- Expense escalators = 3% per year
- Selling expense = 7%
- Loan interest rate = 6%
- Amortization period = 25 years
- Loan term = 7 years
- Sell at the end of year 5
- Sell at a cap rate of 8%
Deposit
Year 1 Cash Flow
Year 5 Cash Flow
Dirty @ 8 cap
Sales revenue
IRI
$1,000,000 (all cash)
$84,600
$95,218
$1,225,932
$1,140,117
11.17%
$500,000 (50% LTV)
$45,942
$56,560
$1,225,932
$690,457
15.66%
$250,000 (75% LTV)
$65,271
$75,899
$1,225,932
$915,287
24.16%
Upon close inspection, you’ll see that compared to the 25% down payment, buying with all cash will give you better cash flow, but a lower overall return. Putting in an intermediate amount gives intermediate results.
So why isn’t everyone looking for top performance? In these variations, putting in the smallest amount gives the largest investment because you are leveraging your money with the loan. It must be easier to raise $250,000 than a million dollars, so why do some people buy everything with cash?
One reason might be the ability to get a discount for a cash purchase, where the seller doesn’t have to wait to see if your loan will clear on time, if at all.
It could also have to do with the mentality of the investors in the group who contribute their money. Younger investors who have many years left before retirement typically have a steady and growing income from their job and are often looking to work for a big payday in the future. Their risk tolerance may be relatively high, as they have plenty of time to make up for the mistakes they make now.
People nearing retirement or already retired can place a higher value on stronger 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 term of the loan expires. They just don’t have as high a risk tolerance as they did in their younger years.
Many of the businesses we see today are the result of projects that are not valuable enough in today’s market to refinance the loan to pay off maturing debt. So paying cash means no loan, so no balloon. As with all investments, the higher the return, the higher the risk. Therefore, successful backers will match the required capital with the risk tolerance of their investors.