leverage, interest rate differentials & ROE’s

Growing up in Australia as a “stock picker” I naturally received criticism from many people who would claim that the only way to grow your wealth was through the acquisition of investment properties. In my early years, I struggled to see the appeal given most of my research into property prices showed they tend to track their replacement costs over the long run, which roughly equals inflation.

prop replace cost

Given inflation has averaged around 3% for the last 20 or so years (since inflation targeting became the modus operandi for Reserve Banks in the Western world) I struggled to see why someone would choose to accept that sort of return, when the long run nominal returns for equities is closer to 10% once dividends are included.

 

For a long time, I wrote it off as simply “stupid Aussie punters” who failed to appreciate housing prices are cyclical and that Australia has been in a property boom for the better of 20 years! But one day, while reading about the enormous returns private equity firms manage to achieve through acquiring mature, cash generative businesses, the penny dropped. Leverage is the key!

 

The similarity between a private equity deal and residential real estate investing, is that they both use a lot of leverage to acquire a stable stream of cash flows. They then use said cash flows to pay down the debt of the business/asset, thereby, increasing the equity component of the value equation. To further explain, I will use a simple leveraged buy-out example:

  • Assume company XYZ Ltd is a mature business with highly recurring revenues and solid cash flows. Last year it generated $100m in sales, free cash flow of $20m & has no excess cash or debt on the balance sheet.
  • Now, assume that the private equity firm LBO Partners offers to buy XYZ Ltd for $120m and the founder accepts the offer. Given the mature industry and stability of cash flows, LBO Partners are able to convince their bankers to lend them $80m to finance the acquisition at an interest rate of 8% p.a. for 5 years
  • By using debt to reduce the amount of equity required to make the acquisition and by purchasing on an earnings yield (inverse of multiple paid) materially greater than the cost of their debt, the investors in LBO Partners are able to generate a 34% return on their equity:

PE ROE

A similar phenomena occurs when purchasing an investment property.

 

There is a linear relationship between the interest rate differential you acquire an asset on, and the return you generate on the equity employed. For example, if we assume an LVR of 80%, your return on equity will equal the interest rate differential (yield on asset less interest on debt) multiplied by 4 plus a constant:

Real estate ROE

To check the arithmetic and ensure the formula holds up, we can quickly perform the long form calculation. House purchase price $1,000,000, yield income at 9% equals $90,000 and interest costs on $800,000 of debt at 5% interest rate equals $40,000. Therefore:

Equity outlay: $200,000
Rental income: $90,000
Interest costs: $40,000
Net cash flow: $50,000
Return on equity: 25%

 

Therefore, when one uses leverage to purchase a stable stream of cash flows, the interest rate differential is the most important variable. If the differential is large enough, you can generate very attractive returns on equity, before considering any growth in the value of the underlying asset.

 

This exercise has highlighted to me the attraction of the private equity business model & residential property investing, assuming you can purchase the asset at a sufficient yield above what you can acquire the debt to finance it.

 

Interest rate diff

Interest diff graph

 

 

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