impact of loan rates on direct real estate investment holding period return, The

Financial Services Review, Summer 2004 by Larsen, James E

A real estate investor's total return consists of two parts: the cash flow associated with operating the property, and the cash flow associated with the eventual sale of the property (reversion value). If an investor overestimates either component his or her realized return will be less than anticipated. Compared to a higher mortgage rate, a low rate results in a lower mortgage payment that, in turn, results in increased cash flow from operation. Mortgage rates fluctuate, however, and if they increase by the time the investor is ready to sell, the reversion value is likely to decrease causing the investor's realized return to fall short of expectations. This is a very real possibility today because current interest rates arc well below historic means.

Consider an individual contemplating the purchase of a four-unit apartment building, Mythical Apartments, for $500,000. The six-year old property, located in a lower-middle income neighborhood of a Midwestern city, is appraised 90% improvements, 10% land. The investor plans to obtain a 75% loan to value, 5.5% fixed rate loan (amortized over 30 years) with a balloon payment required after five years (and in a second iteration, 10 years)4 To simplify the analysis we initially assume that rental income, all operating expenses, and property value will grow at an annual rate of 6%.5 In addition, we assume that there are no transaction costs associated with acquisition, 7% transaction costs associated with disposition, that the investor is subject to a marginal income tax rate of 40%, and that the property is purchased in January, (the first month of the investor's tax year) 2004. Based on these assumptions, an Excel spreadsheet was used to generate the statement of projected revenues, expenses, and cash flows as well as the reversion value at the end of the investor's planned five-year holding period that is shown in Table 1.

The annual net cash flows are used to calculate the investor's expected internal rate of return (IRR) of 20.95%; the IRR shown on the first line of Table 2, column 6.6 For expository expedience, we assume that this rate exactly matches the investor's required return. Therefore, the property appears to be an acceptable investment. Examination of the remainder of column 6 in Table 2 reveals that if the initial mortgage loan carried a higher interest rate this would not be the case.

To demonstrate the impact of higher initial loan rates on expected holding period return given different sets of assumptions, the spreadsheet shown in Table 1 was recalculated assuming a higher (80%) and lower (70%) LTV, as well as (10%) higher and (10%) lower assumed operating expenses. These results are also summarized in Table 2. Again, for simplicity, it was assumed that the loan rate is constant for any of the LTV ratios examined here. Therefore, it is not surprising that a comparison of the figures in columns 2, 5, and 8, or columns 3, 6, and 9, or columns 4, 7, and 10 shows that expected IRR is positively related to LTV. A comparison of the figures in columns 2, 3, and 4, or columns 5, 6, and 7, or columns 8, 9, and 10 shows the equally intuitive negative relationship between expected holding period return and the ratio of operating expenses to effective gross income. Perhaps of more interest is the magnitude of the impact of higher initial loan rates on expected IRR given different LTV ratios and the operating expense/effective gross income ratios that is shown on the last line of Table 2.