Money for Nothing

Alec J. Pacella, CCIM

Last month, I received the usual stack of junk associated with the daily mail. As I sifted through the catalogs, coupons and waterproofing promotions, I came across an offer from a credit card company. This popular company, no names please, was offering a cash advance at 0% interest for 12 months. Offers such as this have become more common in the wake of rising interest rates and I’m sure that some jump all over this offer for “free money.” So long as everything is paid back within 12 months, this seems too good to be true.

Many think that the hook is that, in the event you don’t pay the full amount back, the associated interest rate jumps to 29%. And I’m sure that some customers fall victim to this. But even if the money is fully paid back within 12 months, the credit card company is still gaining an advantage. Let’s use a quick example.

Suppose that I decide to accept this offer and receive a $10,000 cash advance. And over the next 12 months, I pay this back by sending $833.33 each month. But here is the real hook; the fine print says that in order to get that $10,000, I am assessed a “transfer fee” equal to 4%. Yes, I received $10,000 but it costs me $400, so the net is $9,600. But the repayment has to be based on $10,000 or I get slammed with a 29% rate. If I load this into a financial calculator with ($9,600) as PV, $833.33 as PMT, 12 as N and solve for I/YR, I get the answer. This “free money” is really costing me 7.6%.

In the business world, we call this calculation the borrower’s cost of funds. It’s an important number to understand, for a couple of reasons. One is the concept of leverage. There are three types of leverage: positive, neutral and negative. The most accurate way to determine the type of leverage is to compare the free and clear yield (also known as the unleveraged internal rate of return) to the cost of funds. Extending the example above, the cost of funds for receiving that $10,000 is not zero but 7.6%. If I’m using this to help acquire an investment that has a free and clear yield greater than 7.6%, I will have positive leverage. This will ultimately be a good thing, as my leveraged return (the return being generated specifically on my equity) will be enhanced and exceed the associated yield of buying it with all cash. But if I’m using it to acquire an investment that has an unleveraged IRR less than 7.6%, I will have negative leverage. This is not a good thing, as my leveraged return will be hampered and lower than the yield if I were to buy it with all cash.

There are three types of leverage: positive, neutral and negative. The most accurate way to determine the type of leverage is to compare the free and clear yield(also known as the unleveraged internal rate of return) to the cost of funds.

But there is another reason to understand the cost of borrowed funds. And while less obvious, it’s even more important. Suppose that I’m looking at an investment that costs $1 million. It is expected to produce $80,000 of NOI annually and I plan to sell it after five years for $1 million. Even I can eyeball this one to determine the free and clear yield (unleveraged IRR) is 8%. Let’s assume that I can get a loan equal to 75% of the property’s value, or $750,000, with a 7% inter- est rate, 23-year amortization and loan costs of 3%. Using a financial calculator, the associated payment would be $5,474.39 per month or $65,692.68 per year. So far, so good; the property is producing more than enough income to support the debt. It looks like there is positive leverage but to be sure, I’ll compare the free and clear yield to the cost of funds. This is a three-step process. The first step is to determine the monthly payment at the stated terms and conditions, which was done prior. The second step is to determine the outstanding balance when the loan is retired at the end of the fifth year as a result of the property being sold. I again call on my financial calculator, which tells me a loan balance of $671,291. The third step is to reduce the loan amount to reflect the loan costs. Just like that credit card offer, I’m getting a $750,000 loan but it costs 3% or $22,500. The net result is $727,500. I call on my financial calculator one more time and enter $727,500 in PV, ($671,291) in FV, ($5,442.65) in PMT, 60 in N and, solving for I/YR, discover that this loan is really costing me 7.76%. Not great but I still have a bit of positive leverage, which will increase the leveraged IRR to 8.85%.

Here is the “but.” Assuming I have enough money to buy this property free and clear ($1 million) and I make my decision to use debt solely on the leverage position, I may be winning the battle while losing the war. What I also need to consider, which is ultimately even more important, is my reinvestment rate. Suppose that I have a secondary investment that I believe will achieve a 5% annual yield over the next five years. If I buy the property for cash and then reinvest the $80,000 of cash flows produced each year in this secondary investment at 5%, I will have a total pile of cash at the end of the fifth year of $1,442,051; $1 million from the sale plus $442,051 as a result of the $80,000 cash flows each year being reinvested at 5%. Let’s compare that to a scenario of using leverage. The $272,500 initially invested ($250,000 of equity plus $22,500 of loan costs) will ultimately produce $407,764. Again, this assumes that the annual cash flows after debt service ($80,000 less $65,693) are reinvested at 5%.

But we also need to consider the bulk of the cash; I have $1 million, of which $272,500 is going in the deal. And the $727,500 that I still have, as a result of getting the loan, is invested in the secondary investment at 5%. Over five years, this will grow to $928,495. My total pile of cash, the money from the real estate plus money from the secondary investment, will be $1,336,259. This is over $100,000 less than if I were to buy the property without financing. Let that sink in a minute. Even though the property easily covers the debt service and has positive leverage, I would be better off buying the property without financing, as it will produce a larger pile of cash at the end of the five-year holding period. The key is the cost of funds as compared to the available reinvestment rate. In my example, I would be borrowing at 7.76% to free up cash that is then invested at 5%.

The offer for free money from the credit card company ended up in the same place as all the rest of the junk that day. At least I didn’t get any offers to install microwave ovens or custom
kitchen deliveries.

From November 2023 Properties Magazine.