Property Finance - Equity versus Loans

The proportion of equity finance versus loan funds has a big bearing on the return on the investors contribution.

We have covered topics in Step 8 (see "RESEARCH STEPS" button) relating to property funding strategies, negative gearing, and types of property loans, together with funding sources.

This page (except for a quick link to borrowing sources and rates below) deals with how to maximise returns on equity contributed, by optimising the gearing ratio.

Click here to quickly view finance sources and rates

Firstly we will review some of the measures of returns referred to in property investment terminology.

Return on Equity

This refers to the return on the equity finance contributed. As this is all the investor outlays it is the most important measure for that particular investor. This is not necessarily the same as the “capitalisation rate” or “initial yield” which is a multiplier used for valuation purposes assuming nil borrowings. (All valuations & yields quoted are done on an unencumbered basis i.e. no debt, and therefore no interest included in the expenses.)

This is the only uniform method of measurement, as it is obviously not practical to assume a set loan amount.

However in reality this is rarely the case. Therefore it is better to look at what the return is on the investors outlay. In other words, how much equity finance the investor outlays, and what is the return on that amount.

This also can be annualised, to compare it with all other returns which are normally quoted on an annual basis. This is relatively simple if one is outlaying only one sum at the beginning & getting one sum at the end, and can be done quickly with a financial calculator, by inputting the outlay, the return, the term of the investment, and then finding out the rate of return on an annual basis.

With property it is usual to allow for irregular outlays & returns and incorporate an allowance for time discounting and the measure quoted is the “Internal rate of Return” (IRR). This can be reviewed via a lengthy but simple explanation, which is set out at the end of the Glossary page on this site.

This measure of return on equity will vary depending on the timing and amount of equity injected.

Whether you understand it or not, it is the best & most common method of comparing one property against another, or in this case one finance option against another.

CHOOSING THE BEST FINANCE OPTION TO OPTIMISE THE RETURN ON EQUITY

Obviously different lending ratios and interest rates etc will alter the return to the investor, regardless of what the capitalisation rate or initial yield is.

The extent to which this occurs is not always obvious and depends on a number of things. Fortunately with good software applications this can be tested, adopting varying scenarios.

If one looks at the various sensitivity tables in a feasibility study, it is obvious that the gearing etc. is a very important factor. Principal and Interest loans are less tax effective because of the component of principal which is not tax deductable.

Let us look at some examples below. We have used an interest only loan.

An industrial shed selling for $700,000 and retained for 10 Years, borrowing funds at the rates shown could show the following.

The point that we make here is that a common equity contribution of 40% to 50% shows a return on investors funds of around 13%. This is much higher than the "yield" or "return" or "cap rate" or "initial yield" often quoted.

This increases (as shown above) as gearing increases. This is a key factor used by property investment "spruikers" at seminar presentations along with an infusion of "capital gain". These factors need to be very carefully considered.

The technical explanation regarding the dip before recovery and the lack of a straight trend line in the return on equity graph is quite detailed as far as the non professional investor is concerned, and we will not attempt the explanation here.