Leverage makes it possible to increase shareholders’ capital gains by financing acquisitions with capped rate bank loans. This debt is generally in the special purpose vehicle and is repaid with net rental incomes or disposal proceeds.
Leverage only works if the interest rate on the bank loan is lower than the overall profitability of the deal.
- Acquisition of a building for €30m
- Financed with €15m of capital and €15m of debt, APR of 5% paid annually
- Capital expenditures loan of €10m engaged at the beginning of the deal, APR of 5% paid annually
- Sale of the building for €50m after three years
- Total multiple = 1.25x of the initial value
- Interest on debt = 5% per annum, i.e. a total of €26.25m and a multiple of 1.05x
- Value of equity = €23.75m, i.e. a multiple of 1.58x
The interest rate being lower than the deal’s overall profitability, we have a positive leverage.
Therefore, if the deal is done only with equity, the Equity Multiple is 1.25x. If we leveraged the acquisition with 50% of debt and 100% of the capital expenditure facility, the Equity Multiple reaches 1.58x, which is more than twice more performing than what we could have done without debt.