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We’ve talked a lot about debt on this site. We can’t focus on both investment real estate and personal finance without doing so.

Debt is a complex tool that can trigger many emotions. However, it’s my belief that the more we understand it, and our emotions, the better we will be prepared to use it when needed to acquire a piece of real estate.

As such, I thought we’d talk about the concept of positive and negative leverage and how the loan constant can help us understand where we are. It can be bit dry so I’ll do my best to make it interesting.

In a market of both low interest rates and low capitalization rates (the return an investor would expect), it's often critical to determine if you're really using your leverage correctly.

You Need to Be Constant

A tool you can use in comparing loans or comparing a loan to the performance of a property is called the loan constant. The loan constant, or mortgage constant, is a measure of your strength of leverage. It's calculating by dividing the annual debt service of a property by the original loan amount. The formula looks like this:

Loan Constant = Annual Debt Service ÷ Original Loan Amount

Please note a couple things:

First, annual debt service includes both principal and interest payments.

Second, the denominator (the number under the line) is the original loan amount, not the original purchase price of the property.

So, if you had a $300,000 loan at 4.25% with a 20 year amortization schedule you would have a monthly debt service payment of $1,857.70.

To calculate your loan constant you would do the following …

First, determine your annual debt service.

$1,857.70 x 12 months = $22,292.44

Next, determine the loan constant.

Loan Constant = Annual Debt Service ÷ Original Loan Amount

Loan Constant = $22,292.44 ÷ $300,000

Loan Constant = 7.431%

Simple, right?

Please note, that you can flip the formula (just like high school math, right?)

Annual Debt Service = Loan Constant x Original Loan Amount

Annual Debt Service = 7.431% x $300,000

Annual Debt Service = $22,292.44

Are You Positive That You Understand Leverage?

Now, let’s put the loan constant to some good use.

We’ve talked about Cap(italization) Rates before on the site, but it’s essentially the rate of return an investor would expect on any property. This will vary due to age, location, tenant and the current market.

Below is a breakdown of how the property and its loan compare side by side.

Our fictional property is worth $400,000 and was purchased with the following terms:

- 25% down or $100,000
- 20 year amortization schedule
- 4.25% Interest Rate

At the time of purchase, it was considered an 9% Cap.

The spread between the Cap Rate (the investor’s expected rate of return) and the loan constant (what the borrowed money costs annually) is where you determine how good the deal is.

There is “Positive Leverage” of 1.57%.

What does this mean?

You’ve put $100,000 down which means you should expect a 9% return on that equity.

However, with the 1.57% positive leverage it means you should be making a return on your loan as well.

In other words, you should be making an additional 1.57% on $300,000 or $4,707.56 (beyond your debt service).

This is how the profit breaks down between the Net Operating Income minus the annual debt service. What I'm talking about are the two most important words in real estate investing: Cash Flow.

This is a good deal and one you should consider looking into further.

However, what if this were tweaked slightly.

We’re Going Negative

Let’s imagine that our fictional property has higher than anticipated expenses. I’m not going to delve into why, that’s another article.

For now, the expenses are $25,000.

The Cap Rate (expected return) has fallen to 6.25%.

Look what that’s done to the leverage.

If we were to do this deal, we would be "negatively leveraged." In other words, due to our poor position, we’d lose money on how we borrowed funds, essentially eating away at the profits we should make on our equity.

Again, these two numbers combined represent the property's cash flow. You're just allocating where that money is coming from - your down payment and/or the leveraged funds.

This is a quick concept to run when you’re considering a potential property and a loan. It’s not the end-all-be-all answer by any means. It’s just another tool in your tool box.

Realize that if you apply this to an existing loan, it may show you in a negative leverage point as compared to the performance of your property. This is a factor of time and debt reduction.

For example, the loan payments above would continue to be $22,292 / year, but the loan amount will decrease over time.

At some point, the Loan Constant on our fictional property may look something like this...

Loan Constant = $22,292 $200,000 (after years of pay down)

Loan Constant = 11.12%

We would be in a negative leverage position even in our first example. However, a great amount of debt would have been paid down.

As I said earlier, this is just a tool. Like any tool, you don't use it for every job. You must use it selectively.

What do you think?
Have you heard of the loan constant or
used it in investment property scenario?