Wealth Opportunities in Commercial Real Estate: Management, Financing, and Marketing of Investment Properties

Leveraged Return and Return on Equity

In our example, because NOI is computed before debt service is taken out (that is, before the income stream is reduced by any loan payments), the Cap Rate is an unleveraged yield. It is as if the property is being purchased for all cash. This is also called a free and clear return.

A leveraged return factors in debt. If you are buying the subject property at a 9 percent Cap Rate and can borrow at a rate below this figure, in essence you are replacing part of the equity with debt and will increase your yield on equity due to this positive leverage factor.

Typically, when buying a commercial property, the buyer will fund 20 to 25 percent of the purchase price as his down payment. This ratio is called the down payment ratio.

The companion ratio to the Down Payment Ratio is the Loan-to-Value Ratio (LTV). If the Down Payment Ratio is 25 percent, then the Loan-to-Value Ratio would be 75 percent. The logic is that either the project's funding will come from the owner's own resources or that he will borrow the funds. The Loan-to-Value ratio expressed as a percentage would be the following:

To continue our example, let us assume that Diamond Jack (hereafter known as DJ) is purchasing the project, Diamond Medical Center, for $10,200,000 with a close ...