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Why Loan Constant Determines Positive Leverage in Real Estate

Article Quant Q&A · Author: djc225
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Summary

This exchange examines why borrowing below a property’s capitalization rate may still reduce first-year cash-on-cash return. The key distinction is between the debt interest rate and the loan constant, which measures annual debt service relative to the loan amount. Debt service includes principal repayment as well as interest, so amortization can make the loan’s annual cash cost exceed its stated interest rate.

In the example, a property has a 6.99% cap rate and is financed with 80% debt at 5.75%. The answer calculates a 7.55% loan constant for the 30-year loan and concludes that annual debt service is dilutive to the property yield; the 25-year mortgage is more dilutive. The comparison concerns first-year cash flow and excludes NOI growth. It illustrates the mechanism, but does not provide a broader return analysis that includes appreciation, taxes, refinancing, or later principal reduction.

Key ideas

  • A debt interest rate below the property cap rate does not by itself ensure positive first-year cash-on-cash leverage.
  • The loan constant captures annual debt service relative to the amount borrowed.
  • Principal amortization makes annual debt service larger than the interest expense alone.
  • In the stated example, the 30-year loan constant exceeds the property cap rate, diluting first-year yield.
  • The example excludes NOI growth and does not assess broader holding-period returns.

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Risk managementPosition sizing
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# positive financial leverage in real estate


# positive financial leverage in real estate












I had the understanding that leverage always helped improve cash on cash returns so long as the interest paid was less than the unlevered rate of return/cap rate. doing a quick back of the envelope calculation in excel on first year returns seems to suggest otherwise.

my quick calculations show that there is a spread required from interest rate to cap rate in order to achieve positive first year leverage. It also shows that as amortization tightens the necessary spread increases.

I'm only considering year one one returns with and without leverage, so not taking into account any NOI growth

is my analysis correct here? what am I missing?

my example:

purchase: $7,100,000 cap rate/ unlevered return: 6.99% cash flow: 496,310

if using 80% leverage 30 year debt at 5.75%: payment: 397,763 cash flow: 98,547 cash on cash: 6.94%

if using 80% leverage 25 year debt at 5.75% payment: 428,799 cash flow: 67,511 cash on cash: 4.75%

in both of the examples above I'm using debt that is less expensive than the unlevered return that I'm getting, so why does year one cash on cash suffer?

## Answer by jake_r (score 1)

https://quant.stackexchange.com/a/28126

Alex's post hits the main point: leverage amplifies returns (either positive or negative). In this case, it is not interest rate but loan constant that we should be focusing on. For a \$5.68MM loan (80% of \$7.1MM), the loan constant is 7.55%.

In excel, I used the function: $$PMT(5.75\%/12,30\times12,5680000)\times12$$ to come up with annual debt service of \$496,290 which gives a loan constant of 7.55%.

Thus the annual debt service is dilutive to the yield of 6.99% (and even moreso for the 25-year mortgage).

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.