Once you’ve determined the value of the commercial income property deal, you don’t necessarily depend on the amount of money you have in the bank.
As with any investment, investors can utilize many creative strategies to finance the purchase of a promising property.
Some of these strategies are fairly simple, such as using private lenders to fill in the gap. Others strategies might be more complicated. They require the combination of several methods to cover both purchase and renovation costs of the income property.
The purchase possibility of a property doesn’t guarantee that it’s a good investment.
If the interest on the borrowed funds is higher than the return on the asset, then the leverage is negative. The investors will find themselves in financial trouble. For the leverage to work, the cost of borrowing the money must be less than the expected return on the income property.
Debt vs. Equity
Obtaining finances for a property can be done through what is called debt or equity. Debt means that you borrow money from banks, private lenders, or anyone who is willing to provide the money you need.
Paying off the loan, or servicing the debt, will take a chunk out of the property’s cash flow. You’ll need to make sure that you don’t cut things close when anticipating the property’s expenses. HVAC, plumbing, or roof repairs can wipe out your cash flow if you haven’t allocated at least 1%-3% of the property’s yearly value.
You’ll also need to factor in the cost of renovating a space if a tenant leaves. Add an additional 5%-7% of the monthly gross rent for capital expenditures. Those are the improvements that add value to your income property. Putting on a new roof, updating the electrical or plumbing systems, are good examples of large expenses that if not planned for, could leave you broke.
Make sure that any debt you take leaves you with at least a 1.1 ratio of free cash flow left after you take care of all of the expenses.
If you purchase a property that is expected not to have a cash flow, then it would be wise to structure the financing. The lack of cash flow might happen if you purchase raw land or an income property that has high vacant vacancies.
You have to pay as little as possible upfront before cash flow starts coming in. It might mean deferring interest and tax payments or using a construction or renovation loan to cover costs.
Equity financing, on the other hand, allows you to minimize the loss of cash flow. But it requires you to “pay back” the loan by giving a percentage of the profits. There is a number of ways to structure equity financing. It depends on the type of investment and the equity financier’s preferences.
Equity can also take the form of capital gains or a combination of income and capital gains. Equity financing allows investors to purchase higher-priced properties with a comparatively smaller amount of money down. It’s one excellent method of using other people’s money to gain profits.
Determining Rate of Return When Combining Different Types Of Financing
As you gain more experience with obtaining financing for, you’ll want to start combining various types of financing when purchasing a property.
For example, you might decide to use debt financing to help you pay the down payment for the income property. And you might use a standard bank mortgage to cover the rest. Equity improvements might require another lender while an equity financing might ccover capital improvements.
It can be complicated figuring out what the rate of return for the property is when each source of financing uses different interest rates. That is why you’ll need to determine the WACC or weighted average cost of capital.
This figure involves figuring out the weight of each piece of debt or equity and then multiplying that number by its cost.
Here’s the formula:
Weighted average cost of capital (WACC) = (cost of debt × proportion of debt) + (cost of equity ×proportion of equity).
In more specific terms, the formula looks like this:
In this case, bonds (B) is the debt, securities (S) is the equity
R subscript B is the interest, and R subscript S is the rate of return.
You can also watch this video to help you understand WACC in detail.
The WACC is useful for both large and small investments. It will also help you determine the best way to structure finances so you can achieve an optimal ROI.