Underestimating the danger of debt is one of the most frequent errors investors make when analyzing a real estate equity transaction. Investors tend to concentrate on the upside of transactions, examining the stated projected internal rate of return (IRR) or equity multiple, without appropriately measuring and adjusting their return demand for the risks assumed.
But the fact is that debt significantly influences the degree of risk an investor confronts; thus, I think that every investor should grasp how to utilize weighted average cost of capital (WACC) to assess debt risk. WACC is described as the weighted average of all sources of investment financing. WACC is the cost of capital — debt and equity — and the required return on total capital to accomplish the investment’s goals.
An investor must always be informed of how the transaction will be financed, including the proportions of senior debt, junior debt, and preferred stock. Since debt is repaid first and has a first lien on the real estate collateral until it is repaid, it is the most minor hazardous investment in this equation. The equity input into the WACC calculation is an estimate based on the management team’s assumptions about the company plan, which a potential investor must obtain and analyze.
The WACC Calculation:
(Percent Debt Financing * Cost of Debt) + (percent Equity Financing * Cost of Equity) = Weighted Average Cost of Capital
Let’s utilize this method to evaluate a transaction funded with 60% debt at 5% debt cost and 40% equity at 20% equity cost. Then, we will determine what transpires when we make the same investment with the same asset-level risk and business strategy but use more debt and less equity.
Example #1:
(60 percent * 5 percent) + (40 percent * 20 percent) = WACC 3 percent + 8 percent Equals WACC 11 percent = WACC
Therefore, our venture’s overall cost of capital, including debt and equity, is 11 percent.
Let’s calculate the new cost of equity if we raise the amount of debt but maintain the current WACC of 11 percent. In this case, the price of debt would also rise since lenders usually demand a greater interest rate when they lend more significant amounts of cash due to the increased risk involved.
Keeping the WACC at 11% and the higher debt level of 80% at a debt cost of 6%, we can now calculate x, the new cost of equity, by solving for x.
Example #2:
(80 percent * 6 percent) + (20 percent * x) = 11 percent
4.8 percent + 20 percent x = 11 percent
20 percent x = 11 percent – 4.8 percent
20 percent x = 6.2 percent x = 6.2 percent / 20 percent
Our current cost of equity is 31%.
Simply increasing the proportion of debt from 60 to 80 percent raised the needed cost on equity from 20 to 31 percent. As can be seen, using more outstanding debt increases the risk associated with a private real estate opportunity and the needed rate of return to reward equity investors.
Investors should utilize the WACC method to estimate the debt risk of assets they are evaluating and avoid transactions with loan-to-value ratios beyond 75%. Do not rely only on the given returns since they are often exaggerated due to impossible assumptions. Reputable managers should be open and honest about the amount of debt employed in their transactions, but keep in mind that the operator wants to borrow finance for their project at the lowest possible cost. It is the stock investor’s responsibility to demand a reasonable return for the risks assumed.
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