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Originally posted by RIArules RIArules wrote:

Look, we have pranced around this subject before, but leverage comes with its own unique set of risks, particularly for private/small business.  There is a reason that I made exactly 1 SBA guaranteed loan in the last 8 or so years in that biz - if the loan was worth making, it shouldn't require an SBA guarantee.  There were some intriguing options for lenders willing to sell off the guaranteed portions and retain service (much like selling an A share fund, but with some additional incentives from a bank leverage standpoint), but we came to the determination that it was more headache than it was worth.

Now, explain to me why you think that an SBA loan is cheap (2% plus upfront fee, prime plus 2.75% interest), and how are you going to de lever when the floating rate (which 99% of them are) is expensive?

Ok, leverage is cheap unless the interest rate is unsustainable. I'll use real estate as an example since an extreme form of leverage (and of course you used Donald Trump as your tongue in cheek remark Smile).
 
I can buy a house for say 100k. If I am allowed to buy it for 90k in borrowed funds and 10k in my own funds (and lets assume I have 100k as an option to pay cash instead). I can either buy one house or buy 10 (assuming I can maximize my leverage).
 
Even if the return I can get on Cash is LESS THAN the return I can generate with borrowed money in cash flow it's not a bad idea assuming the thing I'm buying has a greater TOTAL return.
 
Example:
 
Scenario A) Buy 10 houses, each with a 3% appreciation in value per year (stricktly inflation). Borrowing cost is 7% interest on 100k. Scenario B) Or buy 1 house with 0% borrowing cost. Assume each house rents for 1000 per month.
 
Math:
A) 10 houses = 10,000 per month cash flow = 120k per year cash flow in. Debt Service for 900k loans = 6,000k per month (30 year amortization). Cash flow from leverage 48k per year. Cash on Cash return = 48% for year 1.
 
B) 1 house = 1000 per month cash flow, 12k per year. Debt Service = 0, Cash from no leverage 12k per year. Cash on Cash return 12%.
 
Leverage increased my return by 4 fold even at a higher interest rate. The only point at which leverage in this case would be a bad idea is if my cash flow from operations decreased to the point where my cash on cash return was less than an unlevered operation.
 
So lets look at the interest rates you provided in your example.
 
Prime = 3.25%, 2% upfront, SBA rate P+3%(rounded up for simplicity). Assume again a 100k total investment needed. At 10% down (your example numbers) I'd have 10k in the business and 90k debt. Lets just say we're using a 10 year amortization (typical amort schedule).
 
Math:
90k debt service at 6.25% (10 year Am schedule) = 1012 per month or 12144. I have 12k in the transaction (2% upfront fee not rolled in and 90% LTV). Assuming the business generates at least 36k per year in revenues (which is quite low by the business plan) my IRR is still 27%. It pays to leverage up when your IRR is that much  higher than the Cost of Funds. The NPV using those calculations assuming the required discount rate of 6.25% (the cost of funds) then the NPV of 90k at these rates is 85k.
 
So, As long as the loan is over 85k using these numbers it's SOUND BUSINESS FINANCE to lever up.
 
The leverage risk just means your numbers you use has to have less wiggle room, not that the leverage itself presents more inherent challenge.
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Post Options Post Options   Thanks (0) Thanks(0)   Quote Moraen Quote  Post ReplyReply Direct Link To This Post Posted: Jan/21/2011 at 12:18pm
Holy shit LSU, you are the Ron14 of credit threads.
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No, his answer (to RIA's question about explain to me how you think X is cheap...) would have been.

FU, it just is, watch the damn game you idiot.
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I was a corporate controller/finance director in the real estate/hotel industry for years.  There was not even one single time that a piece of property was ever bought for cash.  50% leverage was about the LEAST amount of leverage I ever saw.  And I was involved in/witness to literally hundreds of deals.  Unless it is a pure spec/turnaround play, it's virtually impossible to make money (a return anywhere near compensating you for the risk or opportunity cost of your capital) in real estate without leverage.  That is the beauty of leverage, and why hard real estate generally trumps buying REITS with cash.
"If Bellicheat pulls that rabbit out of his a$$ with this kid at quarterback, I'll personally kiss his ring." - Sporsfreak, 09/20/16

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+1
Leverage is some sort of dirty word nowadays when it shouldn't be.
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Originally posted by B24 B24 wrote:

I was a corporate controller/finance director in the real estate/hotel industry for years.  There was not even one single time that a piece of property was ever bought for cash.  50% leverage was about the LEAST amount of leverage I ever saw.  And I was involved in/witness to literally hundreds of deals.  Unless it is a pure spec/turnaround play, it's virtually impossible to make money (a return anywhere near compensating you for the risk or opportunity cost of your capital) in real estate without leverage.  That is the beauty of leverage, and why hard real estate generally trumps buying REITS with cash.
Were we talking about real estate? 
We may "rob you slowly," but you're not going to see that shit.

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Originally posted by LSUAlum LSUAlum wrote:

Originally posted by RIArules RIArules wrote:

Look, we have pranced around this subject before, but leverage comes with its own unique set of risks, particularly for private/small business.  There is a reason that I made exactly 1 SBA guaranteed loan in the last 8 or so years in that biz - if the loan was worth making, it shouldn't require an SBA guarantee.  There were some intriguing options for lenders willing to sell off the guaranteed portions and retain service (much like selling an A share fund, but with some additional incentives from a bank leverage standpoint), but we came to the determination that it was more headache than it was worth.

Now, explain to me why you think that an SBA loan is cheap (2% plus upfront fee, prime plus 2.75% interest), and how are you going to de lever when the floating rate (which 99% of them are) is expensive?

Ok, leverage is cheap unless the interest rate is unsustainable. I'll use real estate as an example since an extreme form of leverage (and of course you used Donald Trump as your tongue in cheek remark Smile).
 
I can buy a house for say 100k. If I am allowed to buy it for 90k in borrowed funds and 10k in my own funds (and lets assume I have 100k as an option to pay cash instead). I can either buy one house or buy 10 (assuming I can maximize my leverage).
 
Even if the return I can get on Cash is LESS THAN the return I can generate with borrowed money in cash flow it's not a bad idea assuming the thing I'm buying has a greater TOTAL return.
 
Example:
 
Scenario A) Buy 10 houses, each with a 3% appreciation in value per year (stricktly inflation) Boy, that worked out well over the last 5 years (snort). Borrowing cost is 7% interest on 100k. Scenario B) Or buy 1 house with 0% borrowing cost. Assume each house rents for 1000 per month.
 
Math:
A) 10 houses = 10,000 per month cash flow = 120k per year cash flow in. Debt Service for 900k loans = 6,000k per month (30 year amortization).Which lender do you know of (even before the credit crisis) that was willing to amortize a rental property loan for 30 years.  15, POSSIBLY 20, but 30???  And there is a risk associated with balloons that no-one took into account, but I digress.  Cash flow from leverage 48k per year. Cash on Cash return = 48% for year 1. Until you have a combination of vacancy/delinquency of > 40%.  Then your ass is in a crack, because you plunked your entire $100K into maximizing your investment, and set aside no reserve.  And this doesn't even take into account taxes, insurance, reserves for replacement and/or repairs, which would further reduce your cash flow and coverage ratio, making your margin of error even thinner.  Are you going to manage these properties, or will you be paying for that too?   There is a reason that you can't margin rental property at 90% (or if you did, it would be completely imprudent).  If you need the numbers for a true world scenario, I will be more than happy to oblige, but it will have to wait until I have some time and access to my 12B.
 
B) 1 house = 1000 per month cash flow, 12k per year. Debt Service = 0, Cash from no leverage 12k per year. Cash on Cash return 12%.
 
Leverage increased my return by 4 fold even at a higher interest rate. The only point at which leverage in this case would be a bad idea is if my cash flow from operations decreased to the point where my cash on cash return was less than an unlevered operation.
 
So lets look at the interest rates you provided in your example.
 
Prime = 3.25%, 2% upfront, SBA rate P+3%(rounded up for simplicity). Assume again a 100k total investment needed. At 10% down (your example numbers) I'd have 10k in the business and 90k debt. Lets just say we're using a 10 year amortization (typical amort schedule).  Ha!  More like 5 years tops conventional bank debt, 7 max SBA, but lets not quibble.
 
Math:
90k debt service at 6.25% (10 year Am schedule) = 1012 per month or 12144. I have 12k in the transaction (2% upfront fee not rolled in and 90% LTV). Assuming the business generates at least 36k per year in revenues (This business has no expenses?  No problem, I'll let that slide) (which is quite low by the business plan) Which is an educated guess, as oposed to the monthly bank nut, which is set in stone.  In my experience it is just as likely that you will experience negative cash flow, at least in the first couple of years. my IRR is still 27%. It pays to leverage up when your IRR is that much  higher than the Cost of Funds. The NPV using those calculations assuming the required discount rate of 6.25% (the cost of funds) then the NPV of 90k at these rates is 85k.
 
So, As long as the loan is over 85k using these numbers it's SOUND BUSINESS FINANCE to lever up.  Unitl you hit the real world.  Say your wife leaves you for the cabana boy, or decides she doesn't want to do it anymore.  Maybe the Feds cut reimbursement for OT.  You have to remember, in this scenario, you are offsetting your loan with an essentially worthless asset.
 
The leverage risk just means your numbers you use has to have less wiggle room, not that the leverage itself presents more inherent challenge.
 
LSU, don't throw out all that textbook scenario tripe.  I think we all know the principals of IRR, cash on cash, etc (at least I think we all do LOL).  I am not against prudent leverage, but you act as if there are no risks in the real world. 
We may "rob you slowly," but you're not going to see that shit.

Edward Jones Newb, Circa September 2016
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Originally posted by RIArules RIArules wrote:

Originally posted by LSUAlum LSUAlum wrote:

Originally posted by RIArules RIArules wrote:

Look, we have pranced around this subject before, but leverage comes with its own unique set of risks, particularly for private/small business.  There is a reason that I made exactly 1 SBA guaranteed loan in the last 8 or so years in that biz - if the loan was worth making, it shouldn't require an SBA guarantee.  There were some intriguing options for lenders willing to sell off the guaranteed portions and retain service (much like selling an A share fund, but with some additional incentives from a bank leverage standpoint), but we came to the determination that it was more headache than it was worth.

Now, explain to me why you think that an SBA loan is cheap (2% plus upfront fee, prime plus 2.75% interest), and how are you going to de lever when the floating rate (which 99% of them are) is expensive?

Ok, leverage is cheap unless the interest rate is unsustainable. I'll use real estate as an example since an extreme form of leverage (and of course you used Donald Trump as your tongue in cheek remark Smile).
 
I can buy a house for say 100k. If I am allowed to buy it for 90k in borrowed funds and 10k in my own funds (and lets assume I have 100k as an option to pay cash instead). I can either buy one house or buy 10 (assuming I can maximize my leverage).
 
Even if the return I can get on Cash is LESS THAN the return I can generate with borrowed money in cash flow it's not a bad idea assuming the thing I'm buying has a greater TOTAL return.
 
Example:
 
Scenario A) Buy 10 houses, each with a 3% appreciation in value per year (stricktly inflation) Boy, that worked out well over the last 5 years (snort). Borrowing cost is 7% interest on 100k. Scenario B) Or buy 1 house with 0% borrowing cost. Assume each house rents for 1000 per month.
 
Math:
A) 10 houses = 10,000 per month cash flow = 120k per year cash flow in. Debt Service for 900k loans = 6,000k per month (30 year amortization).Which lender do you know of (even before the credit crisis) that was willing to amortize a rental property loan for 30 years.  15, POSSIBLY 20, but 30???  And there is a risk associated with balloons that no-one took into account, but I digress.  Cash flow from leverage 48k per year. Cash on Cash return = 48% for year 1. Until you have a combination of vacancy/delinquency of > 40%.  Then your ass is in a crack, because you plunked your entire $100K into maximizing your investment, and set aside no reserve.  And this doesn't even take into account taxes, insurance, reserves for replacement and/or repairs, which would further reduce your cash flow and coverage ratio, making your margin of error even thinner.  Are you going to manage these properties, or will you be paying for that too?   There is a reason that you can't margin rental property at 90% (or if you did, it would be completely imprudent).  If you need the numbers for a true world scenario, I will be more than happy to oblige, but it will have to wait until I have some time and access to my 12B.
 
I have plenty of real world numbers. I currently own 3 said rental properties in the DFW metroplex. All of them bought with 30 amortization non-owner occupied loans. BTW Fannie allowed 10 such properties and the 30 year financing still occurs on the A paper conforming loan side for Non-owner occupied. You can still, to this very day, buy rental property for 10% down and margin it up 90%. I'm not sure where you get your numbers but if you want, I'll be happy to send you some information on normal, everyday conforming Fannie/Freddie loans.
 
As for real world numbers, whether you use leverage or do not use leverage those expenses are constant. Leverage does not increase your risk. What leverage does is require your numbers to be more exact. The margin of error for you numbers decreases as you lever up. However, using your example the Leverage actually REDUCED my risk. You see, if I paid cash for the house and the house was vacant I now STILL have the risk of repairs but no cash to accomodate that. By leveraging up my asset base I've spread that risk over 10 houses instead of one.
 
B) 1 house = 1000 per month cash flow, 12k per year. Debt Service = 0, Cash from no leverage 12k per year. Cash on Cash return 12%.
 
Leverage increased my return by 4 fold even at a higher interest rate. The only point at which leverage in this case would be a bad idea is if my cash flow from operations decreased to the point where my cash on cash return was less than an unlevered operation.
 
So lets look at the interest rates you provided in your example.
 
Prime = 3.25%, 2% upfront, SBA rate P+3%(rounded up for simplicity). Assume again a 100k total investment needed. At 10% down (your example numbers) I'd have 10k in the business and 90k debt. Lets just say we're using a 10 year amortization (typical amort schedule).  Ha!  More like 5 years tops conventional bank debt, 7 max SBA, but lets not quibble.
 
The SBA will loan up to 25 years for property and up to 10 years for working capital under the 7 (a) loan program. Those are the federal guidelines.
 
http://www.sba.gov
 
Math:
90k debt service at 6.25% (10 year Am schedule) = 1012 per month or 12144. I have 12k in the transaction (2% upfront fee not rolled in and 90% LTV). Assuming the business generates at least 36k per year in revenues (This business has no expenses?  No problem, I'll let that slide) (which is quite low by the business plan) Which is an educated guess, as oposed to the monthly bank nut, which is set in stone.  In my experience it is just as likely that you will experience negative cash flow, at least in the first couple of years. Comments at end of post.my IRR is still 27%. It pays to leverage up when your IRR is that much  higher than the Cost of Funds. The NPV using those calculations assuming the required discount rate of 6.25% (the cost of funds) then the NPV of 90k at these rates is 85k.
 
So, As long as the loan is over 85k using these numbers it's SOUND BUSINESS FINANCE to lever up.  Unitl you hit the real world.  Say your wife leaves you for the cabana boy, or decides she doesn't want to do it anymore.  Maybe the Feds cut reimbursement for OT.  You have to remember, in this scenario, you are offsetting your loan with an essentially worthless asset. Comments at end/
 
The leverage risk just means your numbers you use has to have less wiggle room, not that the leverage itself presents more inherent challenge.
 
LSU, don't throw out all that textbook scenario tripe.  I think we all know the principals of IRR, cash on cash, etc (at least I think we all do LOL).  I am not against prudent leverage, but you act as if there are no risks in the real world. 
I'm not entirely sure you do know the principals of IRR and NPV. Your calculations about the business having no expenses is pretty clear that you don't understand how to calculate IRR. NPV is how much is a future set of cash flows worth in today's dollar. We aren't talking about whether the business is a good business or a bad business. We're talking about what the COSTS of financing said business are.
 
Your comments indicate you really don't know the difference between A) deciding whether to buy something and B) Deciding the best way to PAY for something once you've decided to buy it.
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Post Options Post Options   Thanks (0) Thanks(0)   Quote RIArules Quote  Post ReplyReply Direct Link To This Post Posted: Jan/21/2011 at 4:17pm
Originally posted by LSUAlum LSUAlum wrote:

Originally posted by RIArules RIArules wrote:

Originally posted by LSUAlum LSUAlum wrote:

Originally posted by RIArules RIArules wrote:

Look, we have pranced around this subject before, but leverage comes with its own unique set of risks, particularly for private/small business.  There is a reason that I made exactly 1 SBA guaranteed loan in the last 8 or so years in that biz - if the loan was worth making, it shouldn't require an SBA guarantee.  There were some intriguing options for lenders willing to sell off the guaranteed portions and retain service (much like selling an A share fund, but with some additional incentives from a bank leverage standpoint), but we came to the determination that it was more headache than it was worth.

Now, explain to me why you think that an SBA loan is cheap (2% plus upfront fee, prime plus 2.75% interest), and how are you going to de lever when the floating rate (which 99% of them are) is expensive?

Ok, leverage is cheap unless the interest rate is unsustainable. I'll use real estate as an example since an extreme form of leverage (and of course you used Donald Trump as your tongue in cheek remark Smile).
 
I can buy a house for say 100k. If I am allowed to buy it for 90k in borrowed funds and 10k in my own funds (and lets assume I have 100k as an option to pay cash instead). I can either buy one house or buy 10 (assuming I can maximize my leverage).
 
Even if the return I can get on Cash is LESS THAN the return I can generate with borrowed money in cash flow it's not a bad idea assuming the thing I'm buying has a greater TOTAL return.
 
Example:
 
Scenario A) Buy 10 houses, each with a 3% appreciation in value per year (stricktly inflation) Boy, that worked out well over the last 5 years (snort). Borrowing cost is 7% interest on 100k. Scenario B) Or buy 1 house with 0% borrowing cost. Assume each house rents for 1000 per month.
 
Math:
A) 10 houses = 10,000 per month cash flow = 120k per year cash flow in. Debt Service for 900k loans = 6,000k per month (30 year amortization).Which lender do you know of (even before the credit crisis) that was willing to amortize a rental property loan for 30 years.  15, POSSIBLY 20, but 30???  And there is a risk associated with balloons that no-one took into account, but I digress.  Cash flow from leverage 48k per year. Cash on Cash return = 48% for year 1. Until you have a combination of vacancy/delinquency of > 40%.  Then your ass is in a crack, because you plunked your entire $100K into maximizing your investment, and set aside no reserve.  And this doesn't even take into account taxes, insurance, reserves for replacement and/or repairs, which would further reduce your cash flow and coverage ratio, making your margin of error even thinner.  Are you going to manage these properties, or will you be paying for that too?   There is a reason that you can't margin rental property at 90% (or if you did, it would be completely imprudent).  If you need the numbers for a true world scenario, I will be more than happy to oblige, but it will have to wait until I have some time and access to my 12B.
 
I have plenty of real world numbers. I currently own 3 said rental properties in the DFW metroplex. All of them bought with 30 amortization non-owner occupied loans. BTW Fannie allowed 10 such properties and the 30 year financing still occurs on the A paper conforming loan side for Non-owner occupied.  Interesting, 1-4 family four-plex? You can still, to this very day, buy rental property for 10% down and margin it up 90%. I'm not sure where you get your numbers but if you want, I'll be happy to send you some information on normal, everyday conforming Fannie/Freddie loans.  I never claimed to be a mortgage broker, I used to originate/manage in-house lending programs.  I guess it is possible that Fannie/Freddie would allow up to 10 non-owner occupied homes. Although my gut tells me that there are some second-home shenanigans going on there, I will give you the benefit of the doubt and will not argue.  I do, however find it laughable that you would hold Fannie and Freddie out as the poster children of prudent lending standards.
 
As for real world numbers, whether you use leverage or do not use leverage those expenses are constant. No, they are variable.  Leverage does not increase your risk. What leverage does is require your numbers to be more exact. Whoop!!  Leverage doesn't increase risk?  All my clients are going into 3X ETF funds this afternoon.  The margin of error for you numbers decreases as you lever up. However, using your example the Leverage actually REDUCED my risk. You see, if I paid cash for the house and the house was vacant I now STILL have the risk of repairs but no cash to accomodate that. What about the cash inflow that you don't have to pay the bank?  Or in the case of a really bad problem, a home improvement loan that you would otherwise not be able to get because you have no LTV margin?  By leveraging up my asset base I've spread that risk over 10 houses instead of one.
 
B) 1 house = 1000 per month cash flow, 12k per year. Debt Service = 0, Cash from no leverage 12k per year. Cash on Cash return 12%.
 
Leverage increased my return by 4 fold even at a higher interest rate. The only point at which leverage in this case would be a bad idea is if my cash flow from operations decreased to the point where my cash on cash return was less than an unlevered operation.
 
So lets look at the interest rates you provided in your example.
 
Prime = 3.25%, 2% upfront, SBA rate P+3%(rounded up for simplicity). Assume again a 100k total investment needed. At 10% down (your example numbers) I'd have 10k in the business and 90k debt. Lets just say we're using a 10 year amortization (typical amort schedule).  Ha!  More like 5 years tops conventional bank debt, 7 max SBA, but lets not quibble.
 
The SBA will loan up to 25 years for property and up to 10 years for working capital under the 7 (a) loan program. Those are the federal guidelines.  SBA has monkeyed with their website to where the loan grid is not easy to find, but the guideline used to be 5 years tops for working capital, with a typical 7 year amortization for a WC/office equipment blend loan.  The 25 years was for real estate.
 
http://www.sba.gov   Nice Link!
 
Math:
90k debt service at 6.25% (10 year Am schedule) = 1012 per month or 12144. I have 12k in the transaction (2% upfront fee not rolled in and 90% LTV). Assuming the business generates at least 36k per year in revenues (This business has no expenses?  No problem, I'll let that slide) (which is quite low by the business plan) Which is an educated guess, as oposed to the monthly bank nut, which is set in stone.  In my experience it is just as likely that you will experience negative cash flow, at least in the first couple of years. Comments at end of post.my IRR is still 27%. It pays to leverage up when your IRR is that much  higher than the Cost of Funds. The NPV using those calculations assuming the required discount rate of 6.25% (the cost of funds) then the NPV of 90k at these rates is 85k.
 
So, As long as the loan is over 85k using these numbers it's SOUND BUSINESS FINANCE to lever up.  Unitl you hit the real world.  Say your wife leaves you for the cabana boy, or decides she doesn't want to do it anymore.  Maybe the Feds cut reimbursement for OT.  You have to remember, in this scenario, you are offsetting your loan with an essentially worthless asset. Comments at end/
 
The leverage risk just means your numbers you use has to have less wiggle room, not that the leverage itself presents more inherent challenge.
 
LSU, don't throw out all that textbook scenario tripe.  I think we all know the principals of IRR, cash on cash, etc (at least I think we all do LOL).  I am not against prudent leverage, but you act as if there are no risks in the real world. 
I'm not entirely sure you do know the principals of IRR and NPV. Your calculations about the business having no expenses is pretty clear that you don't understand how to calculate IRR.  Your proposition for a business with revenue and no expenses has me thinking you slept through finance AND accounting.  IRR is calculated off of cash flow.  I can provide a link if you need one. NPV is how much is a future set of cash flows worth in today's dollar. We aren't talking about whether the business is a good business or a bad business. We're talking about what the COSTS of financing said business are.  No, YOU are, within a narrow scope without taking anything else into account.
 
Your comments indicate you really don't know the difference between A) deciding whether to buy something Don't make me laugh and B) Deciding the best way to PAY for something once you've decided to buy it.  Sure, mathematically, as much leverage as possible can often make the most sense.  In practice, you leave yourself open to lose the asset, your entire investment, and possibly your shirt.
We may "rob you slowly," but you're not going to see that shit.

Edward Jones Newb, Circa September 2016
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Post Options Post Options   Thanks (0) Thanks(0)   Quote Guests Quote  Post ReplyReply Direct Link To This Post Posted: Jan/21/2011 at 5:11pm
Originally posted by RIArules RIArules wrote:

Originally posted by LSUAlum LSUAlum wrote:

Originally posted by RIArules RIArules wrote:

Originally posted by LSUAlum LSUAlum wrote:

Originally posted by RIArules RIArules wrote:

Look, we have pranced around this subject before, but leverage comes with its own unique set of risks, particularly for private/small business.  There is a reason that I made exactly 1 SBA guaranteed loan in the last 8 or so years in that biz - if the loan was worth making, it shouldn't require an SBA guarantee.  There were some intriguing options for lenders willing to sell off the guaranteed portions and retain service (much like selling an A share fund, but with some additional incentives from a bank leverage standpoint), but we came to the determination that it was more headache than it was worth.

Now, explain to me why you think that an SBA loan is cheap (2% plus upfront fee, prime plus 2.75% interest), and how are you going to de lever when the floating rate (which 99% of them are) is expensive?

Ok, leverage is cheap unless the interest rate is unsustainable. I'll use real estate as an example since an extreme form of leverage (and of course you used Donald Trump as your tongue in cheek remark Smile).
 
I can buy a house for say 100k. If I am allowed to buy it for 90k in borrowed funds and 10k in my own funds (and lets assume I have 100k as an option to pay cash instead). I can either buy one house or buy 10 (assuming I can maximize my leverage).
 
Even if the return I can get on Cash is LESS THAN the return I can generate with borrowed money in cash flow it's not a bad idea assuming the thing I'm buying has a greater TOTAL return.
 
Example:
 
Scenario A) Buy 10 houses, each with a 3% appreciation in value per year (stricktly inflation) Boy, that worked out well over the last 5 years (snort). Borrowing cost is 7% interest on 100k. Scenario B) Or buy 1 house with 0% borrowing cost. Assume each house rents for 1000 per month.
 
Math:
A) 10 houses = 10,000 per month cash flow = 120k per year cash flow in. Debt Service for 900k loans = 6,000k per month (30 year amortization).Which lender do you know of (even before the credit crisis) that was willing to amortize a rental property loan for 30 years.  15, POSSIBLY 20, but 30???  And there is a risk associated with balloons that no-one took into account, but I digress.  Cash flow from leverage 48k per year. Cash on Cash return = 48% for year 1. Until you have a combination of vacancy/delinquency of > 40%.  Then your ass is in a crack, because you plunked your entire $100K into maximizing your investment, and set aside no reserve.  And this doesn't even take into account taxes, insurance, reserves for replacement and/or repairs, which would further reduce your cash flow and coverage ratio, making your margin of error even thinner.  Are you going to manage these properties, or will you be paying for that too?   There is a reason that you can't margin rental property at 90% (or if you did, it would be completely imprudent).  If you need the numbers for a true world scenario, I will be more than happy to oblige, but it will have to wait until I have some time and access to my 12B.
 
I have plenty of real world numbers. I currently own 3 said rental properties in the DFW metroplex. All of them bought with 30 amortization non-owner occupied loans. BTW Fannie allowed 10 such properties and the 30 year financing still occurs on the A paper conforming loan side for Non-owner occupied.  Interesting, 1-4 family four-plex? No, SFR.You can still, to this very day, buy rental property for 10% down and margin it up 90%. I'm not sure where you get your numbers but if you want, I'll be happy to send you some information on normal, everyday conforming Fannie/Freddie loans.  I never claimed to be a mortgage broker, I used to originate/manage in-house lending programs.  I guess it is possible that Fannie/Freddie would allow up to 10 non-owner occupied homes. Although my gut tells me that there are some second-home shenanigans going on there How would non owner occupied have anything to do with second home shenanigans? Non Owner occupied is Specifically NOT for second homes, as those are considered a different risk class and owner occupied., I will give you the benefit of the doubt and will not argue.  I do, however find it laughable that you would hold Fannie and Freddie out as the poster children of prudent lending standards.
 
As for real world numbers, whether you use leverage or do not use leverage those expenses are constant. No, they are variable.By constang I mean they are independent of the financing options. A broken A/C unit has zero correlation to whether you paid cash or financed.  Leverage does not increase your risk. What leverage does is require your numbers to be more exact. Whoop!!  Leverage doesn't increase risk?  All my clients are going into 3X ETF funds this afternoon. No, leverage does not increase risk. Whether I pay cash for a business or finance the business has no bearing on if the business will have revenues or not. The risk is 100% about the certainty of your business numbers. If you overstate revenue projections your business will fail. All leverage does is require your numbers to be more precise. Leverage isn't the risk, uncertainty in your projections is the risk. And your clients buying a 3x ETF is exactly that point. The degree of certainty they have in the movement of the underlying index is what causes the risk, not the 3x OF THAT MOVEMENT.   The margin of error for you numbers decreases as you lever up. However, using your example the Leverage actually REDUCED my risk. You see, if I paid cash for the house and the house was vacant I now STILL have the risk of repairs but no cash to accomodate that. What about the cash inflow that you don't have to pay the bank?  Or in the case of a really bad problem, a home improvement loan that you would otherwise not be able to get because you have no LTV margin? So, if I paid cash for the house would I have had MORE cash to pay the bank the mortgage payment? Using up capital in lieu of leverage causes this risk to AMPLIFY. As for the Home Improvement Loan, if you leveraged up from the get go, you now can pay CASH for the home improvement. The bottom line is that the leverage reduced the risk .  By leveraging up my asset base I've spread that risk over 10 houses instead of one.
 
B) 1 house = 1000 per month cash flow, 12k per year. Debt Service = 0, Cash from no leverage 12k per year. Cash on Cash return 12%.
 
Leverage increased my return by 4 fold even at a higher interest rate. The only point at which leverage in this case would be a bad idea is if my cash flow from operations decreased to the point where my cash on cash return was less than an unlevered operation.
 
So lets look at the interest rates you provided in your example.
 
Prime = 3.25%, 2% upfront, SBA rate P+3%(rounded up for simplicity). Assume again a 100k total investment needed. At 10% down (your example numbers) I'd have 10k in the business and 90k debt. Lets just say we're using a 10 year amortization (typical amort schedule).  Ha!  More like 5 years tops conventional bank debt, 7 max SBA, but lets not quibble.
 
The SBA will loan up to 25 years for property and up to 10 years for working capital under the 7 (a) loan program. Those are the federal guidelines.  SBA has monkeyed with their website to where the loan grid is not easy to find, but the guideline used to be 5 years tops for working capital, with a typical 7 year amortization for a WC/office equipment blend loan.  The 25 years was for real estate. I know it was for real estate, hence the part where I wrote UP TO 25 YEARS FOR PROPERTY.
http://www.sba.gov   Nice Link!
 
Math:
90k debt service at 6.25% (10 year Am schedule) = 1012 per month or 12144. I have 12k in the transaction (2% upfront fee not rolled in and 90% LTV). Assuming the business generates at least 36k per year in revenues (This business has no expenses?  No problem, I'll let that slide) (which is quite low by the business plan) Which is an educated guess, as oposed to the monthly bank nut, which is set in stone.  In my experience it is just as likely that you will experience negative cash flow, at least in the first couple of years. Comments at end of post.my IRR is still 27%. It pays to leverage up when your IRR is that much  higher than the Cost of Funds. The NPV using those calculations assuming the required discount rate of 6.25% (the cost of funds) then the NPV of 90k at these rates is 85k.
 
So, As long as the loan is over 85k using these numbers it's SOUND BUSINESS FINANCE to lever up.  Unitl you hit the real world.  Say your wife leaves you for the cabana boy, or decides she doesn't want to do it anymore.  Maybe the Feds cut reimbursement for OT.  You have to remember, in this scenario, you are offsetting your loan with an essentially worthless asset. Comments at end/
 
The leverage risk just means your numbers you use has to have less wiggle room, not that the leverage itself presents more inherent challenge.
 
LSU, don't throw out all that textbook scenario tripe.  I think we all know the principals of IRR, cash on cash, etc (at least I think we all do LOL).  I am not against prudent leverage, but you act as if there are no risks in the real world. 
I'm not entirely sure you do know the principals of IRR and NPV. Your calculations about the business having no expenses is pretty clear that you don't understand how to calculate IRR.  Your proposition for a business with revenue and no expenses has me thinking you slept through finance AND accounting.  IRR is calculated off of cash flow. So you think that revenue isn't cash flow? I don't need a link, I think you need a link. Here is the definition of NPV for you "
  1. value of investment project: the value of an investment project found by adding the present value of expected future cash flows and the cost of the initial investment
 
When you break out your trusty financial calculator you'll notice the INITIAL investment is the cost to BUY the project (in this case 100k for the business) and the expected future cash flows from this investment (revenue). Maybe you're confusing NET revenue with GROSS revenue? Re-read my original post, I said revenues of 36k per year for my wife's clinic. Did you think that was GROSS of expenses ? If so, why on earth would you open a clinic with 36k in GROSS revenue per your business plan? 
I can provide a link if you need one. NPV is how much is a future set of cash flows worth in today's dollar. We aren't talking about whether the business is a good business or a bad business. We're talking about what the COSTS of financing said business are.  No, YOU are, within a narrow scope without taking anything else into account.
 
Your comments indicate you really don't know the difference between A) deciding whether to buy something Don't make me laugh and B) Deciding the best way to PAY for something once you've decided to buy it.  Sure, mathematically, as much leverage as possible can often make the most sense.  In practice, you leave yourself open to lose the asset, your entire investment, and possibly your shirt.Absolutely there is a point where leverage becomes excessive. That point is called the uncertainty in your numbers, not the leverage amount. For instance, if you were 100% certain to land on 8 black at the roulette table, there is NO AMOUNT of leverage that would increase your risk. There is NO amount of Leverage that would be excessive. It's the uncertainty in whether you land on 8 black that makes the leverage ratio relevent. It is not the leverage that increases risk.
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In order to save space here, and not expound the fight over the definition of "Revenue", "Gross Income", "Net Income" and "Cash Flow", I will lay it out as follows:

1)  You believe that a business plan can be used to project cash flow to a high degree of certainty; and
 
2)   Given that high degree of certainty you should use leverage to the degree that your IRR will exceed your cash on cash return.
 
I am done arguing this, as it has little to contribute to the board.  But.... if you ever decide to get into the loan business again, would you consider being my loan officer??  Party
We may "rob you slowly," but you're not going to see that shit.

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RIA - I will take all of that and that breakfast wrap they have.
I've met with my consultant today, and he reached the same conclusion as that FP article.  I think he just read the article and not the report himself.  Made me think why I (and by "I" I mean out of my Compliance budget) am paying him.
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BREAKFAST WRAP???  Angry

We may "rob you slowly," but you're not going to see that shit.

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Wasn't it a toquito or something like that?
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I think we need to add more colors to the text options. 
 
Leverage increases risk.  The need to be more accurate with projections is due to this increased risk.  I'm going to work now.
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Originally posted by LSUAlum LSUAlum wrote:

Originally posted by RIArules RIArules wrote:

Originally posted by LSUAlum LSUAlum wrote:

Originally posted by RIArules RIArules wrote:

Originally posted by LSUAlum LSUAlum wrote:

Originally posted by RIArules RIArules wrote:

Look, we have pranced around this subject before, but leverage comes with its own unique set of risks, particularly for private/small business.  There is a reason that I made exactly 1 SBA guaranteed loan in the last 8 or so years in that biz - if the loan was worth making, it shouldn't require an SBA guarantee.  There were some intriguing options for lenders willing to sell off the guaranteed portions and retain service (much like selling an A share fund, but with some additional incentives from a bank leverage standpoint), but we came to the determination that it was more headache than it was worth.

Now, explain to me why you think that an SBA loan is cheap (2% plus upfront fee, prime plus 2.75% interest), and how are you going to de lever when the floating rate (which 99% of them are) is expensive?

Ok, leverage is cheap unless the interest rate is unsustainable. I'll use real estate as an example since an extreme form of leverage (and of course you used Donald Trump as your tongue in cheek remark Smile).
 
I can buy a house for say 100k. If I am allowed to buy it for 90k in borrowed funds and 10k in my own funds (and lets assume I have 100k as an option to pay cash instead). I can either buy one house or buy 10 (assuming I can maximize my leverage).
 
Even if the return I can get on Cash is LESS THAN the return I can generate with borrowed money in cash flow it's not a bad idea assuming the thing I'm buying has a greater TOTAL return.
 
Example:
 
Scenario A) Buy 10 houses, each with a 3% appreciation in value per year (stricktly inflation) Boy, that worked out well over the last 5 years (snort). Borrowing cost is 7% interest on 100k. Scenario B) Or buy 1 house with 0% borrowing cost. Assume each house rents for 1000 per month.
 
Math:
A) 10 houses = 10,000 per month cash flow = 120k per year cash flow in. Debt Service for 900k loans = 6,000k per month (30 year amortization).Which lender do you know of (even before the credit crisis) that was willing to amortize a rental property loan for 30 years.  15, POSSIBLY 20, but 30???  And there is a risk associated with balloons that no-one took into account, but I digress.  Cash flow from leverage 48k per year. Cash on Cash return = 48% for year 1. Until you have a combination of vacancy/delinquency of > 40%.  Then your ass is in a crack, because you plunked your entire $100K into maximizing your investment, and set aside no reserve.  And this doesn't even take into account taxes, insurance, reserves for replacement and/or repairs, which would further reduce your cash flow and coverage ratio, making your margin of error even thinner.  Are you going to manage these properties, or will you be paying for that too?   There is a reason that you can't margin rental property at 90% (or if you did, it would be completely imprudent).  If you need the numbers for a true world scenario, I will be more than happy to oblige, but it will have to wait until I have some time and access to my 12B.
 
I have plenty of real world numbers. I currently own 3 said rental properties in the DFW metroplex. All of them bought with 30 amortization non-owner occupied loans. BTW Fannie allowed 10 such properties and the 30 year financing still occurs on the A paper conforming loan side for Non-owner occupied.  Fannie & Freddie were not formed and/or chartered for that purpose  Interesting, 1-4 family four-plex? No, SFR.You can still, to this very day, buy rental property for 10% down and margin it up 90%. I'm not sure where you get your numbers but if you want, I'll be happy to send you some information on normal, everyday conforming Fannie/Freddie loans.  I never claimed to be a mortgage broker, I used to originate/manage in-house lending programs.  I guess it is possible that Fannie/Freddie would allow up to 10 non-owner occupied homes. Although my gut tells me that there are some second-home shenanigans going on there How would non owner occupied have anything to do with second home shenanigans? Non Owner occupied is Specifically NOT for second homes, as those are considered a different risk class and owner occupied. You obviously have no clue about uncscrupulous mortgage brokers, I will give you the benefit of the doubt and will not argue.  I do, however find it laughable that you would hold Fannie and Freddie out as the poster children of prudent lending standards.
 
As for real world numbers, whether you use leverage or do not use leverage those expenses are constant. No, they are variable.By constang I mean they are independent of the financing options. A broken A/C unit has zero correlation to whether you paid cash or financed.  I would love to see your rental properties in 30 years  Leverage does not increase your risk. What leverage does is require your numbers to be more exact. Whoop!!  Leverage doesn't increase risk?  All my clients are going into 3X ETF funds this afternoon. No, leverage does not increase risk. Whether I pay cash for a business or finance the business has no bearing on if the business will have revenues or not. The risk is 100% about the certainty of your business numbers. If you overstate revenue projections your business will fail. All leverage does is require your numbers to be more precise. Leverage isn't the risk, uncertainty in your projections is the risk. And your clients buying a 3x ETF is exactly that point. The degree of certainty they have in the movement of the underlying index is what causes the risk, not the 3x OF THAT MOVEMENT.   The margin of error for you numbers decreases as you lever up. However, using your example the Leverage actually REDUCED my risk. You see, if I paid cash for the house and the house was vacant I now STILL have the risk of repairs but no cash to accomodate that. What about the cash inflow that you don't have to pay the bank?  Or in the case of a really bad problem, a home improvement loan that you would otherwise not be able to get because you have no LTV margin? So, if I paid cash for the house would I have had MORE cash to pay the bank the mortgage payment? No, there would be NO mortgage payment.  Duh....  Using up capital in lieu of leverage causes this risk to AMPLIFY. As for the Home Improvement Loan, if you leveraged up from the get go, you now can pay CASH for the home improvement. The bottom line is that the leverage reduced the risk .  By leveraging up my asset base I've spread that risk over 10 houses instead of one.
 
B) 1 house = 1000 per month cash flow, 12k per year. Debt Service = 0, Cash from no leverage 12k per year. Cash on Cash return 12%.
 
Leverage increased my return by 4 fold even at a higher interest rate. The only point at which leverage in this case would be a bad idea is if my cash flow from operations decreased to the point where my cash on cash return was less than an unlevered operation.
 
So lets look at the interest rates you provided in your example.
 
Prime = 3.25%, 2% upfront, SBA rate P+3%(rounded up for simplicity). Assume again a 100k total investment needed. At 10% down (your example numbers) I'd have 10k in the business and 90k debt. Lets just say we're using a 10 year amortization (typical amort schedule).  Ha!  More like 5 years tops conventional bank debt, 7 max SBA, but lets not quibble.
 
The SBA will loan up to 25 years for property and up to 10 years for working capital under the 7 (a) loan program. Those are the federal guidelines.  SBA has monkeyed with their website to where the loan grid is not easy to find, but the guideline used to be 5 years tops for working capital, with a typical 7 year amortization for a WC/office equipment blend loan.  The 25 years was for real estate. I know it was for real estate, hence the part where I wrote UP TO 25 YEARS FOR PROPERTY.
http://www.sba.gov   Nice Link!
 
Math:
90k debt service at 6.25% (10 year Am schedule) = 1012 per month or 12144. I have 12k in the transaction (2% upfront fee not rolled in and 90% LTV). Assuming the business generates at least 36k per year in revenues (This business has no expenses?  No problem, I'll let that slide) (which is quite low by the business plan) Which is an educated guess, as oposed to the monthly bank nut, which is set in stone.  In my experience it is just as likely that you will experience negative cash flow, at least in the first couple of years. Comments at end of post.my IRR is still 27%. It pays to leverage up when your IRR is that much  higher than the Cost of Funds. The NPV using those calculations assuming the required discount rate of 6.25% (the cost of funds) then the NPV of 90k at these rates is 85k.
 
So, As long as the loan is over 85k using these numbers it's SOUND BUSINESS FINANCE to lever up.  Unitl you hit the real world.  Say your wife leaves you for the cabana boy, or decides she doesn't want to do it anymore.  Maybe the Feds cut reimbursement for OT.  You have to remember, in this scenario, you are offsetting your loan with an essentially worthless asset. Comments at end/
 
The leverage risk just means your numbers you use has to have less wiggle room, not that the leverage itself presents more inherent challenge.
 
LSU, don't throw out all that textbook scenario tripe.  I think we all know the principals of IRR, cash on cash, etc (at least I think we all do LOL).  I am not against prudent leverage, but you act as if there are no risks in the real world. 
I'm not entirely sure you do know the principals of IRR and NPV. Your calculations about the business having no expenses is pretty clear that you don't understand how to calculate IRR.  Your proposition for a business with revenue and no expenses has me thinking you slept through finance AND accounting.  IRR is calculated off of cash flow. So you think that revenue isn't cash flow? I don't need a link, I think you need a link. Here is the definition of NPV for you "
  1. value of investment project: the value of an investment project found by adding the present value of expected future cash flows Look at these LAST TWO WORDS THAT YOU QUOTED TO REFUTE ME and the cost of the initial investment
 
When you break out your trusty financial calculator you'll notice the INITIAL investment is the cost to BUY the project (in this case 100k for the business) and the expected future cash flows from this investment (revenue). Maybe you're confusing NET revenue with GROSS revenue? Re-read my original post, I said revenues of 36k per year for my wife's clinic. Did you think that was GROSS of expenses ? If so, why on earth would you open a clinic with 36k in GROSS revenue per your business plan? 
I can provide a link if you need one. NPV is how much is a future set of cash flows worth in today's dollar. We aren't talking about whether the business is a good business or a bad business. We're talking about what the COSTS of financing said business are.  No, YOU are, within a narrow scope without taking anything else into account.
 
Your comments indicate you really don't know the difference between A) deciding whether to buy something Don't make me laugh and B) Deciding the best way to PAY for something once you've decided to buy it.  Sure, mathematically, as much leverage as possible can often make the most sense.  In practice, you leave yourself open to lose the asset, your entire investment, and possibly your shirt.Absolutely there is a point where leverage becomes excessive. That point is called the uncertainty in your numbers, not the leverage amount. For instance, if you were 100% certain to land on 8 black at the roulette table, there is NO AMOUNT of leverage that would increase your risk. There is NO amount of Leverage that would be excessive. It's the uncertainty in whether you land on 8 black that makes the leverage ratio relevent. It is not the leverage that increases risk.
 
I have a feeling this is a bad idea.  I had buried the hatchet, but I couldn't help myself. 


Edited by RIArules - Jan/28/2011 at 11:02pm
We may "rob you slowly," but you're not going to see that shit.

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We may "rob you slowly," but you're not going to see that shit.

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Post Options Post Options   Thanks (0) Thanks(0)   Quote Guests Quote  Post ReplyReply Direct Link To This Post Posted: Feb/01/2011 at 6:07pm
ROFL @ RIAs if that happens.
 
Sorry guys, but that would really suck for you.
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The consipiracy theorist in me says the Wirehouses are using this as a way to force RIA's under the same regulations as they are. This seems to play into the wirehouse hands.
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Post Options Post Options   Thanks (0) Thanks(0)   Quote Moraen Quote  Post ReplyReply Direct Link To This Post Posted: Feb/01/2011 at 6:36pm
As I said, I am on my way out of the IA business.  Who the fuck wants to deal these jacktards?
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