Question

Bob buys a property with an 80% LTV interest only mortgage at an annual rate of 6%, with annual compounding and annual payments. Bob’s annual cap rate for the first year is 5%.

Which of the following is true about Bob’s Return on Equity (ROE) for the first year?

(A)         ROE is the same as it would have been if he didn’t use leverage

(B)         There is not enough information to answer this question

(C)         ROE is higher than if he didn’t use leverage

(D)         ROE is lower than if he didn’t use leverage

Answer 1

Use of leverage to buy property, would increase the ROE of the property in the first year for the owner because :

Lets assume, property is purchased for $100,000

Lets assume rental income from property to be $10,000

If the property is purchased using own money, equity will be $100,000 and ROE would be $10,000 / $100,000 = 10%

If leverage is used :

Lets assume loan has to be repaid within 20 years

LTV is 80%. Hence, $80,000 are borrowed and only $20,000 is equity.

ROE would be :

Rental income = $10,000

Less : Interest at 5% on $80,000 because 5% is cap rate = $4,000

Less : Principle amount = $2,174

Net rental income = $3,826

ROE = $3,826 / $20,000 = 19.13%

Hence, ROE increases due to leverage

Answer is (C) ROE is higher than if he didn’t use leverage