Unlike regular corporations, the tax component is excluded here because REITs are not subject to corporate income tax.
There is nothing special about this formula—it simply weights the returns on debt and equity. However, what I found interesting is that through this weighting, we arrive at both positive and negative Cash-on-Cash leverage.
First, take a look at the table:
- The first section presents the assumptions.
- The second section shows how operating and capital returns are distributed between creditors and equity holders under a given leverage structure.
One key nuance: since we are talking about cash, the loan amortization portion is also considered. This means that even though the interest rate on the loan is 6%, the bank effectively takes another percentage point from operating income to cover principal repayment. However, it no longer takes anything from capital gains.
Now, if we flip the middle column of the upper table horizontally and observe how leverage changes, we can see that operating (rental) income increases with leverage. In other words, leverage increases operating cash flow—this is known as positive Cash-on-Cash leverage.
Now, let’s see what happens if the loan interest rate increases from 6% to 8%.
As you can see, in this case, increasing leverage reduces operating cash flow. This is how even a slight change in interest rates affects cash flow.
Excel File – Cash-on-Cash Leverage
Source:
Commercial Real Estate Analysis and Investments – D. M. Geltner, N. G. Miller, J. Clayton, P. Eichholtz
P.S.
For more on positive and negative leverage, check out: Positive vs. Negative Leverage in Real Estate. This article discusses overall returns (not just operating/rental income) in terms of IRR and demonstrates that there is an optimal loan interest rate at which leverage no longer affects the return on equity.