Negative leverage is a situation where additional debt in a real estate transaction results in reduced levered returns compared to unleveraged returns. It typically occurs when the cost of borrowing surpasses the return generated by the asset. Using negative leverage not only diminishes overall returns but also increases the risk and narrows the scope for operational flexibility.
The concept of leveraging debt to buy commercial real estate assets generally enjoys a positive reputation for its potential to enhance returns. However, there are instances where increased debt can backfire, causing the investment returns to slide. This is called “negative leverage.”
In this blog, we shed light on what negative leverage is, why it happens, and how it can influence the ROI on a commercial real estate investment.
Negative leverage occurs when an investment return actually diminishes upon taking on more debt. This is generally the result of the debt's interest rate being higher than the return generated by the investment's cash flows.
The key difference between positive and negative leverage is straightforward:Positive leverage means that the asset is generating returns higher than thecost of borrowing, thus enhancing the overall returns.
In contrast, negative leverage occurs when the cost of debt exceeds the returns on the asset, thus reducing the cash-on-cash return and putting pressure on the investment.
To better grasp the concept of negative leverage, it’s important to familiarize oneself with the terms "levered" and "unlevered" in the context of cash-on-cash returns.
These terms offer two different perspectives on an investment's performance, and each comes with its own set of implications for how you manage your investment strategy.
-> A levered return paints a picture of an investment's annual profitability after accounting for the cost of borrowing or debt service. This is the more "real-world" scenario for many investors who use financing options to purchase commercial real estate.
In calculating the levered return, you would take into account the net operating income (NOI), the annual debt repayments, and any other associated costs of maintaining the loan.
For example, let's assume you buy a property for $1 million, with a down payment of $200,000 and a loan of $800,000 at an interest rate of 5%. Your annual debt service could be around $50,000.
If the property has an NOI of $100,000, the cash flow after debt service would be $50,000. With a down payment of $200,000,the cash-on-cash return would be 25%.
-> The unlevered return, on the other hand, gives you an idea of the annual returns you could expect if you purchased a property entirely with cash.
In this case, the calculation for cash-on-cash return becomes simpler as there are no loan repayments to consider. The unlevered return would be solely based on the property's NOI divided by the purchase price.
Continuing with the previous example, if you had bought the $1 million property outright with cash, and it generated an NOI of $100,000, the unlevered cash-on-cash return would be 10%. This represents a no-debt scenario where all the earnings are directly proportional to the capital invested.
Both levered and unlevered returns are important metrics for commercial real estate investments for several reasons.
-> Understanding the unlevered return helps you evaluate the underlying performance of the property irrespective of the financing structure. It essentially answers the question: Is the property itself a good investment?
-> The levered return, meanwhile, is crucial for understanding how debt impacts your overall returns and how effectively you are using leverage.
If the levered return is significantly higher than the unlevered return, it signifies that the debt is working in your favor, providing what is commonly known as "positive leverage."
On the other hand, if the levered return is less than the unlevered return, the situation is one of "negative leverage," where the cost of borrowing is eroding your returns. In such a case, you would need to reconsider the financing structure or even the viability of the property as an investment.
Havinga good grasp of the concepts of levered and unlevered returns allows you toassess an investment from multiple angles.
The unlevered return offers insight into the quality of the property as an investment in its own right, while the levered return shows you how your financing decisions impact your overall profitability. Being adept at calculating and interpreting both can be a significant asset in your real estate investment toolkit.
To illustrate, let’s consider a simplified example.
The unlevered row in the table below shows a property bought with $3 million in cash. In the levered row, the same property is acquired with $1 million in cash and a $2 million loan.
But what happens when the interest rate goes up? Let’s consider the same property, but this time with an interest rate of 8%:
As you can see, the CoC return drops from 8.00% to 6.50%, signifying negative leverage.
To avoid negative leverage, it's crucial to look at the property's capitalization rate. This percentage shows the estimated annual return on a property, assuming no debt.
If this rate is higher than the interest rate on your loan, your investment will likely be positively leveraged. On the flip side, if the cap rate is lower thanthe loan's interest rate, you're heading into negative leverage territory.
Related blog: What is capitalization rate?
Keeping an eye on the LTV ratio is an effective way to ensure you're not slipping into a negative leverage scenario. Lenders usually have an upper limit on the LTV ratio they're willing to offer, often around 80%. The LTV ratio can serve as an indirect indicator of the risk level of your investment.
Note that a high LTV isn't inherently bad. It only becomes a concern when paired with a low capitalization rate. If your capitalization rate is significantly higher than the loan interest rate, a higher LTV could still result in positive leverage.
On the other hand, if your capitalization rate is close to or lower than the loan interest rate, a high LTV could plunge you into negative leverage.
Understandinghow the LTV ratio interacts with other factors like property size, location,market conditions, and tenant profile can help you determine the risk level andwhether your asset is positively or negatively leveraged. This insight allowsyou to make informed decisions on the amount of debt that is prudent for yourinvestment.
The prevailing wisdom is that more debt usually equals better returns. However, if an asset is negatively leveraged, this belief doesn't hold water. This simplistic paradigm and can be perilous in the real world of fluctuating interest rates, variable property performance, and economic downturns.
In such cases, each added dollar of debt exacerbates the negative leverage situation. Adding more debt to an asset that is negatively leveraged will only deteriorate the returns further and can increase the risk profile of the investment to an uncomfortable level.
In reality, more debt is advantageous only when it brings positive leverage to the table. This nuanced approach takes into account the importance of the cost of borrowing and compares it directly to the return the asset is generating.
If the return exceeds the cost of borrowing, then leveraging makes sense; if not, each added dollar of debt is essentially eating into the profitability of the investment.
Using borrowed funds can magnify your returns, but it can also heighten your risks. The key to using debt wisely is understanding how to achieve positive leverage.
Investorsshould always undertake their own due diligence to understand all the risks involved. Look at the property's cap rate, compare it to the commercial investment property loan interest rate, and assess any other variables that could impact the property's income or your loan repayments.
This allows you to be confident in your investment and ensures that you're aware of the risks you're taking on.
It’s also important for investors to be agile and willing to adapt their strategies. If you find that an asset is negatively leveraged, it may be wise to consider de-leveraging by either negotiating for a lower interest rate, selling the property, or paying down the principal to improve the loan-to-value ratio.
Taking proactive steps to address negative leverage situations can make a significant difference in the long-term success of your investment portfolio.
