Investing in commercial real estate appears fairly simple at face value. After all, it involves understanding and applying relatively straightforward financial concepts: buyers, lenders, debt, capital, and interest.
However, things get more complicated when these concepts are combined with mathematical calculations, and this can be unexpectedly daunting for investors who do not regularly work with numbers.
A fundamental retail real estate calculation that is often intimidating to new investors is leverage. If you’ve heard this term before but don’t fully grasp it, you’re likely left mulling questions, such as
“What is the difference between positive and negative leverage?”
and
“Why does leverage matter to me as an investor?”
This article will explain positive and negative leverage, help you understand why the distinction is important to investors, and how to use this knowledge to make more strategic, informed investment decisions.
What is Leverage?
Within real estate, “leverage” refers to using borrowed capital to increase the potential return on an investment.
By utilizing leverage, investors can acquire more real estate than they could using only their funds. Fundamentally, leverage involves using other people’s money, generally through loans, to amplify investment returns.
Let’s use the home purchasing process as an analogy for leverage.
Picture this scenario: an individual wishes to buy a property valued at $1 million but only has $100,000 available for a down payment. To acquire the additional funds, the individual secures a loan from a bank that covers the extra $900,000 and purchases the home. Over time, as the individual pays off the mortgage, they can gradually build equity while enjoying the benefits of living in the property. The leverage in this scenario is the $900,000 borrowed from the bank to purchase the home.
Understanding Positive Leverage in Commercial Real Estate
Leverage works similarly in commercial real estate. However, the terms must be further defined, clarifying what “positive” and “negative” leverage mean.
Positive leverage occurs when a property’s capitalization rate is higher than the interest rate on the loan used to purchase it. The cap rate is calculated by dividing a property’s Net Operating Income (NOI) by its acquisition price. NOI includes rent, parking fees, amenity fees, and all other revenue generated from the property.
For example, consider a scenario where a shopping center is available for $1 million, generating an annual NOI of $100,000. The cap rate for this property would be 10% (the amount found when $1 million is divided by 100,000). If an investor finances the loan with a 7% interest rate, the deal exhibits positive leverage.
In this scenario, the property's income exceeds the cost of servicing the debt. Thanks to the favorable difference between the cap and interest rates, this positive leverage results in improved annual profits for the investor.
Positive leverage can be a useful and powerful tool for real estate investing when structured correctly and effectively. Through correctly structured positive leverage, investors can enhance their equity yields by having their borrowed funds be lower in cost than the returns the investment generates.
Positive leverage can result in consistent cash flow and increased investment returns when maintained over a significant period.
Understanding Negative Leverage in Commercial Real Estate
Conversely, negative leverage occurs when the debt from a loan has an interest rate that exceeds the investment’s cap rate. In a negative leverage situation, the unleveraged cash-on-cash return (calculated by dividing the property’s annual pre-tax cash flow by the total cash invested) is higher than the levered cash-on-cash return. Essentially, the property needs to require additional income to cover the cost of the debt.
In other words, in negative leverage situations, the lender benefits from the property’s income instead of the investor benefiting.
This poses substantial risks, as the investor may struggle to meet debt obligations, which could result in significant financial distress or property loss.
On the other hand, when properly managed, positive leverage offers substantial advantages that can propel an investor's success by enhancing returns and building equity over time.
Positive Leverage: Good, but Not Always Great
Positive leverage is a promising sign in the real estate investment industry. When the cap rate exceeds the interest rate on debt, the investment is more likely to generate positive cash flow, offering greater opportunities for increased returns.
These scenarios of positive leverage offer greater opportunities for increased returns by taking on additional debt, provided that the debt remains positively leveraged.
Two things happen as an investor repays debt: the property appreciates, and equity accumulates.
Once the loan is entirely paid off, the income from the property flows directly to the investors, further enhancing returns. Additionally, interest payments on the debt are usually tax-deductible, highlighting another financial benefit of positive leverage.
While positive leverage can be a powerful strategy, it's important to approach it with caution and awareness. This is to avoid the dangers of 'over-leveraging,' which occurs when high debt is used to buy a property or pay for improvements and renovations.
On the one hand, over-leveraging can amplify prospective returns on an investment when the property's value rises or when the rental income from tenants exceeds the cost of borrowing. On the other hand, with this increased potential for higher reward comes a higher level of danger. If the property does not increase in value and give high returns to investors, there is a higher risk of losing the property and the entirety of the investment to cover the debt.
Avoiding Negative Leverage: Due Diligence is Key
Having a positively or negatively leveraged deal should not be left up to chance. Investors should always conduct due diligence to ensure that leverage works in their favor. This is especially important to avoid negative leverage when evaluating potential real estate deals.
When doing due diligence, consider the following factors:
- Loan-to-Value Ratio (LTV): When an LTV ratio is high, a property’s debt is substantial relative to its market value. A high LTV ratio is a red flag for investors.
- Interest Rate Stability: Interest rates change. A way to mitigate the risk of fluctuating interest rates is for investors to secure fixed-rate loans. Fluctuating interest rates can turn positively leveraged deals into negatively leveraged ones, so preparing for changes in these rates is important.
- Negotiating Terms: Negotiating favorable loan terms with lenders is essential in ensuring that the interest rates provided align with the investment’s cap rate.
- Keeping NOI Consistent: To maintain positive leverage, investors should regularly seek opportunities to increase a property’s NOI (keeping the value of a property high through improvements like renovations or expansions).
While, as an investor, it might be tempting to leap into a promising deal, it is necessary to stop and evaluate whether the numbers add up or not. There can be significant risk if a deal involves negative leverage. This can quickly erode any investment’s profitability, no matter how optimistic or determined an investor is.
How Savvy Investors Utilize Their Knowledge of Leverage
Understanding the distinction between positive and negative leverage is fundamental for an accredited investor to succeed in the commercial real estate market.
Positive leverage can enhance returns while creating growth opportunities. Negative growth, on the other hand, poses significant risks that can seriously undermine an investment’s profitability.
By regularly conducting thorough due diligence and maintaining a balanced approach to leverage, investors can confidently make informed decisions aligned with their financial goals.
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