The CRE industry brings in a lot of benefits and opportunities for investors. Investing herein will require a large amount of capital which is one of the primary reasons why most transactions need to be financed through loans or borrowing.
Using the borrowed funds for investing in real estate property is known to be leveraged. The borrowing can help handle the property investment return only under certain conditions.
You must have a good idea about the current market so that you choose the right type of debt for your investment and get a good return. Remember, once you get in negative leverage, things can become complicated.
So you should manage the aspects correctly and choose the best one for your requirement. The guide here will help you understand negative leverage and associated elements, which will clear your mind and help you better understand what can happen in case of a wrong decision.
Negative leverage- What is it?
Using borrowed funds or money for investing in the CRE industry can be pretty easy as it greatly reduces the capital contribution that needs to come from the investor’s end. However, funding or getting the total purchase price from a borrowed fund comes with many risks.
The major one is the negative leverage which is the situation wherein the use of the borrowed money can significantly impact the return that the investors can earn on the overall equity capital compared to the unleveraged return.
A leverage return is an amount or the IRR that property investment can bring in without using the borrowed fund. A significant cause of the negative leverage can be the high loan cost related to the return generated from the property and the cash flow.
Evaluating if a property will result in positive or negative leverage
There has always been an argument that a preliminary assessment of the borrowing will result in negative or positive leverage. It can be carried out by comparing the mortgage constant of the loan to the unleveraged investment return.
If the mortgage constants come to be higher than the unleveraged return that is expected to be made with the use of the loan, then it will result in negative leverage. First, however, an accurate analysis of the same needs to be conducted.
It can be done by calculating the unleveraged and leveraged return based on the property’s expected quarterly or annual cash flow over the holding period. The analysis will consider the loan amount during the acquisition, the loan repayments, and the remaining loan balance payment from the proceeds of the property when the investor exits from the investment.
Once the calculation is done, it will be easier to evaluate if using a specific loan will result in positive or negative leverage.
If the leveraged IRR comes to be higher than the unleveraged IRR, then using a particular loan will result in positive leverage. Conversely, if the leveraged IRR comes to be lower than the unleveraged IRR, then it will result in negative leverage.
Risk of negative leverage
There are a lot of risks that come associated with negative leverage. It is not just restricted to the high mortgage rate. Still, also they have got the potential reductions in the net operating income and the property value over the holding period.
A significant decrease in the NOI can force the investors to use their own money to pay a portion of the total debt service. In such circumstances, there will be negative leverage which will reduce the overall return of the investor and will also result in losses.
In the worst scenario, the investor can make the debt payment which could result in the loss of equity capital and the investor’s ownership. Herein the equity capital will be the one that was used in combination with the borrowed fund for investment in the property.
It is vital to know that the risks associated with the negative leverage come to be small due to the fluctuations in the NOI of the property. This happens when the property income comes from long-term leases with trustworthy companies and credit tenants.
In such cases, laboratories’ benefits can be highly used by real state investors as long as fixed-rate financing is used. However, if there are adjustable mortgage rates, the risk of borrowing will increase significantly.
Just like the name suggests, the adjustable mortgage rate is the one that can be adjusted during the loan term based on the market interest rate.
The investors must do thorough market research to understand the current condition and know what to expect in the future. It is the key to getting a mortgage that does not lead to complications or higher interest in the future.
Example of negative leverage
To help you understand better the negative leverage, you can consider a property currently valued at $1.5 million. It comes with an expected internal rate of return of about 5.5% without any use of the borrowed fund.
The investor is now considering using a 20-year mortgage loan with a 70% loan-to-value ratio and a 5% fixed rate. So now, based on the property value, the investor will take out a loan of $1050000.
So the annual payment will come to around $84254.72, representing the mortgage constant of 8.02%. It is a lot as the payment will not only include the interest payment but will also include the principal payment.
Following the rule, the use of the loan in such cases no doubt results in negative leverage as the mortgage constant can be relatively higher than the unleveraged return the investor can expect from the property.
Understanding negative leverage and the property investment strategy
Using borrowed capital for financing CRE property, no doubt, can be pretty helpful for investors looking for double-digit returns as long as such funds can enhance the equity return of the investor.
For example, such a strategy can be pretty helpful in boosting a 10% unleveraged return to a double-digit equity return. However, there can be a case of uncertainty concerning the future net operating income of the property.
Thus the investors are advised to use the leverage to very low levels to restrict the negative leverage in any cases. The final decision concerning the borrowed fund must be made after estimating the expected leveraged return from the property conducted through a detailed analysis of the expected cash flow.
There is no such explanation that states negative leverage will mean the borrowed fund was not used for financing a specific real estate investment. It may be the cost of reduced equity return due to the negative leverage, which is still acceptable to the investor even if it comes with higher chances of default.
This happens when no other alternatives are available for financing the transaction. So the investor can go ahead and make use of the leverage to acquire the property. So it can be said that the negative leverage cannot always be bad as some investors can be willing to take that risk given the benefits they will get after the property sale.
As a general rule, negative leverage is not considered a profitable CRE investment strategy. To avoid the situation, the investors must take a close look at the cost of debt compared to the property’s capitalization rate.
In this comparison, the cap rate must represent the annual rate of return that one can expect on the purchase made through cash. So as long as the cap rate here will better than the debt cost, the property will be positively leveraged. So the investor will benefit significantly from it.
Private equity and negative leverage
The private equity firms, no doubt, are pretty careful in negotiating the debt terms, including amortization, loan amount, interest rate, etc. They do it to avoid any negative leverage scenario.
This is the specific part of the value that will be brought to a transaction. However, investors need to perform due diligence to guarantee they are comfortable with the risk associated with the specific transaction.
A wrong estimate can lead to tremendous and also other complications. It is thus vital that then investors understand the market condition before they make use of a borrowed fund for the purchase of a property.
If you are unsure about a specific investment or if you need funding, then taking a professional is no doubt will be beneficial. You can consider getting in touch with Private Capital Investors for professional support.
They have experienced professionals who will not only help you understand the market condition but also guarantee you can get a good return on your investment. The professionals will explain things in detail so that you have a better chance of getting a positive result.