Blog rate

BLOG: Is negative leverage an indicator of what lies ahead?

The Federal Reserve made news at the June meeting when it raised the federal funds rate by 75 basis points – the biggest rate increase in nearly 30 years. These rapidly rising rates, coupled with historically low cap rates, are driving a commercial real estate (CRE) phenomenon we haven’t seen in quite a while: negative leverage.

A successful CRE investment requires positive cash flow. But more than just positive cash flow, investors focus on their cash return (or return on the investor’s equity). Negative leverage impacts cash returns, which erodes the profitability and viability of investments if property cash flows are lower than mortgage payments. When we are in a period of negative leverage, it usually portends a correction in the CRE market, capital markets…or both.

What is negative leverage?

Negative leverage occurs when borrowing costs exceed the return realized from a property’s cash flow. Adding debt causes the leveraged return to be lower than the unleveraged return. With positive leverage, the capitalization rate is higher than the cost of debt, which results in a return on equity (ROE) that is higher than the capitalization rate.

In today’s CRE market, negative leverage occurs more often than at any time in recent memory. Along with rising interest rates, the 10-year Treasury note is currently hovering around 3%, nearly twice as high as it was just six months ago.

This rapid rate change took many real estate investors today by surprise. Contracts signed to buy property at a cap rate of 3.5% a few months ago are now financed at 5% or more, which has significantly reduced the potential ROE for investors.

The effects of negative leverage

The following example illustrates the potential effects of negative leverage on a CRE investment:

Suppose an apartment building is purchased for $25 million. Net operating income is $1 million and the cap rate is 4%. If the building is financed with a permanent loan at 68%, or $17.2 million, with an interest rate of 4.6% (interest only), the annual mortgage payment would be $791,000 and the cost of capital would be 4.6% ($791,000/$17,200,000) .

Since the capitalization rate (4%) is lower than the cost of capital (4.6%), the cash return would only be 2.7% (net operating income of $1 million less $791,000 $ = $209,000/$7,800,000 equity = 2.70%. This is negative leverage.

The importance of leveraging equity

Achieving a high cash-on-cash return, or leveraging equity, is one of the main financial incentives to invest in CRE. In fact, this is the main attraction of CRE investing – no other type of investment offers this.

Let’s look at our example in a positive leverage environment. If the interest rate were 3.5% and the capitalization rate 4%, as it was a few months ago, the investment would have a positive leverage effect since the capitalization rate is higher than the borrowing costs. The cash-on-cash return would be 5.1%, the return investors would receive in the first year, compared to just 2.7% with negative leverage.

Appetite remains for CRE — despite negative leverage

So why do investors continue to invest in CRE when there is negative leverage? Well, there are many reasons, but the ones described here are some of the most common. Some investors have raised capital in a fund or private placement and need to allocate it. Other investors think they can increase rental prices enough to create positive leverage in the future. While some are finding value-added opportunities outside of rent-controlled asset classes and others are looking to CRE as a hedge against inflation, even with concerns about negative leverage.

But what if rents don’t rise enough, interest rates continue to rise, supply is still tight, and cap rates remain compressed? In this case, CRE investors may have to temper their ROE expectations.

In the near term, the bigger question is whether the Fed continues to raise interest rates, perhaps to more than 3%, as Chairman Powell has suggested. We are entering a very interesting period with the volatility of the financial markets impacting the high street.

Adam Mortanian is the co-founder and managing director of PACT Capital, a leading commercial real estate capital advisory firm and correspondent for Life Company with offices in Los Angeles and Fresno. As a relationship-focused real estate lender, PACT Capital advises clients on construction loans, freeing up cash, improving cash flow, and managing short and long-term liabilities to optimize real estate holdings. .

To learn more about PACT Capital, visit PACT Capital online or call (213) 799-7228 in Los Angeles or (559) 775-7228 in Fresno.