Should an investor in Commercial Income or Investment property leverage with debt to gain a higher quality property or not?
There is no set definitive answer because all investors are different. They have different concepts or risk/reward tolerance levels and conservative or gambling instincts.
How To Properly Utilize Leverage In Commercial Income Or Investment Property?
If you borrow more money from a lender to get a higher price property and a better tenant, you run the risk of losing the property. It could happen if the tenant goes bad or leaves your property. Another factor is that the economy might sink and you have to sell for a property during that period of time.
The loan you get may or may not have a non-recourse quality, where you are responsible only for what they call carve-outs. Carve-outs are mainly related to dishonest dealings by you as a borrower. If you have a recourse loan, you will be held responsible for the payment regardless of the tenant’s ability to pay.
Sometimes when interest rates are at all-time lows like today, it may benefit you to take the chance of borrowing additional dollars. You could do this if your tenant is strong enough, credit wise to do so and has increased in their rents.
If the loan is assumable with no prepayment penalty and the next owner can take over a low-interest rate loan, you may found yourself in a great position. It’s because the interest rates will rise and your loan will be lower than the norm when selling.
You always gamble when you highly leverage. That means that over 70 percent loan to value in most cases and your typical cash on cash return will shrink. This is happening because you borrow so much money at an interest rate that is not that much better than the cap rate you paid for the entire property today.
Generally speaking, 50% to 65% loan to value is typical for borrowing purposes to be safer in case of a downturn or tenant issue.
Higher leverage is applied in most cases with long-term credit leases with national tenants like Walgreens and CVS as examples. But Walgreens in most cases have no increases in their rent. So when borrowing high debt, keep in mind that when you sell the interest rates, they need to be lower. The same goes for cap rates too, in order to make a profit.
Your primary term on your lease is getting shorter and decreasing the value of the asset to the next buyer.