When Not To Use Leverage In Commercial Real Estate

Oct 13, 2016

It’s a common saying among commercial real estate investors that leverage is the best way to improve a property. It’s because you are able to yield while freeing up cash for other investments. This is true in some cases, but sometimes, income property owners assume that the more leverage they can get, the better.

The idea is the cash that is not dropped into an investment can be spread out to purchase several other properties instead. It will leave the investor with a larger portfolio and a higher overall return.

However, assuming that leverage is always good and failing to run the numbers can cause a situation where the property loses money.

In the article below, you’ll learn how to calculate leverage, what positive leverage is, how much debt is too much debt, and how to ensure you don’t end up on the losing end of a bad deal.

What Is Positive Leverage?

Leverage is the process of taking on debt, either through a mortgage through private lenders, in order to pay a portion of the purchase cost of a commercial property. If the rate of return increases when debt is placed on the property, its called positive leverage. It’s the cost of borrowing the money is less than the return on the property.

The chart below shows two scenarios. The first one is where the property’s paid cash and the second is the property’s placed debt, as a result of positive leverage.

Positive Leverage All Cash
Cost of Property $2,500,000 $2,500,000
Loan Amount (I/O 5.5%) $1,500,000 none
Net Operating Income $175,000 $175,000
Debt Service $82,500 none
Cash Flow $92,500 $175,000
Cash on Cash $92.5K/$1M= 9.25% $175K/$2.5M=

7%

Arbitrage 2.25%

What Is Negative Leverage?

In negative leverage, the cash on cash return is less in the leveraged situation than in the all-cash situation. This occurs when the interest on the loan is higher than the property’s returns.

disadvantages of leverage in cre

For example, in the case above, there is positive leverage when the interest rate is at 5.5%. But the situation changes drastically when the interest is just one and a half percent higher.

Negative Leverage All Cash
Cost of Property $2,500,000 $2,500,000
Loan Amount (I/O 8%) $1,500,000 none
Net Operating Income $175,000 $175,000
Debt Service $120,000 none
Cash Flow $55,000 $175,000
Cash on Cash $55K/$1M= % $175K/$2.5M=

7%

Arbitrage – 5.5%

The case above now becomes a situation of negative leverage, with a significant loss incurred.

How Can You Avoid Negative Leverage?

It’s tempting to consider one factor when deciding whether or not to use leverage. However, in the same way, that the value of an investment property is more than it’s CAP rate, there is more than one number to consider to avoid negative leverage.

The CAP rate should be higher than what is termed the ECD, or the Effective Cost of Debt. The Effective Cost of Debt takes into account costs in addition to the interest rate, namely loan points, and prepayment penalties. This gives you the actual cost you’ll need to pay when taking on extra debt.

Thus, ECD = interest rate + loan points + prepayment penalty.

Prepayment penalties, which typically occur before year ten of a loan, can create a significant impact on the ECD. So if you plan on selling the property before that, you’ll want to take this into account.

The other points to consider even in a positive leverage situation, are the higher mortgage payments you’ll be forced to make. This could become a problem if you need to do major repairs. Or if the market turns and the property suffers from lower vacancy rates.

Also, don’t be tempted to overpay for a property because you’ll be rolling the extra money into a loan. It will wreak havoc with your projected income since appreciation will actually be much less than it should be.

Even if appreciation has been high in the past, there is no guarantee that those rates will continue: you might be forced to carry a loss if the market is weak or the property or ends up needing significant renovations to achieve maximum value.

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