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The Danger Of Over-Leveraging In Commercial Real Estate

Using leverage to acquire properties is a well-known tactic in commercial real estate.

On the most basic level, leverage is the use of borrowed funds in order to purchase property, with the intent of getting a higher return on the purchased property. Often, first-time investors use LEVERAGE as a way of getting started in commercial real estate, since they typically don’t have much money.

over-leveraging

Leveraging is also used by experienced investors in order to PURCHASE a property whose price point would normally be out of their league. In this case, the goal of the investor is to use as little money as possible on the initial investment, while getting a higher return for their money, and allowing them to use the money that would have been spent on a down payment in order to buy other properties.

When leverage works, it can substantially boost an investor’s returns, allowing them to gain equity faster, which they can turn around at a later point to invest in other properties.

Here’s an example:

Jim and Denise are both planning on buying a commercial income property.

Jim puts 60% down on a commercial real estate investment property, at 7% interest for the money he borrows. His yield was 4% during the 11 years he owned it.

Denise puts 25% down on a similar commercial property, borrowing the rest of the purchase price. Her interest is 10%, and her investment yielded 13% during the 11 years she owned it.

When you look at the above example, you see that Denise used positive leverage in order to increase her returns: not only does she end up with a higher yield, but if she is scrupulous about paying down her principal, she’ll be able to pay off the loan, and will then be able to turn around and purchase more commercial property – all with a much higher ROI than Jim.

However, there is a downside to leverage, and it’s one that investors don’t always anticipate.

The downside is called negative leverage, and occurs whenever the return component in the property is lower than the interest rate on the debt. Property values go up and down, and a significant change in property values can have a serious affect on your real estate investment property. When the values go down, or when interest rates change, the amount of equity on the property goes down, leaving the owner at the end of the loan on a property with little to no equity.

Since loans for commercial properties are typically only about 3-5 years, owners don’t have much time to pay down the principal unless they are meticulous about investing all returns back into the loan. If they aren’t, the lack of equity on the property will force them to refinance the loan at higher interest rates – leaving them with a property that is costing them money to hold.

All of these calculations exclude surprise expenses, vacancies, and other unexpected factors that can impact on the PROFITABILITY of a commercial income property.

So how do you know when it’s a good idea to use leverage to increase your returns?

Here are some suggestions:

  1. Never base a property’s expected returns on “ifs.” Instead, use the historical performance of the property as a guideline, and then consider the worst-case scenario. Could you handle it if the property performed 20% lower than it is now?
  2. Make a plan for paying down the principal, and put it into action. For example, decide how much you can pay down per month, and have that amount automatically deducted from your monthly net income, and transferred to your loan holder.
  3. Always keep an eye on your long-term investment plan. Knowing where you want to be in 10 years will help you decide if a leveraging a particular property will help you get to where you want to be.Remember, it’s not just this property’s returns you need to look at: you also need to consider exactly how you’ll use those returns to purchase your next property.

Leverage is a tool that the commercial real estate investor has available. Like any tool, results will depend on the skills and experience of those who wield it.

Ever used leveraging and had it bite back? Or did you take a chance and have it work out in the end? Let us know in the comments.

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Tags: commercial properties, commercial real estate investor, interest rate, negative leverage, ommercial income property, over-leveraging, overleveraged, overleveraging, positive leverage