What is Negative Leverage?
Negative Leverage in commercial real estate (CRE) refers to the situation where the unlevered cash-on-cash return exceeds the levered cash-on-cash return.
The cash-on-cash return, or “cash yield”, can be lower on a levered basis if the cost of debt worsens the annualized yield on the equity investment.
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What is the Risk of Negative Leverage?
In the commercial real estate (CRE) market, the funding structure for most transactions is financed with debt, or borrowed capital from lenders.
The borrowing of capital from lenders to finance a substantial proportion of the funding requirements is an inherent part of CRE investing.
The less equity contributed by the investor, the higher the yield on the investment property – all else being equal.
Given the increase in purchasing power with debt, CRE investors can acquire commercial properties while risking less equity capital to fulfill the total purchase price necessary to complete the transaction.
In theory, a decrease in the original upfront cost at the time of acquisition – i.e. the initial outlay – should improve the yield on the equity investment (or “cash contribution”).
The issue at hand, however, is that the decision to employ leverage comes with a trade-off that must first be closely considered.
While leverage can in fact enhance the return on investment (ROI) on a property investment, the effects are bi-directional – i.e. the positive and negative effects can both be amplified.
Conceptually, negative leverage implies the cash-on-cash return (or “cash yield”) on a levered investment is less than a comparable investment financed using no debt (or all-cash).
Therefore, negative leverage describes the sequence of events whereby the cost of borrowing offsets (and exceeds) the annual yield earned on an equity investment, resulting in a net loss.
The inclusion of debt in the financing of a real estate transaction introduces mandatory annual debt service (ADS), which in the event of unforeseeable circumstances and underperformance, can reduce returns, extend the hold period, or perhaps even result in property foreclosure post-default.
Inflation and Negative Leverage Risk
The topic of negative leverage has become more common following the Fed’s interest rate hikes that started in early 2022.
Once the U.S. economy seemed to normalize post-pandemic, the Fed started to increase interest rates to fend off the risk of inflation after a period of “printing” money that received widespread criticism.
Negative Leverage vs. Positive Leverage: What is the Difference?
There are two main types of leverage – negative leverage and positive leverage – in the deal structuring process in commercial real estate (CRE).
- Negative Leverage → Negative leverage emerges if the cap rate is lower than the loan constant. The annual yield on equity tends to decrease, as the financing obligations exceed the cash flow generated by the property.
- Positive Leverage → In contrast, positive leverage occurs if the cap rate of a real estate property is greater than the loan constant. The annual yield on equity increases because the cost of servicing the debt is less than the cash flow generated by the property, resulting in more residual profits.
Since leverage is a core driver of returns in CRE investing, the fact that positive leverage is preferable in most cases should be relatively intuitive.
Single-Year Analysis (Year 1)
The risk of negative leverage should be intuitive, as the return earned on the property investment declines due to the cost of borrowing used to fund the initial transaction.
Yet, certain real estate investors still purchase properties while being aware of the risk attributable to negative leverage, contrary to what most would expect.
Why Purchase Properties in Negative Leverage Environment?
A few potential reasons that a real estate investor might continue to purchase a CRE property, even with negative leverage, are as follows.
- Long-Term Hold Period → Prioritization is Capital Appreciation in the Property Value over the Long-Term (Exit Proceeds > Lower Initial Yield)
- Opportunistic Purchase → Strategic Acquisition to Capitalize on the Current Market Conditions to Improve (e.g. Market Volatility)
- Portfolio Diversification → Low “Hurdle Rate” as the Property Investment is Part of a Diversification Strategy (and Hedge to Broader Market)
- Rental Growth and Value-Add Opportunities → Property Improvements, Renovations, and Strategies to Enhance Operating Efficiency Can Create Positive Economic Value (and Positive Cash Flow) to Offset the Losses from Negative Leverage