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Negative Leverage

Step-by-Step Guide to Understanding Negative Leverage in Commercial Real Estate (CRE)

Last Updated February 20, 2024

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Negative Leverage

What is the Risk of Negative Leverage?

Negative leverage causes the equity yield received on an investment property to decrease.

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.

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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.

In the initial period – or the first period in which a property investment is stabilized – the equity cap rate is compared to the loan constant.

Single-Year Analysis (Year 1)

Leverage Type Guideline
Negative Leverage
  • Equity Cap Rate < Loan Constant
Neutral Leverage
  • Equity Cap Rate = Loan Constant
Positive Leverage
  • Equity Cap Rate > Loan Constant

Multi-Year Analysis

Leverage Type Guideline
Negative Leverage
  • Cash-on-Cash Return < Mortgage Yield Rate
Neutral Leverage
  • Cash-on-Cash Return = Mortgage Yield Rate
Positive Leverage
  • Cash-on-Cash Return > Mortgage Yield Rate

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

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Negative Leverage Formula

The risk of negative leverage in a particular real estate investment can be quantified by calculating the property’s cap rate minus its loan constant (or “mortgage constant”).

Negative Leverage (%) = Equity Cap Rate  Loan Constant

Where:

  • Equity Cap Rate (%) → The annual return expected to be generated on the equity investment in a property by a real estate investor.
  • Loan Constant (%) → The loan constant is the annual debt service expressed as a proportion of the total principal for fixed-rate loans.

The cap rate is calculated by dividing the net operating income (NOI) of a property at stabilization by its current market value.

Equity Cap Rate (%) = Before-Tax Cash Flow (BTCF) ÷ Initial Equity Investment

The formula used to determine a loan constant — otherwise known as the mortgage constant — is the annual debt service divided by the total loan amount.

Loan Constant = Annual Debt Service ÷ Loan Amount

If the cap rate exceeds the loan constant, the debt is accretive and has a favorable impact on the annual yield. But if the cap rate is less than the loan constant, then the yield is likely to decline.

Negative Leverage Calculator

We’ll now move on to a modeling exercise, which you can access by filling out the form below.

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1. Commercial Real Estate (CRE) Assumptions

Suppose a commercial real estate (CRE) investment firm is estimating the cash-on-cash return of a potential commercial building.

To illustrate the concept of negative leverage, we’ll start by calculating the cash-on-cash return on a “levered” basis (post-interest) – the standard method of measuring the cash yield.

Furthermore, the “unlevered” cash-on-cash return will also be determined for the sake of comparability.

The two comparable properties are each commercial office buildings that are equivalent for the most part.

For instance, below are the assumptions for net operating income (NOI) and cap rate.

  • Net Operating Income (NOI) = $20 million
  • Cap Rate (%) = 5.0%

By dividing the stabilized NOI by the cap rate, we can estimate the price of the properties (or their market values), which comes out to be $400 million.

  • Property Price (All-Cash) = $20 million ÷ 5.0% = $400 million
  • Property Price (Levered Purchase) = $20 million ÷ 5.0% = $400 million

2. Loan to Value Ratio (LTV) Calculation Analysis

The loan-to-value ratio (LTV) is zero for the all-cash purchase, while the LTV ratio is assumed to be 75% for the levered purchase.

By multiplying the purchase cost of the property by the loan-to-value (LTV) ratio, the size of the commercial loan is $300 million, priced at an interest rate of 6.0%.

  • Loan to Value Ratio (LTV) – Levered Purchase = 75.0% × $400 million = $300 million
  • Annual Interest Rate (%) = 6.0%
  • Annual Debt Service = $18 million

Therefore, the annual debt service for the levered purchase – assuming the loan is in its interest-only phase – is $18 million per year – while the all-cash purchase scenario remains unchanged (i.e. left blank).

The pre-tax cash flow for the all-cash purchase is $20 million, since no deductions were applied to the property’s NOI.

Negative Leverage Calculation Example

On the other hand, the NOI for the levered purchase is $2 million, which is the difference between the NOI and annual debt service.

  • Pre-Tax Cash Flow – Levered Purchase = $20 million – $18 million = $2 million

3. Negative Leverage Calculation Example

In the final section of our exercise, we’ll determine the equity contribution for each side, which equals the property price minus the size of the commercial loan.

The equity contribution for the all-cash purchase is straightforward since no debt was used to fund the purchase.

But for the levered purchase, we must deduct the $300 million commercial loan from the property’s price, resulting in $100 million.

  • Equity Contribution = $400 million = $300 million = $100 million

Since the required assumptions are now all set in our model, we can calculate the cash-on-cash return for both scenarios.

  • Unlevered Cash-on-Cash Return (%) = $20 million ÷ $400 million = 5.0%
  • Levered Cash-on-Cash Return (%) = $2 million ÷ $100 million = 2.0%

Therefore, the yield on the all-cash purchase is greater than the yield earned on the levered purchase, reflecting how debt is not a shortcut to increasing returns.

In conclusion, since the levered cash-on-cash return (or “cash yield”) on the property is implied to be less than that of the unlevered cash-on-cash return (all-cash), the investment opportunity is likely to be a “pass”, especially if the real estate project is a strategic acquisition with minimal value-add improvements.

  • Unlevered Cash Yield (All-Cash Purchase) → Neutral Leverage
  • Levered Cash Yield (Levered Purchase) → Negative Leverage

Negative Leverage Calculator

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