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Positive Leverage

Step-by-Step Guide to Understanding Positive Leverage in Real Estate

Last Updated February 20, 2024

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Positive Leverage

How Does Positive Leverage Work in Real Estate?

In real estate, positive leverage refers to the state whereby the equity yield earned on a property investment is greater than the cost of debt.

The funding structure of most purchases in the real estate market — both on the residential and commercial side — are financed using debt, or borrowed capital from lenders.

But of course, the debt capital provided by the lender comes at a price:

  • Periodic Interest → The periodic interest payments owed on a loan, which is a function of the outstanding balance.
  • Principal Amortization → The gradual paydown of the loan principal, which can be partial amortization (i.e. remaining balance at maturity paid off in a lump sum “balloon” payment), or full amortization.

If the cash on cash return (or “equity yield”) on an investment exceeds the cost of the debt – the concept of positive leverage in real estate – that implies the rental income generated by the property can sufficiently offset the borrowing costs.

In effect, the real estate property is likely more profitable and will produce a higher return on behalf of the landowner.

Therefore, positive leverage is the target outcome on a property investment since the operating cap rate is higher than the interest rate, or cost of borrowing.

Note: The concept of analyzing positive and negative leverage is only applicable for fixed-rate loans. The annual debt service must remain constant over the maturity term.

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How to Create Positive Leverage and Maximize Returns?

So, how can one determine the appropriate amount of leverage to use in real estate investing to maximize the potential return?

In short, leverage enables a real estate investor to acquire properties that could not be purchased by using only cash.

However, the primary reason is not always from a lack of funds – especially in the commercial real estate (CRE) market — instead, the reliance on leverage pertains more to enhancing the potential returns earned on a property investment.

The contribution of debt from lenders reduces the equity contribution of the investor, causing the equity yield to increase — all else being equal.

At the end of the day, the incentive to purchase a property is to generate a positive return. Therefore, unless the owner intends to personally live there, the property is a monetary investment.

If the equity cap rate exceeds the loan constant post-investment, the outcome is positive leverage (and the reverse if the loan constant is greater).

  • Positive Leverage → Cash on Cash Return (Equity Yield) > Loan Constant
  • Negative Leverage → Cash on Cash Return (Equity Yield) < Loan Constant
  • Neutral Leverage → Cash on Cash Return (Equity Yield) = Loan Constant

Equity Cap Rate vs. Cash on Cash Return: What is the Difference?

In the hold period of the property investment, the underlying rules remain the same, however, the cash-on-cash return (or “cash yield”) is used, rather than the equity cap rate.

Conceptually, the two measures are virtually identical in terms of intent.

The only difference between the two is that the income component of the cash-on-cash return metric is the annual cash flow after debt service (CFADS) on a rolling basis.

On the other hand, the equity cap rate measures the post-stabilization unlevered return on a real estate investment, i.e. the potential return in Year 1.

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Positive vs. Negative Leverage: What is the Difference?

The cash-on-cash return, or equity yield, can be perceived as the “equity cap rate” (i.e. the rate of return on the cash investment), while the loan constant can be perceived as the “lender cap rate”.

If the annual cash yield increases year-over-year (YoY), the return on equity rises because the “spread” between the cash flow generated by the property and the cost of servicing the debt has become greater, i.e. there is more excess return.

In the event of default, where the borrower is unable to fulfill its debt obligations to the lender per the lending agreement, the lender (or now “creditor”) has the right to seize the property, since the property was pledged as collateral to obtain the initial financing.

Conversely, if the cash-on-cash return (CoC) on a levered basis is less than the cost of debt, that causes the return on the equity investment to decline — all else being equal.

The lower the “spread” there is between the cap rate and interest rate – the concept of positive leverage – the more income (and return) is lost from the cost of borrowing.

Since high interest rates in the financial markets are unfavorable for the real estate market, demand from buyers tends to decline in such periods because of the increased risk of incurring losses (or retrieval of lackluster returns compared to the risk undertaken).

The drawback to leverage is that if the property performs below expectations and defaults on its debt obligations, the negative outcome would be even worse – i.e. leverage is a “double-edged sword”.

In fact, even if the residual cash flow post-repayment of debt is enough to avoid the risk of default (and property foreclosure), the return earned on the equity side would in all likelihood miss the minimum rate of return, or “hurdle rate”, of the investor.

Equity Yield vs. Lender Cap Rate: Why Does the Difference Matter?

From the perspective of a real estate investor, who owns a stake in the equity of the capital stack (i.e. the lowest seniority), the implied potential return must exceed the yield earned by lenders.

Otherwise, the investment was an irrational decision, as more risk must be compensated with more “upside” potential in returns, per the trade-off theory.

Positive Leverage Formula

To determine if positive leverage occurs post-investment, the formula is the ratio between the equity cap rate (or “cash yield”) and loan constant.

Positive Leverage = Equity Yield (%) Loan Constant (%)

If the output is a positive figure, there is positive leverage. Otherwise, there is negative leverage on the investment, and a net loss is incurred.

Where:

  • Equity Yield (%) → The annual cash yield earned on an investment property, neglecting the non-equity sources of financing to focus on the equity investment. The equity yield reflects the relationship between the pro forma income of a given property and the equity investment at purchase, instead of the market value of the property.
  • Loan Constant (%) → The loan constant, or “mortgage constant”, is the annual debt service (interest + principal amortization) expressed as a percentage of the original principal on a fixed-rate loan issuance.

For example, if the equity cap rate is 6.25% while the loan constant is 6.0%, there is positive leverage (and the equity investment is implied to be profitable).

  • Positive Leverage (%) = 6.25% – 6.0% = 0.25%

While the percent differential might seem menial, the implication on returns can be significant.

Equity Yield (%) = Pre-Tax Levered Cash Flow ÷ Invested Equity
Loan Constant (%)= Annual Debt Service ÷ Loan Amount

Negative leverage is thus a material risk in the real estate market and must be mitigated by ensuring there is enough of a margin for error between the expected equity yield and cost of borrowing.

Otherwise, the investor is prone to incur losses from negative leverage, which can become far more substantial in the event of default.

Positive 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. Positive Leverage Calculation Example

Suppose we’re tasked with measuring the effectiveness of leverage on three different real estate transaction structures.

The investment opportunity is a commercial building with a purchase price of $200 million, and the following pro forma data:

  • Net Operating Income (NOI) = $10 million
  • Market Cap Rate (%) = 5.0%
  • Property Price = $10 million ÷ 5.0% = $200 million

There are three scenarios in our spreadsheet – “Neutral Leverage”, “Negative Leverage” and “Positive Leverage” – where the distinction between each is the capitalization, i.e. the percentage of debt used to fund the purchase and the interest rate.

There is no leverage in the initial transaction structure, which we’ll refer to as “Scenario A”. Hence, the loan-to-value ratio (LTV) is 0%, while the cap rate is equivalent to the cash-on-cash return.

Why? Our original all-in cap rate assumption of 5.0% is already on an unleveraged basis because there is no debt financing used, i.e. it is an all-equity purchase.

For the latter two scenarios, the loan-to-value ratio (LTV) is 75%, implying the equity contribution from the real estate investor is 25% — since the total funding sources must equal 1.0 (or 100%).

  • Equity Contribution (%) = 1 – 75.0% = 25.0%
  • Equity Contribution ($) = 25.0% × $200 million = $50 million

The annual debt service can be determined by multiplying the annual interest rate by the size of the commercial loan.

For Scenario B, we’ll assume the annual interest rate is 6.0%, whereas the interest rate is lower at 4.0% for Scenario C.

  • Commercial Loan = 75.0% × $200 million = $150 million
  • Annual Interest Rate (Scenario B) = 6.0% × $150 million = $9 million
  • Annual Interest Rate (Scenario C) = 2.0% × $150 million = $6 million

Positive Leverage in Real Estate Calculation Example

2. Real Estate Positive Leverage Analysis Example

In the next part of our real estate modeling exercise, the remaining steps are to calculate the cash-on-cash return and measure the implied effects of leverage on the investment.

The stabilized NOI is $10 million, as stated earlier, which we’ll reduce by the annual debt service (interest-only) of the two respective transaction structures.

  • Levered Pre-Tax Cash Flow (Scenario B) = $10 million – $9 million = $1 million
  • Levered Pre-Tax Cash Flow (Scenario C) = $10 million – $6 million = $4 million

In conclusion, we can divide the levered pre-tax cash flow by the property price to calculate the cash-on-cash return, and then compare the equity yield to the overall cap rate to measure the “spread”, which determines if the investment reflects negative or positive leverage.

Investment Structure — Scenario A

  • Cash on Cash Return (%) = $1 million ÷ $200 million = 2.0%
  • % Spread (Equity Yield – Cap Rate) = 2.0% – 5.0% = (2.0%) → Negative Leverage

Investment Structure — Scenario B

  • Cash on Cash Return (%) = $4 million ÷ $200 million = 8.0%
  • % Spread (Equity Yield – Cap Rate) = 8.0% – 5.0% = 3.0% → Positive Leverage

Positive Leverage Calculator

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