Welcome to negative leverage in CRE

Negative leverage has emerged in CRE investing as interest rates have risen and capitalization rates have remained compressed. One of the most important axioms of a successful real estate investment and development program is to acquire or build real estate with positive leverage. Positive leverage occurs when the capitalization rate is higher than the cost of debt, which means that the return on equity will be higher than the capitalization rate. Negative leverage is just the opposite and defined as when the capitalization rate on a real estate acquisition is lower than the cost of debt or constant debt and therefore the cash-on-cash return is lower than the rate of capitalization. The debt constant is the annual debt service payment (principal and interest) divided by the amount of debt.

When negative leverage occurs, it means the investor’s cash return or return on equity is lower than the capitalization rate and that’s a big “No-No” in CRE. This is happening with more frequency in this robust CRE market, as interest rates have soared with the 10-year Treasury currently at 3.0% and up from 1.48% just a year ago. Apparently, this surprised many real estate investors, even some of the biggest and shrewdest private equity firms in the industry, because the property they signed a deal to purchase at a 3.5 cap rate % or 4.0% only a few months ago, must be financed with debt which now costs 4.5% to 5.0% or more.

Let’s say an apartment is purchased for $50 million, with a net operating income of $2 million or a cap rate of 4.0%. If the property is financed with a permanent loan at 70% or $35 million, with an interest rate of only 4.50%, the annual mortgage payment would be $1.575 million. The annual debt constant is therefore 4.5% ($1.575 M/$35 M), the same as the interest rate since there is no amortization of the loan. Since the cap rate of 4.0% is lower than the constant debt of 4.5%, the return on cash drops to only 2.8% (NOI of $2.0M less the debt payment of $1.575M, equals cash flow to equity of $425K, divided by equity of $15M, equals a return of only 2.8%) and this is an effect negative leverage.

One of the most important financial incentives for investing in CRE is to provide investors with a high cash return or commonly referred to as “leverage”. Raising equity capital is the whole attraction of the CRE investment activity. No other alternative investment program like private equity, venture capital and hedge funds provide this simple leverage technique. The leveraged equity return structure is inherent to CRE’s investment and development. In the example above, if the interest rate on debt was 4.0% and the capitalization rate was 5.0%, as it was about a year ago, the investment would have a positive leverage effect because the capitalization rate of 5.0% would be higher than the constant debt of 4.0% and the cash-on-cash return would be attractive at 7.3% and this is the return that investors would receive the first year of positive leverage and significantly higher than the 2.8% in the negative leverage example.

Why do investors continue to buy CREs with negative leverage? I think there are three reasons. The first is that they have the capital raised in a fund or private placement and are eager to spend it. Second, they believe rent increases will be high enough in coming years to create positive leverage down the road and third, many investors seek CRE investments for inflation protection, despite related concerns to negative leverage. However, what if those rent increases don’t materialize and interest rates rise even higher or cap rates continue to remain compressed? The golden days of CRE investing that we have all enjoyed since the end of the Great Recession in 2012 may be coming to an end with higher interest rates and higher capitalization rates. It all depends on the Federal Reserve. Is the Fed serious about raising the fed funds rate to over 3.0% from just 0.75%, as many governors and Fed chair have said, or are they , “All hat and no cattle?” I believe the latter, but we’ll find out who’s right in the next few months.

Joseph J. Ori is Executive Managing Director of Paramount Capital Corporation, a commercial real estate advisory firm

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