Imagine a commercial property that produces $50,000 in cash flow annually and has a cost of $1,000,000. If a real estate investor purchased this property with cash, they could expect an annual cash on cash return of 5% ($50,000 / $1,000,000). Now, imagine this same property, but it is purchased with $250,000 in cash and $750,000 in debt. In this scenario, the cash flow is reduced to $30,000 annually due to the debt payments, but the cash on cash return jumps to 12% ($30,000 / $250,000). This scenario highlights the power of using debt or “leverage” to increase returns in a commercial real estate transaction. But, more debt is not always better.
In this article, we are going to discuss a concept known as “negative leverage.” We will define what it is, why it matters in commercial real estate, and how it compares to “positive leverage.” By the end, readers will be able to tell the difference between the two and use this information as part of their pre-purchase due diligence process.
At First National Realty Partners, we deploy debt strategically and only when it benefits our investors. To learn more about our current investment opportunities, click here.
Negative Leverage Explained
As a general rule, the addition of “leverage” or debt to a commercial real estate investment boosts the cash on cash return as described in the scenario above. And, the more leverage the better.
But, this is not always the case. Depending on the terms of the debt (interest rate, debt service, etc.) the addition of more leverage to a transaction can actually cause the return to fall. When it does, this is known as “negative leverage.” To illustrate how this works, the example above is continued in the following table:
|Cash Purchase||Positive Leverage||Negative Leverage|
|Cash To Distribute||$50,000||$25,000||$9,000|
|Cash on Cash Return||5.00%||10.00%||9.00%|
In the example, it can be seen that the addition of leverage increases the cash on cash return from 5% to 10%, which is good. But, as more debt is added, the required debt service goes up, which means that the cash available for distribution and the cash on cash return, goes down. This is an example of negative leverage.
Negative Leverage vs. Positive Leverage
The key difference between negative leverage and positive leverage can be seen in the table above.
When the leverage is “positive” it causes the cash on cash return to rise in conjunction with the amount of debt. When it is negative, the return goes down. So, perhaps, the more important question is, what causes leverage to be positive vs. negative?
The short answer is that the terms of the debt are the primary driver. The details can be quite technical, but the key point is that, if the interest rate on the debt is lower than the unlevered internal rate of return, the leverage is positive.
Conversely, if the interest rate in the debt is higher than the unlevered internal rate of return (IRR) produced by the property’s cash flow, the leverage is negative. For example, if an investor creates a five year proforma for an investment property and it suggests an unlevered IRR of 7%, any leverage would be considered negative if the cost of debt was greater than 7%.
Determining if Debt Will Be Negative or Positive Leverage
To determine if leverage is positive or negative, it is a best practice for investors to model leveraged vs. unleveraged cash flow for all years in the holding period. If the levered return decreases as debt is added, leverage is negative and it may be an indication that investors should reconsider key deal variables like purchase price, loan to value ratio (LTV), loan amount, and interest rate.
Risks of Negative Leverage
From the description above, the risk of negative leverage should be clear. The addition of it can cause returns to decline, which is a negative for the investment. Again, this highlights the importance of creating a financial model for the investment on both a leveraged and unleveraged basis to ensure that returns go up with the addition of debt.
Why Investors Need to Understand Negative Leverage
On their own, real estate investors need to understand the concept of negative leverage to ensure they do not end up in a situation where they unknowingly take it on. This can be the difference between a successful overall return versus one that is disappointing.
Private Equity Real Estate & Negative Leverage
Creating an accurate and comprehensive financial model for a potential property investment can be very complex. It is a skill that can take years and many real repetitions to master. For individual investors who don’t have this skill set, but still want exposure to commercial real estate (CRE) assets, it may be a good idea to partner with a private equity firm to deploy capital.
The primary benefit of doing so is that the private equity firm does all of the hard work of finding the property, creating the financial model, and most importantly, negotiating the financing terms with lenders. When these factors are combined, they can work on the investor’s behalf to ensure that a deal does not end up in a negative leverage situation.
Summary & Conclusion
In the commercial real estate industry, negative leverage is a financial condition that causes a property’s annual return to decline with the addition of leverage to the deal.
Negative leverage happens when the cost of real estate financing (e.g. the interest rate) is higher than the unlevered internal rate of return.
The key difference between negative leverage and positive leverage is that a property’s rate of return actually increases with the addition of positive leverage.
Individual real estate investors need to understand the concept of negative leverage, and they need to be able to spot it in a financial model, to ensure they can maximize their return on investment.
For investors unfamiliar with the concept of negative leverage, it can be helpful to partner with a private equity commercial real estate firm to ensure that this scenario is avoided.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.