So, you want to buy a property. Or you want to invest in a syndication. Either way, you are investing equity, which will be combined with a mortgage to acquire the asset. And, of course, every real estate deal is bought with a mortgage, aka leverage, so that is the right path, right?
Positive Leverage vs. Negative Leverage
Like most things in life, the answer is a solid, "It depends." Taking on mortgage debt can generally fall into two categories: positive leverage and negative leverage. And which your investment falls into all comes down to the numbers. Effectively:
Positive leverage is when the current yield on the asset is HIGHER than the interest rate of the mortgage (or if there are multiple loans and/or preferred equity in the deal, the combined interest rate).
Negative leverage is when the current yield on the asset is LOWER than the interest rate of the mortgage.
The easiest way to determine if you are investing in a deal with positive leverage or negative leverage is to compare the in-place cap rate to the interest rate. If you are assessing a new acquisition with an in-place cap rate of 5%, and the mortgage carries a 5.5% interest rate, you are investing in a negative leverage deal. Alternatively, if you invest in a deal with an in-place cap rate of 6% and the mortgage carries a 5.5% interest rate, you are investing in a positive leverage deal.
So, why would anyone invest in a negative leverage deal? Wouldn’t having negative leverage mean your deal is losing money?
First, there are several reasons why someone would invest in a negative leverage deal. The most prevalent is that the buyer will execute a value-add business plan and increase the in-place yield (cap rate) over time. In fact, Tony Landa wrote a blog about just this.
Second, won’t negative leverage mean you're losing money? Yes and no. Using a similar example to Tony’s, you can see that even with negative leverage you can still be cash flow positive. However, the returns are actually lower in the short term due to this negative leverage.
An example of negative leverage would look like the following:
As you can see, if no leverage were placed on this example deal, the cash-on-cash return would be higher than the in-place example with leverage.
An example of positive leverage would look like the following:
As you can see, the in-place cash-on-cash return in the middle set of numbers is HIGHER than the cap rate, by 0.75% per year.
So, Why Do Investors Use Negative Leverage?
The short answer is not enough equity is available. As a private investor, we all have our own capital limitations, and often a lot of our net worth is tied up in the portfolio we already own. And as a syndicator, it is hard to raise equity and buy deals, and our investors only have limited capital.
Again, in the example above, we are looking at a 60% loan-to-value asset, and in this case it is $100 million. Already, this example requires at least $40 million to be raised, and more if you include capital improvement budgets, reserves, and up-front fees. This is no easy task, and even more challenging if the raise included the full $100 million. And while this is a very large transaction, the challenges remain the same when you scale down the prices.
The Ideal Scenario
But ignoring, or downplaying, the real world, what is the ideal scenario to maximize returns for a deal like the above example, where negative leverage is present?
From a purely financial standpoint, the ideal scenario would be to never get into a negative leverage position. This would like the following:
- Purchase the property in all cash.
- Begin executing a business plan to increase the current yield.
- Once the property is creating a current yield higher than then-prevalent interest rates, refinance the deal.
- Continue operating until stabilization.
By purchasing cash and refinancing once the current yield of the property is higher than the interest rates in the market, you are always maximizing the overall return for the property. You still get the benefits of leverage, while never taking the diluting effects of a mortgage that's costing you more than you're earning from the property.
Conclusion
Positive leverage is when the current yield of the property (at acquisition, this is the in-place cap rate) is HIGHER than the interest rate. Positive leverage creates HIGHER cash-on-cash returns.
Negative leverage is when the current yield of the property is LOWER than the interest rate. Negative leverage can still be cash flow positive, as shown in the example. Negative leverage creates a LOWER cash-on-cash return compared to an all-equity transaction.
About the Author:
Evan is the Director of Investor Relations for Axia Partners, a diversified real estate fund operator, focused on recession-resilient assets. With over 16 years of real estate experience, Evan spends his days working with investors to better understand their investment goals and backgrounds. Please feel free to connect with Evan on LinkedIn, where he shares his insights into the syndication space.
Disclaimer:
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.
