Navigating Negative Leverage in Real Estate
With interest rates more than doubling over the past 15 months, I've been hearing more about "negative leverage" in commercial real estate investing. This phenomenon has existed since I began underwriting multifamily buildings nearly ten years ago but only recently garnered attention.
While negative leverage isn't an irreversible blunder for investors, it does foreshadow a riskier project. The concept must be fully understood and considered when reviewing investment opportunities.
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Negative Leverage Definition
Negative leverage means your cash-on-cash return is less than if you were to have purchased the project with no debt (100% cash). In other words, the financing is making your annual yield worse.
Let’s say you were interested in purchasing a $10,000,000 property using $7,000,000 of debt. The NOI of the property is $725,000, and the annual debt service is $518,000. The high-level numbers look like this:
Price: $10M
Debt: $7M
Equity: $3M
NOI: $725K
Debt Service: $518K
Cash Flow: $197K
Cash-on-Cash Return: 6.55%*
*$197K / $3M
What if you were to purchase in cash instead of using debt?
Price: $10M
NOI: $725K
Cash Flow: $725K
Cash-on-Cash Return: 7.25%*
*$725K / $10M
In this example, the loan is hurting the annual yield (7.25% > 6.55%), and from strictly a cash-on-cash perspective, you would be better off purchasing in cash.
Why Negative Leverage is Common
The first question you might ask is why an investor would ever move forward with a deal that projects negative leverage. There are multiple justifications.
Less Equity
A big motivator for a larger loan with a higher rate that could lead to negative leverage is less equity (cash) needed upfront. The negative leverage is less critical if you are banking on significant appreciation (risky). Especially if you factor in the yields generated by sale proceeds (primarily measured by the IRR and equity multiple metrics)
Appreciation Expectation
As I mentioned, appreciation can cover up a lot of operational mistakes, and we saw that happen from 2011 – 2021. If you purchase a project for $10 million and are confident you could flip it for millions or more in a few years, regardless of asset performance, you'd likely put less emphasis on annual cash flow. While this is a dangerous thought process, appreciation is the only way to generate yield in certain submarkets around the county.
Operating Upside
Some investors see negative leverage as a temporary hindrance. They are confident they can increase cash flow from operations (primarily rental increases, improved occupancy, cutting concessions, and expense cutting) to increase NOI and see dilutive leverage turn accretive in future years.
Improving operations is the most common way to combat negative leverage when underwriting multifamily value-add. Leverage is often negative in Year 1. Once the NOI climbs higher in future years, the cash-on-cash return eventually overtakes the "all-cash" yield.
Principal Pay Down
Paying down the loan's principal balance with project cash flow will increase yield when selling the property later. I’ve even seen some groups calculate a “modified” cash-on-cash return that adds loan principal paydown each year (which I don’t recommend, as it’s technically not cash flow and dependent on future refinance or sale proceeds).
Unique Preferences
Some buyers aren't as concerned about yield. They might have a 1031 exchange or other tax-motivated ambitions that aren't as focused on cash flow. Some investors with scale may want to add units to their investment portfolio and will overpay to ensure they are the winning bidder, regardless of yield.
Components of Negative Leverage
Negative leverage has been getting attention lately because it has become common to hear of offerings with cap rate guidance lower than the interest rate investors would be quoted on their mortgages.
Loan Interest Rate > Cap Rate
If the loan interest rate is higher than the cap rate, negative leverage is likely prevalent, but it isn't an accurate measurement of where negative leverage begins. The project is likely already into a "very deep" negative leverage threshold. The real thing we need to understand is the loan constant.
Loan Constant = Total Debt Service / Total Loan Proceeds
Debt Service includes both principal and interest payments. While the interest rate plays a role in the equation above, there is also:
Amortization Schedule
Interest-Only Period (more on this shortly)
It’s important to note that the following variables will also play a role (albeit indirectly).
Total Loan Proceeds (LTV vs. LTC)
CAPEX Requirements (if CAPEX is financed)
The more loan proceeds you have, the more likely the rate will be higher (because with more leverage, the deal is riskier). The same can be said about renovations funded with financing. More total leverage generally leads to a higher interest rate. If a lender were to give you more loan proceeds and not change the rate or amortization schedule, the loan constant would stay the same.
Let's continue with our example from earlier, but add a few wrinkles. You're considering purchasing a $10,000,000 property with a $1,000,000 renovation plan. You get financing term sheets from two different banks.
Bank #1 Terms:
Proceeds: 70% LTV
10-Year Term
25-Year Amortization
5.75% Interest Rate
Bank #2 Terms:
Proceeds: 65% LTC
7-Year Term
30-Year Amortization
5.75% Interest Rate
Bank #1 Loan Constant:
Total Loan Proceeds: $10,000,000 x 70% = $7,000,000
Annual Payment: $528,449
Loan Constant: $528,449 / $7,000,000 = 7.55%
Bank #2 Loan Constant:
Total Loan Proceeds: ($10,000,000 + $1,000,000) x 65% = $7,150,000
Annual Payment: $500,706
Loan Constant: $500,706 / $7,150,000 = 7.00%
Note: The term doesn't affect anything in our calculations.
From a purely cash flow perspective, Bank #2's offering is more attractive because the loan constant is smaller. However, the loan is shorter-term. It would be best to weigh how important a 10-year vs. 7-year term matters in your business plan.
Loan Constant vs. Cap Rate
Once you calculate a loan constant, you can compare it to your proforma cap rate (preferably adjusted for property taxes). This cap rate should be your realistic assumption, not the broker’s NOI projection in the offering memorandum.
If Loan Constant > Cap Rate = Negative Leverage
If Loan Constant < Cap Rate = Positive Leverage
In the example above, the loan constant for each bank's term sheets was:
Bank #1: 7.55%
Bank #2: 7.00%
The deal you looked at had a projected proforma NOI of $725,000.
Cap Rate = $725,000 / $10,000,000 = 7.25%
Bank #1 Loan Constant of 7.55% > 7.25% = Negative Leverage
Bank #2 Loan Constant of 7.00% < 7.25% = Positive Leverage
It's important to reiterate that negative leverage isn't an investment death sentence. Even though you will see negative leverage, you still might choose the Bank #1 loan because:
It has a longer-term
You expect to raise revenues considerably over that 10-year time frame, which would result in the leverage turning positive in future years.
When I was underwriting multifamily projects in 2019, finding a project with positive leverage in proforma Year 1 was like finding a needle in a haystack. During this period, mortgage rates were around 3%! Why was negative leverage still so common?
Competition: People paid top dollar for multifamily asset classes because overpaying was the only way to win a deal. Therefore, it could be argued that cap rates were artificially low. Even though rates were modest during that era, the loan constant was often higher. Even in a low-interest rate environment, negative leverage was the norm.
Defeating Negative Leverage
The most effective way to beat negative leverage is to pay less.
Paying less means a higher cap rate (better chance cap rate > loan constant), less debt service, and more cash flow, positively affecting the numerator and the denominator of the cash-on-cash return formula. Unfortunately, this is easier said than done in many instances.
Interest-Only Period
When price negotiation isn’t possible, another way to combat negative leverage is to finance the project with an interest-only period. During the early years of the investment hold, it is common to see an interest-only payment (no principal payback), which would boost cash flow and help the cash-on-cash return.
Let's quickly revisit our Bank #1 loan with the following terms:
Bank #1:
Proceeds: 70% LTV ($7,000,000)
10-Year Term
25-Year Amortization
5.75% Interest Rate
Here is the project example inputted into Tactica's Value-Add Model. The current annual yields look like this:
The all-cash return (no leverage) is greater than the cash-on-cash return (leverage) until Year 4. By Year 4, the NOI increases by 7.4%, and leverage no longer dilutes returns but is accretive.
Let's tweak the bank assumption. In addition to the terms above, they offer a 36-month interest-only period. During years 1-3, you’d now be responsible for paying $402,500 in interest instead of the P&I total of $528,449.
The loan constant in Years 1-2 is:
$402,500 / $7,000,000 = 5.75%
The market cap rate = 7.25%
Loan Constant of 5.75% < Cap Rate of 7.25% = Positive Leverage
The interest-only helps keep the leverage return bolstered during the early years of the investment hold. Once the interest-only period ends in Year 4, the cash-on-cash return drops considerably once the principal payment commences but is still slightly higher than the all-cash yield (7.76% vs. 7.67%).
When using interest-only to bridge a period of negative leverage, it's crucial to ensure you can execute a biz plan that turns temporary negative leverage into a long-term positive yield boost. Unfortunately, some projects took on a similar financing arrangement in 2020/2021 and are now facing the harsh reality of hurtful leverage stemming from operational failure.
Video: Negative Leverage in Real Estate: How to Beat It
Summarizing Negative Leverage
Negative leverage has always been standard, even when rates were artificially low. The easiest way to determine if negative leverage will be prevalent is to compare the loan constant to the project cap rate. If the cap rate exceeds the loan constant, debt will be accretive and boost annual yields.
While interest rates are an essential factor in negative leverage, so are:
Total Loan Proceeds
Loan Amortization Schedule
CAPEX Requirements (if CAPEX is financed)
Interest-Only Period
Higher interest rates in today's environment overshadow leverage levels we saw pre-2022, seemingly catching more headlines but ultimately leading to the same result—dilutive annual yields.
Negative leverage isn't the end of the world if you can benefit from the following:
Operating upside
Appreciation
Other unique investment preferences not related to yield
Ideally, you can find a project that exhibits positive leverage immediately, but this could be very unlikely in a heavily marketed real estate offering.
