Negative Leverage
With increasing interest rates, it is important for real estate investors to be conscious of Negative Leverage. As interest rates rise, there is a time lag before real estate prices may rise as a result of the increasing cost of debt.
Negative Leverage occurs when you add debt to an investment property and it reduces the percentage return on the property. Most people believe that by adding debt to a property you increase or leverage up your returns. Negative Leverage happens when the cost of debt is higher than the unleveraged return on the property, or its Cap Rate.
An unleveraged return is the percentage return on a property that has zero debt, when you buy a property with all cash. The Net Operating Income (NOI) from the property as a percentage of the purchase price shows its return, or Cap Rate (Capitalization Rate). See Table below, Scenario C. The NOI of the property is the Net Profit before interest, tax, depreciation and amortization. Similar to EBITDA (Earnings Before Interest Tax Depreciation and Amortization) in corporate financial statements.
A very simple test would be to compare the property Cap Rate to the interest rate on the debt. So long as the Cap Rate is higher than the interest rate, the more debt you add the more you amplify or leverage up the return. And conversely, if the Cap Rate is less than the interest rate, the more debt you add the more you diminsh the return with each additional dollar of debt added. This test works for interest-only loans. If you have an amortizing loan, you should compare the Cap Rate to the loan constant.
The loan constant takes into account your total debt payment (principal + interest), as a percentage of your loan. If you have an amortizing loan you will need to compare your loan constant to the Cap Rate to determine Negative Leverage.
The loan constant is calculated using the interest and principal/amortization payment as a percentage of the loan amount. For example, a $750,000 loan with a 3.5% interest rate and a 30Yr Amortization has a loan constant of 5.39% ($750,000 loan, 3.5% interest, 30Yr Am = $40,414 annual debt servive, divided by the $750,000 loan amount = 5.39%)
It’s important for an investor to know their time horizon for holding a property, whether they are adding value to it during that period (through capital improvements or improved leasing), the market they are in (is it a highly appreciating market or a current income producing market). For investors wanting to hold a property for long term current income, that is, the year to year net cash-flows, they should pay careful attention to avoid buying a property with Negative Leverage as this will dampen down their annual cash return. For investors in high value markets, with low Cap Rates relative to national averages, they may be less concerned with current income and be more interested in the capital appreciation which they will benefit from on a future sale or future cash-out refinance.
In high cost markets such as Boston, where Cap Rates are low, most investors are looking to get capital appreciation over time. For investors in more tertiary markets, where Cap rates will be higher, investors are more interested in current income due to appreciation rates being lower. Make sure you understand what your investment objective is, and if it is current income, avoid acquiring a property with Negative Leverage.
In the Table below, you can see three acquisition scenarios. All three are acquiring a $1mil property, with an NOI of $55,000, for a Cap Rate of 5.5%.
Scenario A gets an interest rate of 3.5% & 30Yrs Amortization, for a loan constant of 5.39%, which is lower than the 5.5% Cap Rate. Therefore the cost of debt is less than the return on the property, so for every extra dollar of debt I can use, I can increase, or leverage up, my return. In this example the cash return was levered up to 5.83%.
Scenario B gets an interest rate of 4.5% & 30Yrs Amortization, for a loan constant of 6.08%, which is higher than the 5.5% Cap Rate. Therefore the cost of debt is more than the return on the property, so for every extra dollar of debt I can use, I decrease, or negative leverage, my return. In this example the cash return was levered down to 3.76%.
Scenario C shows what happens if we purchased with all Cash, no Debt. It’s a simple 5.5% return.
If you have debt maturing soon, or you have a floating variable rate loan, now could be an ideal time to secure a longer-term fixed rate. Unless you are of the view that inflation is purely transitory and will subside before year end, and that we will return to the ultra-low interest rates we have all become accustomed to.
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