Financing Focus

Knowing the Negative

When interest rates decline and borrowers welcome more debt, what opportunities and challenges come with a negative leverage environment?

Discussing commercial real estate financing causes some to quickly check out, their eyes glazed over. While the intricacies can seem boring and irrelevant at times, the devil really is in the details — and the effects of the leverage environment on cash-on-cash returns. 

The Impact of Positive Leverage

For much of the decade following the Great Recession, the U.S. was in a positive leverage environment. If you added another dollar of debt when financing your rental property, it had a positive impact on the property’s cash-on-cash return. The more the property was leveraged, the better the return. Financially, it made perfect sense to add as much debt as possible when financing your property. 

But that situation ended last year. It was a seller’s market resulting in very low cap rates, while interest rose roughly a full point. Those two factors can cause a negative leverage environment, which can affect assets across all classes.

The Impact of Negative Leverage

For most of 2018, we were in a negative leverage environment — meaning the more a property is leveraged with debt, the worse its cash-on-cash return.

While in such a market, I helped a client secure financing for a triple net lease, single-tenant building. The property generated cash flow of $227,369 annually before debt service. I asked my borrower, “How much debt do you want to finance your purchase?” I presented four financing options: no leverage and 50 percent, 65 percent, and 75 percent leverage.

How Leverage Impacts a Property's Cash-On-Cash Return

Table 1 illustrates the results of leverage on the property’s cash-on-cash return. Each column represents one of these four financing options.

Owning the property debt-free resulted in a cash-on-cash return of 6.2 percent. As you can see in Table 1, the more debt that was added to the property, the lower the property’s cash-on-cash return.

What is neutral leverage?

I also wondered at what interest rate would adding debt result in neutral leverage? It turns out, in this case, an interest rate of 4.65 percent resulted in neutral leverage, as shown in Table 2.

At what Interest Rate is Leverage Neutral?

Some of you may be thinking that adding debt of any amount will always have a negative impact on the property’s cash-on-cash return. Not so. Look what happened when I lowered the interest rate to 4 percent. 

With a 4 percent interest rate, the more you leverage the property, the higher the cash-on-cash return.

How did we go from a positive leverage to a negative leverage environment?

For the past year, interest rates rose significantly without a corresponding rise in cap rates. All else being equal, when interest rates rise, the increasing mortgage payment reduces the property’s cash flow after debt service. A lower cash flow after debt service reduces the property’s cash-on-cash return. To reverse this trend, property values need to be adjusted downward to compensate for higher interest rates. 

Example of Positive Leverage

 

Why should we care when a market enters a negative leverage environment?

Negative leverage is another sign the real estate market cycle may be headed for a contraction, along with:

  • Rising interest rates.
  • Moderating rent increases.
  • More product coming online, slowly increasing vacancy rates and eventually leading to concessions.
  • More regulation to restrict property owners.

In the past six months, interest rates have dropped, putting much of the U.S. back into a positive leverage environment, though some primary markets such as New York, Chicago, and areas of California may remain in a negative leverage space. Still, if interest rates rise, this situation could change. If markets move back into negative leverage environments, buyers will eventually realize that it’s better to pay the capital gains taxes than to buy an overpriced property.

Doug Marshall, CCIM

Doug Marshall, the founder and president of Marshall Commercial Funding Inc., in Portland, Ore., recently published a book, “Mastering the Art of Commercial Real Estate Investing.” Contact him at doug@marshallcf.com.

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