Written by Gabriel Dillard
The Federal Reserve made news in the June meeting when it raised the federal funds rate by 75 basis points — the biggest rate increase in nearly 30 years. These rapidly rising rates coupled with historically low cap rates are bringing about a commercial real estate (CRE) phenomenon we have not seen in quite a while — negative leverage.
Successful CRE investing requires positive cashflow. But more than just positive cashflow, investors focus on their cash-on-cash return (or return on investor’s equity). Negative leverage impacts cash-on-cash returns, which erode profitability and investment viability if the property’s cash flow falls short of the mortgage payments. When we are in times of negative leverage, it typically foreshadows a correction in either the CRE market, capital markets…or both.
What is negative leverage?
Negative leverage occurs when the borrowing costs are higher than the return realized from a property’s cash flow. The addition of debt causes the levered return to be less than the unlevered return. With positive leverage, the cap rate is higher than the debt cost, which results in a return on equity (ROE) that’s higher than the cap rate.
In the current CRE market, negative leverage is occurring more often than at any time in recent memory. Along with rising interest rates, the 10-year Treasury is currently hovered around 3%, nearly twice as high as it was just six months ago.
This rapid rate change has caught many real estate investors today by surprise. Contracts signed to purchase property at a cap rate of 3.5% months ago now are being financed at 5% or higher, which has significantly lowered investors’ prospective ROE.
The effects of negative leverage
The following example demonstrates the potential effects of negative leverage on a CRE investment:
Suppose an apartment building is purchased for $25 million. The net operating income is $1 million, and the cap rate is 4%. If the building is financed with a permanent loan at 68%, or $17.2 million, with an interest rate of 4.6% (interest only), the annual mortgage payment would be $791,000 and the cost of capital would be 4.6% ($791,000/$17,200,000).
Since the cap rate (4%) is lower than the cost of capital (4.6%), the cash-on-cash return would be just 2.7% (net operating income of $1 million minus $791,000 = $209,000/$7,800,000 in equity = 2.70%). This is negative leverage.
The importance of leveraging the equity
Realizing a high cash-on-cash return, or leveraging the equity, is one of the main financial incentives for investing in CRE. In fact, this is the main attraction of CRE investing — no other type of investment offers this.
Let’s look at our example in a positive leverage environment. If the interest rate was 3.5% and the cap rate was 4%, as they were a few months ago, the investment would have positive leverage since the cap rate is higher than the borrowing costs. The cash-on-cash return would be 5.1%, which is the yield investors would receive in year one, compared to just 2.7% with negative leverage.
Appetite remains for CRE — despite negative leverage
So why do investors continue to invest in CRE when there’s negative leverage? Well, there are many reasons, but outlined herein are some of the most common. Some investors have raised capital in a fund or private placement and need to allocate it. Other investors believe that they can raise rent prices enough to create positive leverage in the future. While some are uncovering value-add opportunities outside of rent-controlled asset classes and others view CRE as an inflation hedge, even with concerns about negative leverage.
But what if rents don’t rise enough, interest rates continue climbing, supply is still constrained, and cap rates remain compressed? In this case, CRE investors may need to temper their ROE expectations.
In the short run, the bigger question is whether the Fed continues raising interest rates, perhaps to over 3% as Chairman Powell has suggested could happen. We are entering a very interesting time with the volatility of the capital markets impact to main street.
Adam Mortanian is the Co-Founder and Managing Director of PACT Capital, a leading Commercial Real Estate Capital Advisory firm and Life Company Correspondent with offices in Los Angeles and Fresno. As a relationship focused real estate lender, PACT Capital advises clients on ground up construction lending, unlocking liquidity, improving cash flow, and managing short-and-long term liabilities to optimize real estate holdings.
To learn more about PACT Capital visit PACT Capital online or call (213) 799-7228 in Los Angeles or (559) 775-7228 in Fresno.