There are three reasons why investors are continuing to buy CRE with negative leverage.
Negative leverage has reared its ugly head in CRE investing, as interest rates have risen, and cap rates have remained compressed. One of the most important axioms of a successful real estate investment and development program is to acquire or build real estate with positive leverage. Positive leverage occurs when the cap rate is greater than the cost of debt, which means the return on equity will be greater than the cap rate. Negative leverage is just the opposite and defined as when the cap rate on a property acquisition is less than the cost of debt or debt constant and therefore, the cash-on-cash return is less than the cap rate. The debt constant is the annual debt service (principal and interest) payment divided by the amount of the debt.
When negative leverage occurs, this means the cash-on-cash return or return on the investor’s equity is less than the cap rate and this is a big “No-No” in CRE. This is happening with more frequency in this robust CRE market because interest rates have shot up with the 10-Year Treasury currently at 3.0% and up from 1.48% only a year ago. Apparently, this has caught many real estate investors, even some of the largest and most astute private equity firms in the business, by surprise, as the property they signed a contract to purchase at a 3.5% or 4.0% cap rate only a few months ago, has to be financed with debt that now cost 4.5% to 5.0% or more.
Let’s say an apartment property is purchased for $50 million, with a net operating income of $2 million or a cap rate of 4.0%. If the property is financed with a permanent loan at 70% or $35 million, with an interest rate of 4.50% interest only, the annual mortgage payment would be $1.575 million. The annual debt constant is therefore 4.5% ($1.575M/$35M), the same as the interest rate since there is no loan amortization. Since the cap rate of 4.0% is less than the debt constant of 4.5%, the cash-on-cash return falls to only 2.8% (NOI of $2.0M less the debt payment of $1.575M, equals the cash flow to equity of $425K, divided by the equity of $15M, equals a return of only 2.8%) and this is negative leverage.
One of the most important financial incentives to invest in CRE is to provide the investors with a high cash-on-cash return or commonly referred to as, “levering the equity.” Leveraging the equity is the whole attraction of the CRE investment business. No other alternative investment program like private equity, venture capital and hedge funds provide this simple leveraging technique. The levered equity return structure is inherent in CRE investment and development. In the above example, if the interest rate on the debt was 4.0% and the cap rate was 5.0%, as they were a year or so ago, the investment would have positive leverage as the cap rate of 5.0% would be greater than the debt constant of 4.0% and the cash-on-cash return would be an attractive 7.3% and this is the yield the investors would receive in year one from positive leverage and substantially higher than the 2.8% in the negative leverage example.
Why are investors continuing to buy CRE with negative leverage? I think there are three reasons. One is they have the capital raised in a fund or private placement and are eager to spend it. Two, they believe that rent increases will be high enough in future years to create positive leverage down the road and three, many investors are seeking CRE investment for inflation protection, notwithstanding the negative leverage concerns. However, what if these rent increases don’t materialize and interest rates go even higher or cap rates continue to stay compressed? The halcyon days of CRE investment that we have all enjoyed since the end of the Great Recession in 2012, may be coming to an end with higher interest rates and higher cap rates. It all depends on the Federal Reserve. Is the Fed serious about jacking up the federal funds rate to over 3.0% from only .75% as many of the Fed Governors and Chairman have stated, or are they, “All hat and no cattle?” I believe the latter, but we will know who is correct in the next few months.
Source: “Welcome to Negative Leverage in CRE“
