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When To Use —and Not Use—Leverage In CRE

December 9, 2020

Positives, negatives, and the COVID effect

When people get involved in commercial real estate investments, their goal is to increase the property’s value, diversify portfolio holdings, avoid volatility while hedging against inflation, and gain some tax benefits. In short, it’s about making money.

One of the available tools to achieve that goal is leverage. Also known as debt-financing, the idea is that in some cases, assuming debt on a property may be more financially lucrative than bypassing a loan. That being said, there is a time when leverage makes sense and, more importantly, when it does not. 

What is positive leverage?

In the simplest of terms, positive leverage occurs when the cost of borrowing money is less than the return on that property. This results in greater profits for the investor, ROI that can then be used to upgrade the property or diversify into additional properties, especially those that are less risky. 

For example, let’s say a property comes on the market for $3 million. The buyer faces two options:

  • The first is an all-cash purchase, which results in an NOI (net operating income) of $250K. Without a loan, there is no debt service and a cash flow of $250K. The result is a cash on cash percentage (cash flow/cost of property) of 8.3%.
  • The other is to initiate a leverage option with a $2 million loan at 6%. The NOI remains the same at $250K, but this encompasses the debt ($120K) and cash flow ($130K). The cash on cash result is $130K divided by $1 million (the out-of-pocket cost of the property) or 13%. In other words, there is a 4.7% higher return with positive leverage rather than an all-cash purchase.

Depending on economic indicators, leverage may not be in the investor’s best interest, particularly if the cost of borrowing money vastly diminishes the cash return of the investment. The closer the cash-on-cash leverage result comes to the all-cash result, the less wiggle room there is to survive any unanticipated crises, such as immediate repairs to the property or an economic slump. 

Using leverage wisely

When leverage makes sense, some investors can fall into the assumption trap—assuming that if some leverage on a property deal is good, then more property leverage is better. But as the saying goes, never “assume” anything, or you can make an “ass” out of “u” and “me.”

To avoid the potential pitfalls of leverage, investors should wisely consider some key points:

  • The CAP rate should be higher than the Effective Cost of Debt (ECD), which takes into account other costs beyond the interest rate of the loan. These other debts include loan points and pre-payment penalties. Typically, pre-payment penalties occur before year 10 of the loan. If you’re planning on selling the property before that 10-year mark, this is a debt that must be considered before choosing the leverage route.
  • Investors need to have a firm understanding of both short- and long-term plans for their personal financial goals and how those match the best predictions for the economy and the property. For example, can the investor manage the debt stress if the market should turn south, vacancies increase, or the property needs significant repairs or upgrades? Build toward a payment that you can live with should times get difficult in the future.
  • When determining appreciation expectations on the property, lean toward the conservative side. Security is found in a lower expectation and leaves room for good news if the appreciation is higher than anticipated.

Leverage and COVID

Not surprisingly, COVID has left its imprint on leverage. And for guidance, many experts look to the Great Recession. Prior to 2008, a large number of loans were issued at peak property values and with high leverage amounts in the 85% and 90% range. When the bubble burst, investors found themselves in dire straits, with outstanding debt more elevated than the properties’ value. The solution for investors was to de-leverage, look for new, smaller mortgages, or default.

COVID is this and so much more—the fallout from the pandemic has been swift for specific sectors, and the overall impacts for CRE are still accruing and yet to come due. While interest rates are extraordinarily low, investors are also looking at a market that has resulted in higher-than-normal vacancies and tenants re-thinking space needs. And many tenants may not be able to return as Federal-relief loans are expiring in the face of surging cases. Nevertheless, there are two key developments:

  • Leverage can only happen if there are lenders. At the moment, lenders that are currently managing COVID-related defaults aren’t so eager to take risks. And many who anticipate defaults or maintain significant uncertainty about the pandemic are also carefully scrutinizing applications. Thus, leverage financing may be more challenging to acquire, particularly as many of the COVID-relief programs expire.
  • If there’s a clear exception, though, it’s in the warehouse sector—particularly those properties connected to e-commerce, which has grown tremendously during the pandemic. Read this blog on the COVID K-shaped economic recovery and which sectors may be winners and losers in the new normal.

To leverage or not to leverage? Get some CRE assistance in SoFlo

The biggest takeaway is that any decision to use leverage can only be made on a case-by-case basis. Excellent financing, for example, can easily become undone with the purchase of the wrong property or by overlooking current and expected trends and comparable properties. Using leverage properly can only be achieved with sufficient due diligence

For help in exploring your options, call Morris Southeast Group at 954.474.1776. You can also reach Ken Morris directly at 954.240.4400 or via email at kenmorris@morrissegroup.com.

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