Most people in the commercial real estate industry are familiar with the benefits of leverage. It’s true that acquiring a property with debt rather than all cash can improve the yield to an investor. But too often this gets extrapolated into “the more leverage the better.” However, placing as much debt as possible on a property is not always a good idea because sometimes you’ll end up with negative leverage. In this short article we’ll take a look at how negative leverage works, how much debt is too much debt, and then tie it all together with an example.
First of all, what is positive leverage? Positive leverage occurs when placing debt on a property improves the overall rate of return. Whenever the return component in the property is higher than the interest rate on the debt, positive leverage will occur. Consider the following series of cash flows:
As shown above, the unlevered cash flows produce an internal rate of return (IRR) of 8%. The acquisition price of this particular property is $3,025,000, as is indicated in time period 0. In the levered series of cash flows above there is $2,000,000 of debt placed on the property at a 4.5% interest rate amortized over 10 years. Because the interest rate component of the loan (4.5%) is less than the return component of the property (8.0%), positive leverage occurs and the levered IRR improves to 12.55%.
Now let’s consider a scenario where the same $2,000,000 of debt is placed on the property with a 10 year amortization. But this time the interest rate is 10%.
As you can see from the levered IRR above, this is a negative leverage situation. In this case more debt is not better. The IRR in the levered example actually decreases to 5.4%. This happens because the interest rate component of the loan (10.0%) is higher than the return component of the underlying property (8.0%).
Many people in the commercial real estate industry think more debt is always better. If you have a fixed amount of equity to invest, then you could invest in one single property without any debt, or instead invest in several properties using leverage to achieve a higher return. This is the typical argument for placing debt on a portfolio of properties. But as shown in the simple examples above, this is not always the case.
Understanding the cash flows of the underlying property is key, as well as the return component of the property’s cash flows. If you need help modeling the cash flows for an income-producing property and quickly running what-if scenarios like this on the fly, consider giving our commercial real estate investment analysis software a spin with a free trial!