Before you can analyze the merits of a for-sale listing you need to have a basic understanding of the property’s numbers. By that I mean you need to thoroughly understand:
- How a property is valued
- How a loan amount is calculated
- How a property’s cash-on-cash return is calculated
- How loan amortization impacts a property’s cash-on-cash return
- How leverage (the amount of debt borrowed to purchase the property) affects a property’s cash-on-cash return
“In your sleep”
You not only need to know the importance of these numbers, but you need to know how to do these calculations “in your sleep.” They need to become second nature to you.
In the first part of this five part series we discussed how a property is valued. In the second part of the series we discussed how the loan amount is calculated. The first two CRE metrics admittedly were very basic but absolutely necessary for a foundational understanding of CRE underwriting. The third part of the series, how a property’s cash-on-cash return is calculated, was an introduction to that topic. It was anything but basic. We discussed the important difference between Return on Investment and Return on Equity. The fourth part of the series discussed how loan amortization impacts a property’s cash-on-cash return. The fifth and final metric all successful real estate investors should know “in their sleep” is how financial leverage affects a property’s cash-on-cash return.
CRE METRIC #5 – HOW LEVERAGE AFFECTS A PROPERTY’S CASH-ON-CASH RETURN
Let’s begin with the basics. Do you understand what I mean when I say leveraging a property? It means the buyer is using debt to help purchase the property. And the more debt the borrower puts on his property, the more he is leveraging the property. In other words, a property that has a 65% LTV loan is more leveraged than a property with a 50% LTV loan. And a property with a 75% LTV loan is more leveraged than a property with only a 65% LTV loan.
Lowering the interest rate or lengthening the amortization improves the property’s cash-on-cash return. Why? Because in both examples, the monthly mortgage payment is reduced. And reducing the monthly mortgage payment increases the property’s cash flow after debt service (CFADS). Right?
So what does increasing the loan amount (adding more leverage) do to the property’s cash-on-cash return?
A. It increases the cash-on-cash return
B. It decreases the cash-on-cash return
C. It has no impact on the cash-on-cash return
D. Not enough information to make a determination
The answer is D. It depends. It depends on whether we are in a positive, neutral or negative leverage environment.
The Impact of Positive Leverage
For the past 25 years we have generally been in a positive leverage environment. By that I mean, if a borrower added another dollar of debt when financing his rental property, it would have a positive impact on the property’s cash-on-cash return (COCR). The more the property was leveraged, the better the return. Purely from a financial return point of view, it has made perfect sense over these years to add as much debt as possible when financing a rental property.
The Impact of Negative Leverage
Occasionally, the real estate market enters into a “perfect storm” scenario where cap rates continue compressing while interest rates increase dramatically. When these two factors converge a negative leverage environment results. By that I mean, the more a property is leveraged, the worse its COCR.
This “perfect storm” scenario existed for much of 2018. Cap rates had been slowly but steadily compressing ever since the Great Recession of 2009. But it didn’t matter to the average investor because interest rates during this time had slowly but steadily declined as well. Real estate investors could pay more for a property because the steady decline in interest rates promoted a healthy COCR.
But this all changed beginning in the fall of 2017. From October of 2017 through October of 2018 interest rates zoomed up 100 basis points, i.e., interest rates rose a full one percent. While this rise in interest rates was going on, cap rates held steady. Sellers were unwilling to lower their prices assuming buyers would capitulate to their asking prices because it was still a seller’s market.
During this time I had a client who was in the process of purchasing a NNN lease, single tenant building. The property had Net Operating Income of $227,369. The question I asked my borrower was how much debt did he want to finance on his purchase? I showed him four financing options: No leverage, 50%, 65% and 75% leverage. Shown below are the results of leverage on the property’s COCR. Each column represents one of the four financing options.
An Example of Neutral Leverage
Owning the property debt free resulted in a COCR of 6.2%. And as you can see the more debt that was added to finance the property, the lower the property’s COCR.
Being curious, I wondered at what interest rate would adding debt result in neutral leverage? By neutral I mean it would not help or hurt the property’s COCR. It turns out in this particular case that an interest rate of 4.65% resulted in neutral leverage as shown below.
An Example of Positive Leverage
Some of you may be thinking that adding debt of any amount will always have a negative impact on the property’s COCR. Not so. To prove my point, shown below I lowered the interest rate to 4.0%.
As you can see, with a 4.0% interest rate, the more you leverage the property, the higher, the COCR.
How a Negative Leverage Environment Occurs
Let me repeat myself. (I’m old, that’s what old people do.) A negative leverage environment is a direct result of rapidly rising interest rates while capitalization rates remain the same. During the twelve month window, from October 2017 to October 2018, interest rates rose a full point. Everything being equal, when interest rates rise, mortgage payments increase which reduces the property’s cash flow after debt service (CFADS). A lower CFADS reduces the property’s COCR. If this trend were to continue long enough, buyers will stop buying. It’s as simple as that.
To reverse this trend, either cap rates must rise (i.e., property values decline) to compensate for higher interest rates or interest rates need to rapidly decline to where they once were. Fortunately for the real estate market, interest rates have declined dramatically. As of this writing (August 16, 2019) interest rates have declined 150 basis points since October of 2018. That’s huge!!
Why Should We Care?
Why should we care that we are no longer in a negative leverage environment? A continuing negative leverage environment would have been one more nail in the coffin of the current real estate market cycle, to go along with:
- Moderating rent increases
- More product coming online which will slowly increase vacancy rates
- Rent concessions in some neighborhoods for the first time in years
- More regulations to reign in the rights of property owners
Fortunately, the real estate market dodged a bullet to the forehead when rates plummeted, and it is now once again in a positive leverage environment.
That’s my opinion. I welcome yours. What are your thoughts about the impact of positive, neutral and negative leverage on investing in commercial real estate?
Doug Marshall is the award winning author of Mastering the Art of Commercial Real Estate Investing. Check it out on Amazon.