I know that when I talk about financing, that it’s easy for my readers’ eyes to glaze over. The intricacies of financing seem boring and irrelevant to many. But what I’m about to tell you, is important. You need to focus. Okay??
The Impact of Positive Leverage
Ever since the Great Recession we have been in a positive leverage environment. By that I mean, if you added another dollar of debt when financing your rental property, it had a positive impact on the property’s cash-on-cash return. The more the property was leveraged the better return. Purely from a financial return point of view it made perfect sense to add as much debt as possible when financing your property. NOT SO ANY LONGER!!
The Impact of Negative Leverage
We are now in a negative leverage environment. The more a property is leveraged with debt, the worse the property’s cash-on-cash return.
I recently helped a client secure financing for a NNN lease, single tenant building. The property generated Cash Flow Before Debt Service of $227,369. The question I asked my borrower is how much debt do you want to finance your 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 Cash-On-Cash Return. Each column represents one of these four financing options.
Owning the property debt free resulted in a Cash-On-Cash Return of 6.2 percent. And as you can see, the more debt that was added to the property, the lower was the property’s Cash-On-Cash Return.
What is Neutral Leverage?
Being curious, I wondered at what interest rate would adding debt result in neutral leverage? By neutral leverage I’m mean it would not help or hurt the property’s Cash-On-Cash Return. It turns out in this particular case that an interest rate of 4.65% resulted in neutral leverage as shown below.
Some of you may be thinking right now, that adding debt of any amount will always have a negative impact on the property’s Cash-On-Cash Return. Not so. To prove my point, shown below I lowered the interest rate to 4.0 percent.
As you can see, with a 4.0 percent interest rate, the more you leverage the property, the higher the Cash-On-Cash Return.
How did we go from a positive leverage to a negative leverage environment?
This is the direct result of interest rates rising while capitalization rates remain the same. For the past year we have seen a significant rise in interest rates without a corresponding rise in cap rates. Everything else being equal, when interest rates rise the mortgage payment increases which reduces the property’s cash flow after debt service. A lower cash flow after debt service reduces the property’s cash-on-cash return. To reverse this trend, property values need to adjust downward to compensate for higher interest rates.
Why should we care that we are currently in a negative leverage environment?
Negative leverage is one more nail in the coffin of the current real estate market cycle, to go along with:
- Rising interest rates
- The moderating of rent increases
- More product coming on line which will slowly increase vacancy rates and eventually add concessions
- More regulation to reign in the rights of property owners
We should all be concerned about negative leverage. If present trends continue, buyers will eventually realize that it’s better to pay the capital gains taxes than to buy an over priced property that doesn’t make financial sense to own.
Those are my thoughts. I welcome yours. Am I making a mountain out of a mole hill?
Do you have a need for financing? Contact me at firstname.lastname@example.org to set a time for us to talk.