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Welcome to Negative Leverage in CRE

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Negative leverage has raised the ugly head of CRE investment 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 aggressive leverage. Positive leverage occurs when the cap rate is greater than the cost of the debt. In other words, the return on equity is greater than the cap rate. Negative leverage is the opposite and is defined as the case where the cap rate of a real estate acquisition is lower than the cost of the liability or the constant of the liability and therefore the cash-on-cash return is lower than the cap rate. The debt constant is the annual debt repayment (principal and interest and interest) payment divided by the amount of the debt.

If negative leverage occurs, this means that the cash-on-cash return or investor equity return is less than the cap rate, which is a big “no no” for the CRE. This is happening more often in this strong CRE market. This is because interest rates have now risen to 3.0% on 10-year government bonds, up from 1.48% just a year ago. Obviously, this has signed contracts for many real estate investors, and even some of the largest and most sensitive private equity companies in the business, to buy at a cap rate of 3.5% or 4.0% in just a few months. Prior to being captured as real estate, it was necessary to raise funds with debt that cost 4.5% to 5.0% or more.

For example, suppose an apartment property is purchased for $ 50 million, has a net operating profit of $ 2 million, or a cap rate of 4.0%. Only if the property is financed with a 70% or $ 35 million perpetual loan and the interest rate is 4.50% will the annual mortgage payment be $ 1,575,000. Therefore, the annual debt constant is 4.5% ($ 1.575M / $ 35M), which is the same as the interest rate because there is no loan amortization. The 4.0% cap rate is less than the 4.5% debt constant, so cash-on-cash returns drop to just 2.8% ($ 2.0M NOI minus $ 1.575M debt payments to $ 425 equity. Equivalent to cash flow. Dividing K by the $ 15 million equity yields a return of only 2.8%). This is a negative leverage.

One of the most important financial incentives for investing in CRE is to provide investors with high cash-on-cash returns, or what is commonly referred to as “increasing equity.” Leveraging equity is the appeal of the CRE investment business. Other alternative investment programs such as private equity, venture capital and hedge funds do not offer this simple leverage approach. The leveraged equity return structure is unique to the investment and development of CRE. In the above example, if the interest rate of the debt is 4.0% and the cap rate is 5.0% as it was about a year ago, the cap rate of 5.0% is 4.0% and the cash-on-cash return is attractive 7.3%. , This is the yield that investors receive from positive leverage in the first year, which is significantly higher than the 2.8% of the negative leverage example.

Why do investors continue to buy CRE with negative leverage? I think there are three reasons. One is that they want to raise money through a fund or private placement and use it. Second, we believe that higher rents will be high enough to generate positive leverage in the future, and third, many investors, despite concerns about negative leverage. You are looking for a CRE investment to protect inflation. But what if these rent increases don’t happen and interest rates rise further or cap rates continue to squeeze? Half a century of CRE investment that we all have enjoyed since the end of the Great Recession in 2012 could end with higher interest rates and higher cap rates. It all depends on the Federal Reserve System. Is the Federal Reserve seriously working to raise interest rates on the Federal Reserve from just 0.75% to over 3.0%, or “all”, as many Federal Reserves and chairs have stated? There is no cow in his hat. ” I believe in the latter, but we will know who is right in the coming months.

Joseph J. Ori is Executive Managing Director of Paramount Capital Corporation, a commercial real estate advisory firm.

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