Negative Leverage Explained
As a real estate investor, you've likely heard of the concept of leverage. It's the use of borrowed funds to increase the potential return on investment. Negative leverage occurs when the cost of borrowing exceeds the un-levered yield or capitalization rate. It’s a situation that investors in high-quality real estate assets find themselves in today. In this article, we'll explore whether negative leverage in multifamily investments can ever be a good idea.
In a positive leverage environment, a borrower can achieve higher returns by leveraging their investment with borrowed funds. However, in a negative leverage environment, the opposite is true. Investors who take on too much debt in a negative leverage situation can diminish their returns, as the borrowing cost is higher than the un-levered yield or capitalization rate.
Negative Leverage Example
For example, consider a commercial multifamily apartment building with a net operating income of $100,000 and priced at a 5.5% capitalization rate, or $1,820,000. In a positive leverage environment, assume the interest rate on debt is 4.5%. The borrower can get up to 75% loan to value with a debt service coverage ratio (DSCR) of 1.25, and their yield on equity will be 4%. However, in a negative leverage environment, assume the interest rate on debt is 6.5%. The borrower can get up to 60% loan to value with a DSCR of 1.25, and their yield on equity will be 2.6%.
To illustrate this concept, let's consider the following table:
As the table shows, investors in a negative leverage environment will have a lower yield on equity than those in a positive leverage environment, even though the asset's net operating income and capitalization rate remain the same.
When Does Buying in a Negative Leverage Environment Make Sense?
So, is negative leverage ever a good idea for multifamily investments? While it may seem counterintuitive, there are certain situations where negative leverage can make sense. For example:
At the end of the day, each investment opportunity is unique, and it's up to the investor to weigh the risks and rewards of negative leverage. As a private real estate investment firm, we specialize in finding strategies that make our investors excellent risk-adjusted returns in any type of market. If you're interested in learning more about how we can help you achieve your investment goals, visit our website at www.esrepartners.com.