by David Repka and Lindsay Rapuano
In the world of commercial real estate investing, the concept of leverage has long been a key driver of returns. By utilizing low-cost borrowed capital, investors and developers could amplify their potential gains. However, in recent times, a concerning phenomenon has emerged, where the cost of financing exceeds the unlevered return one can make in real estate. Throw in the added burden of shorter and shorter amortization periods as lenders try to mitigate their risk and exposure in fast changing markets (interest only loans have given way to lenders asking for 30-25-20-15 year amortization schedules). This has resulted in a negative leverage situation, posing significant challenges for investors. In this blog post, we will explore this problem in detail and provide seven potential solutions to navigate this increasingly complex financial landscape.
Understanding Negative Leverage:
Negative leverage occurs when the interest rate on borrowed capital (call it 6%) exceeds the cap rate at the Seller’s asking price (call it 4.5%). In such a scenario, the investor is faced with a fundamental problem – the cost of financing erodes the profitability of the investment. This poses a considerable obstacle for commercial real estate investors seeking to maximize their returns.
The Impact of Negative Leverage:
Negative leverage can have several implications for commercial real estate investors:
- Reduced Return on Investment (ROI): With financing costs eating into the returns, investors may experience a diminished ROI compared to what they initially anticipated.
- Cash Flow Challenges: High debt service payments relative to property income can put pressure on cash flow, potentially leading to liquidity issues.
- Increased Risk: Negative leverage increases the vulnerability of investors to market fluctuations, making them more susceptible to economic downturns.
Seven Solutions to Navigate Negative Leverage:
1- Lowering Financing Costs:
- Explore multiple lenders and negotiate for competitive interest rates.
- Consider alternative financing options such as credit unions, insurance companies, Wall Street Conduits, Agency Lenders and debt funds, which may offer more favorable terms.
2- Increasing Property Income:
- Focus on enhancing the property's cash flow by increasing rents, reducing vacancies, or diversifying revenue streams.
3- Implement cost-saving measures to improve the property's overall profitability.
- Renegotiating Debt Terms: Engage in open discussions with lenders to renegotiate loan terms, including interest rates, repayment schedules, or refinancing options. Provide lenders with a clear strategy for improving property performance to demonstrate the potential for increased returns.
4- Reevaluating Investment Strategies:
- Consider shifting investment focus to assets with higher yields or alternative real estate sectors where the cost of financing is more favorable (multifamily with low-cost, fixed rate, non-recourse Agency loan from Fannie, Freddie, or FHA rather than investing in another suburban office building).
- Explore emerging markets or regions where investment opportunities offer better potential returns (my home state of Florida welcomes investors with open arms).
5- Seeking Joint Ventures:
- Partnering with other investors or real estate firms can help distribute risks and mitigate negative leverage's impact.
- Collaborate with entities that possess expertise in managing negative leverage situations to optimize investment outcomes.
6- Optimizing Tax Benefits:
- Leverage available tax incentives and deductions to minimize the impact of negative leverage on after-tax returns.
- Work closely with tax professionals to identify potential strategies such as accelerated depreciation and opportunity zones for maximizing tax benefits within the investment structure.
7- Patient Capital and Long-Term Perspective:
- Maintain a long-term investment horizon and align the investment strategy with stable cash flow generation over time.
- Seek patient capital sources that are willing to weather short-term challenges in exchange for potential long-term gains.
Conclusion:
Negative leverage presents a significant hurdle for commercial real estate investors in today's market. However, by adopting a proactive and strategic approach, investors can navigate this challenge and maximize their returns. Lowering financing costs, increasing property income, and renegotiating debt terms are immediate steps to alleviate the negative leverage impact. Reevaluating investment strategies, seeking joint ventures, optimizing tax benefits, and embracing patient capital can provide a long-term perspective and resilience in the face of this predicament. With a comprehensive and adaptable strategy, investors can transform negative leverage into an opportunity for growth and success in commercial real estate investing.
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Bison Financial Group