Leverage in the financial world is a sophisticated way of saying debt. Using debt to invest sounds contradictory to how we’ve been taught to manage our money, but if used correctly it can yield awesome investment returns, and accelerate the compound annual growth of your capital. On the flip side, if you use too much, the risk profile of the investment increases proportionally as well. The ultimate risk is total default. In real estate this foreclosure. Essentially leverage accelerates potential gain, but also potential loss; both to the same proportion.
If you purchase a rental property for $500,000 in an all cash deal and your annual pretax cash flow is $37,500, you get a 7.5% cash on cash return. Enter leverage: say you put down 20% ($100,000 plus closing costs) and got a mortgage for the remaining $400,000 at a fixed interest rate of 3.25% (October 2020’s average rate) amortized over 30 years. Excluding property taxes and insurance, which was already factored into the annual pretax cash flow of $37,500, the principal and interest only come out to roughly $1,740 monthly or $20,880 annually. This reduces pre tax cash flow to $16,620. The new cash on cash return in this hypothetical example is now 16.62% (16,620 / 100,000) which is more than double the return in the all cash example. This works the other way too if the cash flow was negative in the all cash purchase example, the loss would increase proportionally with the same leverage conditions. Investors should be mindful of positive and negative leverage in real estate. The 16.62% was a perfect example of leverage working positively to boost return. In this example, putting 20% down represents 5:1 leverage that had a 2:1 impact on returns. However in other investments, high interest rates combined with low capitalization rates create the headwind of negative leverage; where the cash on cash return is lower when using debt, compared to the purchase capitalization rate of the real estate.
Low cap rates and a rising interest rate environment were the major contributing factors behind a brief commercial real estate slowdown and mini-correction in Q4 2018, which quickly reversed as the Federal Reserve ended its Quantitative Tightening program, lowering commercial and residential mortgage rates from the December 2018 high of 5%+ to now (October 2020) under 3%, resuming a long bull market in American residential and commercial real estate.
Today more and more investors are experiencing the drawbacks of leverage, particularly in commercial real estate. Movie theatres like AMC are low on cash and facing imminent bankruptcy. Hotels are no better with average occupancy rates dangerously low, and nearly half of all CMBS loans in forbearance being tied to hotels. Brick and mortar retail is another bloodbath with B and C class malls facing an avalanche of store closures battering share prices of mall REITs already low on cash, and fighting to stay alive. Many retail REITs are expected to slash dividends to try to weather the storm.
The lesson for investors is to stress test their assets, because the threat of a bear market is always perpetual. Apartment rents are down more than 20% in San Francisco, and there still falling. San Francisco real estate was hailed as the strongest real estate market in the country by its fundamentals of low supply, high demand, population growth and strong wages; the Coronavirus™ has thrown away all trends and fundamentals in classic black swan fashion. Commercial real estate has become a deer in the headlights. The idea that “rents will never fall” has lead real estate investors particularly in multifamily to leverage themselves to the hill.
Although leverage in real estate may be safe relative to other assets classes, a bear market in rents or property values can sink speculators buying properties with low or even negative profit margins, hoping to profit from price appreciation. If investors understood the concept of DCR, or Debt-Coverage Ratio, the Housing Bubble and subsequent GFC in 2008 could have been avoided. Debt coverage is calculated as annual net operating income divided by debt payments (annual). A ratio above 1 indicates that there is enough operating income to service debt, less than 1 indicates negative cash flow. When investors have a low DCR, their real estate is becoming less of an income investment and more of a speculative call on price appreciation.
Differentiating between investing for appreciation and investing for income is important. If you’re bullish on Silicon Valley real estate and you purchase a home for $1,500,000 putting $300,000 down (plus closing costs) and taking a loan of $1,200,000 and proceeding to rent the property for $4,500 a month, you’re guaranteed to bleed cash as low rents relative to mortgage payments ensures an negative DCR. The appeal though is speculative growth. If the home’s value rises to $1,900,000 after two years and you sell it, pocketing a $400,000 gain (minus closing costs) then the investment was highly successful.
However, if the property value falls to $1,300,000 after two years during a recession, your left holding the bag. The speculative nature of real estate investments; becoming less of an income investment and more like FAANG stocks, where investors bet big for even bigger returns, will lead to disaster.
Real estate is fundamentally a good investment. Too much cheap debt and too much speculative fervor has perverted what was a solid income investment into a wild speculative roller coaster. Leverage can be appropriate, but too much of a good thing is dangerous.