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Using Leverage in Real Estate Investments

Using Leverage in Real Estate Investments

A loan may cover the gap between the purchase price and available equity or provide funds to make capital improvements to the property (as a construction loan or a line of credit).

Buyers may also leverage a property strategically to improve cash flow. This occurs when income generated from operating the property exceeds the cost of the loan (i.e., the amount of mortgage interest paid during the loan term). The owner receives more income from borrowed funds than the financing costs, making a profit on the spread.

How do investors assess whether they should use leverage in real estate? How much is optimal? What kind of loan terms are available in the marketplace? How do you evaluate them in the context of a particular deal?

Whether a loan makes sense for a given real estate project depends on the following six factors:

1. Is the loan necessary or beneficial?

As a threshold, do you have sufficient funds to acquire the property, or does your equity comprise only a portion of the purchase price? Do you have enough cash to make the desired up-front improvements to your property without borrowing? Are your working capital reserves sufficient to cover unexpected costs? If the answer to any of these questions is “no,” then a loan may potentially provide a solution.

Even if you do not need a mortgage for any of the above reasons, a loan nonetheless may be beneficial to boost your annual cash flow. Leverage can improve cash flow if the net operating income (“NOI”)[1] from the property exceeds the cost of the loan. The loan essentially enables you to make profits from borrowed funds.

2. How does your projected income compare to the cost of borrowing?

At the outset, ensure your anticipated net operating income will be greater than the cost of borrowing. Negative leverage, where the interest payments are higher than the revenue from the property’s operations, won’t increase cash flow.

Consider the following example: the acquisition of a $1 million property with existing tenants, NOI of $52,000 in the first year, and annual NOI increases of 2.0%. You receive debt quotes for loans with a 30-year amortization[2] at interest rates of 4.25% and 7.00%:

No Loan Lower Interest Higher Interest
Purchase Price $1,000,000 $1,000,000 $1,000,000
Interest Rate 0% 4.25% 7.00%
LTV 0% 70% 70%
Equity Required $1,000,000 $300,000.00 $300,000.00
Loan Amount $- $700,000.00 $700,000.00
Annual Debt Service $- $41,322.95 $55,885.41

Annual Net Income

Year 1 $52,000.00 $10,677.05 $(3,885.41)
Year 2 $53,040.00 $11,717.05 $(2,845.41)
Year 3 $54,100.80 $12,777.85 $(1,784.61)
Year 4 $55,182.82 $13,859.87 $(702.59)
Year 5 $56,286.47 $14,963.52 $401.06

 

In this example, you will have positive cash flow from the outset if you do not take a loan or if your loan has a low-interest rate (4.25% in this case). However, if you can only get a loan at 7.0%, it will take you five years before you start generating NOI after making your loan payments. This may be okay in the long run if there is enough anticipated growth in income or appreciation, such as in the case of development or “value-add” project, but such a loan will not be helpful if you want to generate current cash flow.

Prudent investors may prepare or review cash flow projections to avoid negative leverage, but changing circumstances can turn an initially beneficial loan into a money drain.

For example, if the interest rate is variable or floating (rather than fixed), a rate increase (4.25% to 7.00% in the example above) may put the property into a negative leverage situation. Similarly, a reduction or abatement of a tenant’s rent or the loss of a tenant can cause the NOI to dip below the amount needed for loan payments.

Additionally, it is important to account for transaction costs. These include loan fees and the lender’s legal fees, as well as reserves that lenders often hold back from cash flow to cover future capital improvements, re-tenanting costs or other anticipated expenses. This problem may compound if the loss of rental income triggers loan provisions that allow the lender to sweep future cash flow, holding the NOI generated by the property until new tenants are in place.

Investors can protect themselves from these situations by:

  • using fixed-rate mortgage loans,
  • setting aside sufficient reserves,
  • obtaining insurance for interruption of rental income due to natural disasters, or similar uncontrollable circumstances, and
  • focusing on properties where you can reasonably expect the net operating income and the value of the underlying real estate to appreciate over the term of the loan.

3. Will you be able to repay the loan at maturity?

The most obvious drawback to putting a mortgage on your property is the risk that you will not be able to make the loan payments as they come due. Even worse, you may be unable to pay off the debt at the time of maturity. This concern is especially important if the loan includes an amortization schedule that exceeds the loan term, meaning that there will be a balloon payment for the outstanding principal balance when the loan comes due. This crucial aspect of borrowing is often overlooked or underestimated.

The larger the loan in comparison to the value of the purchase price, the greater the risk. While it may be possible to borrow up to 90% of the purchase price for a property, it may not be advantageous to do so. Lenders will consider the proposed loan-to-value ratio (“LTV”)[3] in their underwriting and frequently offer a more competitive rate for loans with less risk (lower LTVs).

4. Are you permitted to pay off the loan early?

In contrast to conventional mortgages on personal residences, commercial real estate loans usually cannot be prepaid without penalty. Rather, the loans often include provisions precluding the borrower from paying down the loan balance faster by sending in extra principal along with the scheduled monthly loan payment. Such yield maintenance covenants ensure that the lender makes the profit margin targeted in its original underwriting. These covenants are particularly important to banks that package and sell their paper to third parties.

A defeasance provision allows the lender to receive a prepayment penalty if the borrower pays off the loan in full in advance of maturity. This most commonly occurs if the owner wants to sell the property before the loan comes due. Such covenants often have a lockout period at the beginning of the loan term, in which the loan cannot be prepaid at all, as well as a grace period near the time of maturity to give the borrower some flexibility on the timing of disposition.

However, commercial borrowers can avoid significant fees if they want (or need) to sell their property before the loan matures. In many instances, a non-defeasible loan can be assigned to and assumed by a new owner of the property, especially if there are tenants in place paying rent through the remaining loan term. While the lender will have to approve the new borrower, and there may be a fee charged for the transfer, the cost may be substantially less than the prepayment penalty.

5. What type of security does the loan require?

It’s important to consider to what extent the loan will be “recourse.” Recourse refers to the remedies the lender retains in the event the borrower defaults on the loan. Under a full recourse loan, the borrower’s principals will be required to provide a personal guaranty of payment and performance. The lender can recover the outstanding loan balance from the borrower’s principals in the case of a default.

A non-recourse loan, in contrast, provides the lender with the ability to foreclose and take the property in the event of a default. The lender generally cannot access the principals’ personal assets to satisfy the indebtedness, absent fraud or malfeasance by the borrower.

In such case, the principals may be required to provide a carveout guaranty. A carveout excludes the borrower’s gross negligence or acts of misconduct from the limitations on liability included in the loan documents. However, if the borrower defaults for some other reason—such as a tenant going out of business—the lender cannot legally pursue the principals personally to obtain payment. This is particularly important if the foreclosure sale results in a deficiency where the proceeds are less than the outstanding loan balance.

6. Other considerations when using leverage in real estate

You can take advantage of low-interest rates by locking in a long-term loan. In addition to minimizing the overall amount of debt service you will have to pay, this can help you avoid a negative leverage situation. You may also consider an amortization schedule that lets you pay down a greater percentage of the loan (or all of it) so that you only owe a small balance at the time of maturity. This protects you from market downturns when the loan comes due because you’ll have more equity in your property. As noted above, a lower LTV may provide investors with more favorable borrowing terms and lower overall risk from borrowing.

Understand and assess these risks early so that you can evaluate whether—and to what extent—a loan is a good idea for your real estate investment.

[1] Net operating income, or “NOI,” is equal to all of the revenues received from the property (i.e., rents and fees) minus the cost of operating expenses (i.e., utility costs, insurance, and taxes). NOI is a pre-tax figure and does not take into account loan payments, capital expenses, or depreciation costs.

[2] Amortization is the spreading of loan payments over a fixed amount of time in installments of principal and interest. It does not necessarily reflect the term of the loan. For example, a loan may have a 25-year amortization schedule, but be payable over a 10-year term. In that case, a balloon payment reflecting the outstanding balance will be due at maturity.

[3] LTV is a percentage calculated by dividing the loan amount by the value of the property (which is typically either the purchase/sale price or an appraised value).

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