Negative leverage, which occurs when the yields on commercial real estate are lower than the cost of debt, has become more prevalent as interest rates continue to rise and valuations drop.
“The days of positive leverage are gone, and it has left many investors in real estate at a crossroads,” says Daniel Lisser, a senior director at New York-based advisory Marcus & Millichap. “Over the past few years, buyers were able to borrow money at rates below the cap rate they were buying at, creating increased cashflow for the equity. With the reverse now common, investors are facing a situation that they have not seen in a long time – negative leverage.”
“The days of positive leverage are gone, and it has left many investors in real estate at a crossroads”
Marcus & Millichap
The yield on the 10-year US Treasury has been on an upward trend since the start of the year, rising from 1.76 percent in January to 4.21 percent in October. Concurrently, higher interest rates have depressed valuations on properties, with a report from Green Street Advisors tracking a 4.7 percent dip in property prices in 2022 to the end of June.
Speaking in October, Edward Fernandez, president and chief executive of California-based manager 1031 Crowdfunding, said: “When you borrowed money 90 days ago, you were able to get positive leverage – the rates on loans were lower than what the real estate was producing. That has now inverted, [making it] difficult to create current cashflow for investors now.”
There are things sponsors can do to avoid a negative leverage situation, including working with lenders to secure an interest-only loan period for either part of or the entire loan term.
“While this option gives borrowers a higher current cashflow, it magnifies the maturity risk as less of the loan principal is paid down,” Lisser says.
Faropoint, a New Jersey-based manager which focuses on last-mile industrial real estate, floated another idea. Adir Levitas, the firm’s founder and chief executive, suggests managers can close deals on an all-cash basis and then line up longer-term financing for later acquisitions where negative leverage could be an issue.
There are cases in which a sponsor is unable to finance an acquisition in today’s market at the leverage levels once expected because the entry cap rate does not make sense, Levitas says. “The leverage point is starting lower to be able to go through that negative leverage period.
“Another strategy is having a programmatic understanding with a lender to upsize leverage as tenants are renewed and the net operating income of a price property rises.”
Using a credit facility can help a borrower with these issues, Levitas notes. If a sponsor has a credit line in place, it is possible to average the cap rate among acquisitions in a way that will mitigate the effects of negative leverage that could be present on some deals.
The market will have to adjust to negative leverage by either having cap rates go up or investors willing to take a lower return, reckons Lisser. “Many buyers are either adjusting the return they are willing to accept down or are bidding based on the current interest rate environment and losing deals.”
Rising interest rates are dampening transaction activity in the US. But they are also opening the door for equity investors to make short-term credit plays. By Samantha Rowan
Commercial real estate lenders and investors are accepting that the current rising rate environment in the US is likely to persist for the medium- to long-term. Here are three ways in which debt and equity managers are adapting to the realities of today’s market, including shifting investment strategies and finding new ways of evaluating risk.
1 Plugging the gap
Rising interest rates have meant there is a significant gap between lender and borrower expectations. But this gap is leading to a short-term opportunity for well-capitalised equity players to fund credit opportunities. New York-based Canvas Properties, Miami-based Kawa Capital Management and Boston-based Taurus Investment Holdings have all identified this as a possible opportunity set, as per conversations with affiliate title Real Estate Capital USA.
“We are in a unique moment for deals that were structured over the past four to six years and are finding that many sponsors are seeing that a key component of their business plans changed, be it because of changes in rent laws or the pandemic,” says Rob Morgenstern, president of Canvas Properties. “Whatever the change, the debt markets are not as liquid as they were.”
2 Two is better than one
Before the global financial crisis, debt service coverage ratios were a key metric in evaluating the risk profile of a loan. As interest rates dropped however, lenders began to favour debt yield as a more accurate measure of risk. Now the balance has shifted back, with lenders looking at both metrics as they consider new loan originations, says Will Pattison, head of research and strategy at New York-based manager, MetLife Investment Management.
Calculating a property’s debt service coverage ratio involves dividing its net operating income by its debt service, with the aim of evaluating a sponsor’s ability to repay debt. In contrast, debt yield – calculated by dividing a property’s net operating income by the total amount of a loan – helps a lender to determine the risk involved with a loan that is being written.
“As rates are once again on the upswing, DSCR is now a more useful measure or indicator of risk – or at least is being perceived that way,” according to Pattison.
3 Scaling back
In October, Aegon Asset Management released a report that outlined what commercial real estate market participants have observed in 2022. According to the manager’s US CRE Market Insights report, commercial real estate lenders have begun scaling back their activity following a moderately strong start in the first six months of the year. While the US saw fairly robust lending volumes in the first half of 2022 amid rising inflation, interest rate hikes and a weakening US economic growth environment, these volumes have since dropped as the outlook became more uncertain, says Martha Peyton, the firm’s managing director and global head of real assets research.
But Peyton does strike a hopeful note. “The strong labour market, rising wages and continued strong consumer spending amid inflation are positive signs for CRE prospects,” she says. “We believe the ongoing availability of commercial mortgage debt despite tightening monetary policy also bodes well for property investors.”