Commercial Investment Real Estate July/August 2019 | Page 16

FINANCING
FOCUS
Knowing the Negative
When interest rates decline and borrowers welcome more
debt, what opportunities and challenges come with a negative
leverage environment?
by Doug Marshall, CCIM
The Impact of Positive Leverage
For much of the decade following the Great Recession, the U.S.
was in a positive leverage environment. If you added another
dollar of debt when financing your rental property, it had a posi-
tive impact on the property’s cash-on-cash return. The more
Table 1: How Leverage Impacts a Property’s Cash-On-Cash Return
No
Leverage
Cash Flow Before Debt Service
Proposed Mortgage Amount
Interest Rate
Amortization in Years
Annual Mortgage Payments
Cash Flow After Debt Service
Equity
Cash-On-Cash Return
50%
Leverage
65%
Leverage
75%
Leverage
227,369
227,369
227,369
227,369
– 1,837,500 2,388,750 2,756,250
5.45%
5.45%
5.45%
5.45%
30
30
30
30
–
124,507
161,859
186,760
227,369
102,862
65,510
40,609
3,675,000 1,837,500 1,286,250
918,750
6.2%
5.6%
5.1%
4.4%
the property was leveraged, the better the return. Financially, it
made perfect sense to add as much debt as possible when financ-
ing your property.
But that situation ended last year. It was a seller’s market result-
ing in very low cap rates, while interest rose roughly a full point.
Those two factors can cause a negative leverage environment,
which can affect assets across all classes.
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July | August 2019
The Impact of Negative Leverage
For most of 2018, we were in a negative leverage environment —
meaning the more a property is leveraged with debt, the worse
its cash-on-cash return.
While in such a market, I helped a client secure financing for
a triple net lease, single-tenant building. The property gener-
ated cash flow of $227,369 annually before debt service. I asked
my borrower, “How much debt do you want to finance your
purchase?” I presented four financing options: no leverage and
50 percent, 65 percent, and 75 percent leverage.
Table 1 illustrates the results of leverage on the property’s
cash-on-cash return. Each column represents one of these four
financing options.
Owning the property debt-free resulted in a cash-on-cash return
of 6.2 percent. As you can see in Table 1, the more debt that was
added to the property, the lower the property’s cash-on-cash return.
What is neutral leverage?
I also wondered at what interest rate would adding debt result
in neutral leverage? It turns out, in this case, an interest rate of
4.65 percent resulted in neutral leverage, as shown in Table 2.
Some of you may be thinking that adding debt of any amount
will always have a negative impact on the property’s cash-on-cash
return. Not so. Look what happened when I lowered the interest
rate to 4 percent.
With a 4 percent interest rate, the more you leverage the prop-
erty, the higher the cash-on-cash return.
How did we go from a positive leverage to a negative
leverage environment?
For the past year, interest rates rose significantly without a cor-
responding rise in cap rates. All else being equal, when interest
COMMERCIAL INVESTMENT REAL ESTATE
D
iscussing commercial real estate financing causes some
to quickly check out, their eyes glazed over. While the
intricacies can seem boring and irrelevant at times, the
devil really is in the details — and the effects of the
leverage environment on cash-on-cash returns.