Distress in commercial real estate starts to present itself with several notations; one being Negative Leverage.
Negative Leverage occurs when the levered cash on cash return is less than unlevered cash on cash return.
One of the greatest benefits of commercial real estate is leverage. There is no other asset class to that banks will lend 70% of the value at low-interest rates for years at a time. But, all debt is not created equal. Using leverage and making a return that is greater than the interest rate on the debt is positive leverage. Using leverage should boost the performance of an asset, but in the case of negative leverage, the returns are negatively impacted by the implications of being over-levered.
Properties are valued by the capitalization rate which is determined by the positive income the property produces (before the mortgage payment), divided by the purchase price. Capitalization rates that are less than the interest rate on the senior debt are a red flag for risk.
Negative leverage affects the positive income that the property produces. Because there is leverage on the investment, if interest rates climb, so does the debt cost. If the investment already has slim cash flows as is, then this can force the operator to come out of pocket to cover the debt payment.
Operators can push rents to support the increased cost of financing but the question is, how long can this be supported?
The big problems occur when there is negative leverage and a need for a refinance. The reason why this creates a challenge is that the values may not be sustainable at the time with the new risk premium. If a refinance is not possible, the operators would have to come to closing with cash out of pocket. If that is not possible, then comes a wave of defaults…
Conclusion:
One of the main reasons why good real estate deals go wrong is the debt (you know, the term ‘over-leveraged’). It is crucial for investors to understand the capital structure in order to control the risk in an equity investment. Because of the carried risk of leverage, a healthy ‘spread’ between interest rates and cap rates is part of the fundamentals of real estate, which we call, ‘ The Basis’.
We continue to follow our principles and seek growth opportunities, all while controlling the risk.
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