Consistently making money in real estate requires knowing what you are doing. A big part of knowing what you’re doing is understanding the terminology that goes into your decision-making process. Needless to say, real estate investing is known for arcane terms that aren’t used anywhere else. ‘Negative leverage’ is one of them.
What is negative leverage? More importantly, why should real estate investors care? The term describes a relationship between interest rates and market capitalization (market cap). It matters because it can influence an investor’s decision about buying a new property.
More About Market Cap
Understanding negative leverage starts with understanding market cap. In commercial real estate, the market cap is the amount of return a piece of property generates if it is owned free and clear. If you were to purchase a piece of property with a 5% market cap, your annual return, assuming you did not have an outstanding loan on the property, would be 5%.
Now, let us tie that to interest rates. Market capitalization is one of the things lenders look at when considering whether to approve a loan for commercial property investment. Market cap Is one of the primary factors in determining a property’s value.
Let’s say an investor approaches Salt Lake City-based Actium Partners hoping to get a hard money loan on a new property. Actium offers an interest rate that is higher than the property’s market cap. You now have a negative leverage scenario. This does not mean Actium will turn down the loan. But it does mean the investor has to think long and hard before going through with the deal.
And Inverse Relationship
It is interesting to note that the relationship between market cap and property value tends to be an inverse one. As market cap rates increase, property values tend to decrease. This is why negative leverage creates an extra bit of risk for real estate investors. An investor looking to acquire a property even in a negative leverage scenario might be counting and an increased market cap in the long term. However, the subsequent drop in property value could make the investment less attractive.
Negative leverage is also a more serious issue in commercial properties than it is in residential. The residential market is influenced more by emotion and short-term trends. Therefore, investors expect substantial ups and downs within a typical 2–5-year timeframe. On the other hand, commercial real estate values are more heavily influenced by market cap.
Market Capitalization and Purchase Price
Negative leverage is also a concern as it relates to purchase price. Given that higher market caps trend toward lower property values, there is a genuine risk of overpaying. And as any property investor knows, paying too much to obtain new properties can destroy an investor’s portfolio. Investors need to be very careful about the purchase price.
Ideally, investors want an interest rate and market cap that are roughly equal. That way, the risk between the lender and the borrower is minimized. Equal interest and cap rates are also a sign indicating that an investor has found a good balance between investment return and the cost of borrowing.
Negative leverage should never be the sole factor in determining whether an investor should purchase a property. On the other hand, it should not be ignored either. Negative leverage is a strong indicator that an investor should be cautious. The deal should be looked at from every angle before deciding whether to proceed. There are times when negative leverage indicates a bad investment. There are other times when it does not.