Leverage is an indispensable part of commercial real estate investing, but what exactly is it and how does it work? When you use leverage, you’re using borrowed money to — hopefully — increase equity. If you’ve ever taken out a mortgage, you’ve leveraged your assets. Read on to learn more about how to use leverage in commercial real estate financing and how to evaluate the risks.
What is Leverage in Real Estate?
In real estate, leverage refers to using debt for the possibility of yielding a higher rate of return on your real estate investment. Unless you pay for a rental property fully in cash, you’ll be using leverage by buying a property with borrowed money, with the goal of increasing your equity.
How Does Leverage Work in Real Estate Investing?
Say you have $200,000 in the bank. You could decide to take all that money and invest it in a real estate rental property. In two years, the property value increases by 10%. Now your $200,000 is worth $220,000. But was this the best use of your money? Let’s consider an alternative scenario.
Instead, you take your $200,000 and use it as a down payment to purchase a $1M property. You take out a mortgage for the remaining $800,000. After two years, the property value also increased by 10%. In this simplified scenario, the idea is that if you sell that rental property after two years, you’ll have made a total of $100,000 (before fees and expenses) — much more than you’d have made from the first example we illustrated.
So why would you ever not use leverage in real estate investing? This decision depends to a large degree on how much risk you are willing to take. The downside when you use leverage is that — just as you can earn a 50% return on your investment, as in the second scenario — you can lose that same money. In the first scenario, the most you can lose or gain is 10% of your original investment.
Why Use Leverage in Commercial Real Estate?
Of course, the main reason real estate investors use leverage in commercial real estate is for the potential to make more money than you could otherwise, as described in the scenario above. It’s also a chance to build equity without putting your own cash on the line, except perhaps for the down payment.
The amount of leverage you take on a commercial real estate investment will largely depend on the type of deal you’re making. If a deal is more stable, like a single family or multifamily rental property or industrial building, there’s a higher possibility you’ll be able to borrow more money. On the other hand, when the deal is riskier — as office buildings and real shopping centers became during the pandemic — it’ll be harder to secure a deal with high leverage.
Real Estate Leverage: Risks and Liabilities
When you use leverage in real estate, the risks and liabilities vs. advantages tend to balance out.
“Leverage is a double-edged sword,” Miguel Jauregui, Director of Capital Markets at SAB capital, told leverage.com. “Once you take out leverage, it will amplify your cash flow and returns. But if something goes wrong, like a tenant goes vacant, the property goes vacant, or a tenant leaves, you’ve got the opposite. You still have an expense that remains: your debt service, your mortgage payments. And those aren’t going anywhere. You can get away from that.”
In short, when you are borrowing money for a real estate investment, you run the risk that something could go wrong and you’ll be left with the debt. For this reason, some clients choose to opt out of leveraged deals entirely, Jauregui said.
“If my tenant leaves, I don’t want to have it hanging over my head that I still have to make these payments,” these real estate investors tell Jauregui.
When you’re leveraging a commercial real estate deal, you are betting that the rental property will generate a certain amount of income. But what happens if, say, all your office tenants break their lease or don’t renew? Now your property is no longer generating that income, but you’re still left with mortgage payments.
Certain tenants will be riskier than others, and often you’ll find there’s a correlation between the risk you’re taking and the amount of rent a tenant is willing to pay. The cannabis industry is a good example of that dynamic.
“Cannabis tenants pay a lot of money, but it’s risky because the Fed could come in and make it illegal overnight, and they can get wiped out,” Jauregui explained.
Higher Loan Payments
“The risk of using too much leverage is that your loan payments are typically going to be higher,” said Desmond Holzman-Hansen, a Capital Markets Analyst at Lev.
When you’re taking on a high amount of financial leverage, the property needs to be healthy enough to support these high payments. If something goes wrong, and you go from 90% occupied to 70%, you still need to be able to pay back the loan. The more leverage you have on the deal, the more difficult it will be to cover these unexpected turns.
“There is certainly such a thing as over-leveraging a property,” he said. He added that, though there is a large range, standard leverage would be somewhere between 65 and 75% across the board.
What to Look for in a Commercial Real Estate Loan
Every commercial real estate deal is different. When you’re evaluating the terms of a loan, there are multiple factors to consider. Here are the main ones.
Depending on the loan you take out, interest rates can range from 3% to around 6%. The rate for hard money loans and bridge loans can reach up to 15%. You’ll want to factor this cost in when you’re evaluating a loan.
What’s less obvious is that sometimes the amortization can impact the total cost in the long term. Borrowers tend to overlook the way amortization can impact cash flow, Holzman-Hansen noted.
“If you have a loan that amortizes over a longer amount of time, meaning you pay back less of the principal in each period, you have more cash flow at the property and over time you’re making more money. So, even if the interest rates are slightly higher, you still have greater cash flow and lower debt service than you would with a loan that has a shorter term amortization period,” he said.
Recourse vs. Non-Recourse Loans
A recourse loan means that if something goes wrong, the lender can go after the borrower’s personal assets. That’s not the case with a non-recourse loan.
When it comes to CRE, whether a loan is recourse or non-recourse usually depends on the type of deal, Holzman-Hansen said. An apartment with no or very few vacancies will likely be a non-recourse loan, for example. Riskier deals may more often be recourse loans. Private debt funds often offer non-recourse loans, while banks typically lean toward recourse loans.
You’ll want to make sure the length of the loan lines up with your business goals. For example, let’s say your plan is to take a building that’s currently 30% occupied, and lease it to new tenants over the next three to four years until the building reaches 100% occupancy. Then, you can resell the property at a profit.
“You wouldn’t want to sign a loan with a 10-year term because at the end of the four-year period, you know when you look to sell your lenders will want to clip a 5% fee. That’s really going to negate your returns,” Holzman-Hansen explained.
Cutting a loan short often means you’ll be faced with prepayment penalty fees. These fees are “a tool that lenders use to make sure that they capture the returns that they’re seeking over a period of time,” Holzman-Hansen said.
You’ll want to make sure you’re aware of what this fee is and how they will impact your bottom line if you do choose to end your loan term early.
Prepayment penalties are generally structured so that as you get closer to the loan’s maturity date, the more the fee decreases, Holzman-Hansen explained. For example, for a loan with a five-year term, you’ll pay 5% in prepayment penalty fees the first year, then 4% the second year, 3% the third, and so on.
You’ll also want to consider that lenders usually take a fee either at the beginning or end of your loan. The fee is often a lot higher than expected.
“A lot of the time I’ve had two options for a borrower: the interest rate might have been slightly higher on one, but the fees were significantly higher than the other. Sometimes it’s actually cheaper for the borrower to go with a slightly higher interest rate with less fees,” Holzen-Hansen said.
The Risks and Rewards of Leverage
The difference between sleeping better at night and the thrill of potentially making a huge return on your investment is one reason why some people choose to leverage their real estate deals and others don’t. However, sometimes the decision is more practical. After the pandemic, a loan for a multifamily unit will likely secure higher leverage than an office building.
Ultimately, how much a borrower chooses and is able to take on for their loan will depend on their personal financial standing, the type of deal they’re making, how much they can borrow and the amount of risk they want to take.