By Evan Polaski 

Investing in real estate has many advantages from cash flow to appreciation to tax benefits through depreciation.  And, especially important in uncertain times, it is stable, which both benefits the consistency of returns, and also allows for low-cost borrowing.  But not all borrowing is created equal, and while using debt to buy real estate is a very common occurrence, when you are looking at investing in real estate, it is important to know that debt can also hurt returns, even when the asset is performing well.

When it comes to assessing if the debt is helping or hindering the asset, it is a fairly easy assessment.  If the current yield or cap rate is higher than the interest rate, you have positive leverage.  And if the interest rate is higher than the current yield or cap rate, you have negative leverage.

So what is a cap rate?

Cap Rate = Current Annualized Net Operating Income / Property Value

The cap rate is most commonly determined when you have a purchase or sale, since the value is determined by two willing parties.  When a property is currently being renovated, you can also calculate the Current Yield, which is a metric of the current operating yield of the asset.

Current Yield = Current Annualized Net Operating Income / Total Investment in Property

 

With these basic metrics, we can compare the interest rate on the loan to this metric.  To exemplify this, take a look at the two examples below.

We will look at a sample $10million property, bought at a 5% cap rate with a loan at 5.5% interest rate.

Negative Leverage

The primary data point is the in-place cash on cash return of 4.25%.  In this example, if an investor invested in this deal with $100,000, they would received $4,250 in distributions in that first year versus if the deal were purchased with all cash initially, they would receive a 5% yield or $5,000 in distributions in that first year.

Positive Leverage

Using a lot of the same deals as above, but instead of buying the property at a 5% cap rate, it was acquired at a 6% cap rate.

The in-place cash on cash return is now 6.75% in year 1.  And while this is higher than the example above, the real comparison is in cap rate (6%) to cash on cash yield (6.75%).  Because the property without financing is creating a 6% yield right away, borrowing at 5.5% interest creates a boost to the overall return for the investor.

So why would a real estate operator buy a property with negative leverage?

1. Additional transaction costs may be incurred if a property is bought in cash and then the property is refinanced once the current yield is higher than interest rates. Typically, this would require a fast execution of the business plan to increase revenues.

2. The investor believes interest rates will be climbing, so would like to lock in rates at acquisition instead of risking higher rates in the future. This plan only works with long-term fixed rate financing.

3. For many groups, they simply don’t have the equity available to buy assets all cash. As such, they need to take on mortgages at higher interest rates than the property would naturally support just to buy the property. 

At the end of the day, having a property that supports itself and can manage its own financing long term is a sound fundamental that has been applied in real estate over decades.  We at Axia Partners pride ourselves on remaining very conservative with our financing options, both in terms of amount of debt we place on each asset, and how that debt is structured.  This view will protect our assets from any volatility in the debt markets and give us maximum flexibility to execute on our business plans.

Evan Polaski

Evan Polaski

Director of Investor Relations

Evan brings nearly two decades of experience in commercial real estate to Axia. Throughout his career, his primary focus has been on capital markets, orchestrating the acquisition of over $500 million in equity and another $500 million in debt. He has been involved in numerous private investment offerings, catering to a diverse spectrum of investors, ranging from accredited individuals to prominent institutional players. Evan’s expertise extends across a wide array of asset classes. Personally, he maintains a stake as a limited partner in various private real estate ventures and is also a direct proprietor of residential rental properties. Evan holds a Bachelor’s degree in Business Administration, with a focus in Real Estate, from the University of Cincinnati.