What Is Negative Leverage in Real Estate?

Real estate investors often use debt to finance their endeavors. This allows the investor to put up less money in acquiring a property. The use of debt by the investor is called leverage. Basically, the investor is granted buying power through a loan. It’s money the investor would not otherwise have.

There are two types of leverage — positive and negative. If you think negative leverage isn't good, you'd be right. Let's see what negative leverage is and compare it to positive leverage.

What Is Leverage?

An investor who has $100,000 to invest wants to buy a $500,000 property. Of course, $100,000 is only 20% of the way there. The investor needs another $400,000. There are a few ways to do this:

• Find investors
• Bank loan
• Line of credit
• Hard money loan

All of the above add capital that doesn’t belong to the investor. This is called leverage. Instead of only $100,000 in buying power, the investor will have $500,000 after receiving the new funds — the investor will be 5X leveraged.

The additional funds will allow the investor to purchase a property that would have been out of reach. In this way, the investor can take advantage of new opportunities.

Leverage can have the added benefit of boosting returns, assuming the project's value increases. For example, a year later, the above property increased in value to $525,000. That's a 5% overall property value increase. 

However, since the investor put in only $100,000, the return is 25,000/100,000 = 25%. This ignores costs such as debt financing, taxes, and operating expenses. If the investor had to put in the entire $500,000, the return would have been 5%.

Investors need to be aware that leverage works both ways. If the property's value drops by $25,000, the overall return is negative 5%. But for the investor, the return is negative 25%.

The investor used debt financing, which comes with an interest rate. With each payment, the investor pays an interest expense. This is where positive and negative leverage comes in.

Positive and Negative Leverage

When using debt financing, it’s important to know if you are leveraged positively or negatively. Positive leverage means that your cash on cash return is higher than your debt service. Negative leverage is just the opposite. You are paying more in debt servicing than if you had just bought the property with no debt financing.

It’s easiest to see this with an example. In this example, an investor purchases a property for $5MM with a $3MM loan. Here’s the breakdown: 

Purchase price: $5,000,000

NOI: $325,000

Cap rate: 6.50%

LTV: 60.00%

Loan amount: $3,000,000

Interest rate: 4.75%

Amortization (mos): 360

Equity invested: $2,000,000

NOI: $325,000

Annual debt service: -$187,793

Cash flow after debt service: $137,207

Leveraged CoC return: 6.86%

Unleveraged CoC return: 6.50%

CoC means cash on cash return. Using leverage, the investor’s CoC is 6.86%. Had the investor decided against debt financing and used all equity, the return would have been 6.50%. In this case, the investor is able to pay all the debt financing and still produce a return above a full equity deal. Using debt financing is a better option in this scenario.

If we change the numbers so that the interest rate is 5.25%, which increases the financing cost, we can determine if the debt financing surpasses a full equity deal:

Interest rate: 5.25%

NOI: $325,000

Annual debt service: -$198,793

Cash flow after debt service: $128,924

Leveraged CoC return: 6.31%

Unleveraged CoC return: 6.50%

Of course, unleveraged CoC did not change. Leveraged CoC is now affected by the higher interest rate. The investor’s debt service cost is more. This reduces the leveraged CoC return below that of a full equity deal. In this case, the full equity option is a better return.

After factoring in debt servicing costs, if a project's returns are negative, it probably is not worth pursuing. An investor would need a good reason (and additional capital) to fund a negative-yielding project.