Negative Leverage Real Estate: Should You Use It?

Is negative leverage real estate a risky move? Is it suitable for you?

Given the current uncertain economy, increasing inflation, and higher interest rates, I believe it’s an especially unwise decision. However, some real estate investors are opting for this strategy, so it’s important to grasp how to assess the financial consequences and determine if it’s suitable for you.

This article explains how to calculate negative leverage and offers strategies to combat negative leverage for properties falling into this category.

TL;DR

• Negative leverage in real estate investing occurs when returns are lower than the cost of debt or loan interest rates.

• Accepting negative leverage is plausible in certain situations, such as volatile markets or when property value appreciation potential exists.

• Leveraged real estate investments involve borrowing money and can offer higher returns but carry more risk, while unleveraged investments use personal capital and offer stability. Staying focused on fundamentals is crucial for investment success.

What is Negative Leverage?

In real estate terms, negative leverage occurs when the investment returns on a property are lower than the cost of debt or the loan’s interest rate. It’s the opposite of positive leverage, where the cash return is higher than the debt service.

In commercial real estate, negative leverage can occur when the property’s cap rate is lower than the loan’s interest rate. It means the property’s income needs to be more to cover the debt, which affects profitability.

However, there are cases where a temporary negative leverage situation can be acceptable– especially in volatile markets or when there’s potential for property value appreciation over time. You might be OK with negative leverage in these situations.

Evaluating Negative Leverage Investments

Consider the various aspects of negative leverage and how it can affect your real estate investment strategy for a specific property. Here are a few key points to include in your analysis:

Risk And Reward

Investments with negative leverage tend to increase risk since the income earned may not be enough to cover debts. Investors must assess potential rewards and determine if the gains outweigh the risks.

Cash Flow Management

Implementing cash flow management becomes more important when dealing with negative leverage.  Do you have enough reserves to cover shortfalls?  Can you finance stabilizing the property?

Market Conditions

What is happening in the current market? It may not be a good idea when the market is stable or declining due to potential financial strain. However, negative leverage could make sense for a property in a rising market with strong appreciation potential.

Exit Strategy

You need a clear exit plan if you have negative leverage.  Create a plan and strategy on how to make the investment pay off, like through property value growth, refinancing, or other methods.

What To Do If You Have Negative Leverage?

Here are some steps and ideas if you are looking at a property with negative leverage:

Evaluate The Property

Analyze the property’s financial performance to determine why the negative leverage is happening. Look at the rental income, expenses, and market conditions. Find any possible areas to improve or issues affecting the cash flow.

As an example, if you are looking at an apartment complex, is there an opportunity to add stackable washers/dryers in the units and increase rent?  Or add covered parking and charge for those premium spots?

Reassess Financing Options

Consider exploring refinancing options to lower the interest rate or adjust loan terms. Taking this step can help reduce too many debt service payments and improve cash flow. Check with lenders or mortgage brokers to explore available alternatives.

Renegotiate Expenses

To make sure you’re spending wisely, examine all expenses linked to the property. Look for ways to cut costs or improve efficiency, such as negotiating contracts, reviewing insurance policies, or finding cheaper maintenance options.

Consider using a chatbot to offload leasing questions, schedule showings, and automate maintenance requests – all of which can help reduce labor expenses.

Increase Rental Income

Look at rental rates to see if they’re competitive. You can use rent optimization software like Spherexx or Revvy or manually review by looking at market data.  Consider raising the rent to boost your cash flow and increase your cash on cash return. Make sure any increases are fair and follow local rental laws and rules.

Improve Property Performance

To boost the property’s value and increase income prospects, seek ways to enhance its amenities, improve marketing tactics, attract better tenants, and explore alternative property uses.

Some ideas for improving marketing on a multifamily property include hiring a photographer to capture high-quality images, using social media, adding virtual tours, and offering discounts for referrals.

Seek Professional Advice

Seek guidance from a real estate expert like a property manager or financial advisor. They can provide valuable strategies designed for your situation. Consult them to address negative leverage and optimize your investment for better results.

Selling Or Exiting The Investment

Consider selling the property if you’re having difficulty or cannot sustain efforts to improve cash flow and address negative leverage. Look closely at market conditions and see if the timing is right to sell the property.

Summary And My Experience With Negative Leverage

Negative leverage real estate creates extra risks. My commercial real estate investing approach is to stay away from scenarios like this.

I use strict buying criteria, looking for properties that offer positive cash flow from day one to ensure stable returns.  This goes back to my first set of properties where I used credit card cash advances for down payments, had no idea what I was doing, ended up deeply in debt, and had to move back in with my parents…..

Though negative leverage may work for some, I take a conservative stance. In light of economic uncertainties, high inflation, and rising rates, I believe it’s vital to invest wisely. The current market climate calls for calculated risks, not dicey speculations.

Staying focused on fundamentals – annual cash flow, prudent leverage, realistic projections – is key to investment success. Patience, paired with vigilance, will see us through fluctuating cycles.

Negative Leverage Real Estate FAQs

What Is Positive And Negative Leverage In Real Estate?

Negative leverage happens when borrowing costs more than the investment’s returns. It’s like using debt that makes losses bigger and lowers overall earnings. This occurs when the interest rate on borrowed money is higher than the investment’s return rate. Negative leverage is also known as “unfavorable leverage” or “inverse leverage.” It can hurt the investor’s profits and financial stability.

On the other hand, positive leverage occurs when the investment return is higher than borrowing costs. Using debt like this boosts earnings and increases profit. Positive leverage comes from lower interest rates on borrowed money than the investment return. People also call it “favorable leverage” or “direct leverage.” Properly managing positive leverage helps investors earn more and grow wealth.

What Does Leverage Mean In Real Estate?

Leverage means using borrowed money, such as a mortgage or loan, to invest in a property. It allows investors to increase their buying power and potentially enhance their returns on investment.

By utilizing debt, investors can leverage someone else’s funds to purchase properties and benefit from market value appreciation. This strategy helps investors make the most of their investment opportunities and maximize potential gains.