Leverage, also referred to as debt financing, is a useful and often required element of the majority of completed real estate transactions. Still, as the 2008-2009 real estate bubble emphasized, there are instances in which excess leverage can lead to significant financial losses. Accordingly, it is essential for investors and lenders alike to comprehend leverage, the benefits and drawbacks of implementing it into their respective business approaches, what degree of leverage is prudent in a particular scenario, and how it can impact the risk and reward calculation when it comes to the real estate investment space.
The term leverage relates to the aggregated level of debt financing on a given property exists relative to its market value at the given moment. The loan-to-value (LTV) ratio is an additional often-cited term when it comes to considering leverage. LTV is distinct from leverage in that it refers to the amount of a given loan as a percentage of the property value .Leverage incorporates all of the individual components of debt comprising the capital stack, including first and second mortgages as well as mezzanine financing. For instance, a $20 million office building that has a $14 million mortgage and a $2 million mezzanine loan would carry 80% overall leverage.
Property owners, lenders and developers all routinely rely on leverage as a method of enhancing the anticipated return on investment. Debt financing can increase returns on a given real estate asset when the expenses associated with tapping into third-party leverage, such as a bank or hard money loan, are comparatively lower than the unleveraged returns garnered from the investment property. To illustrate, imagine one investor has $2 million in equity available as investment capital, and they devote 50% leverage on an asset, which enables them to acquire a $4 million retail complex ($2 million in equity and $2 million in debt). On the other hand, another investor with the identical $2 million might opt to utilize 75% leverage to purchase a $8 million office complex ($2 million in equity and $6 million in debt). Over the course of the initial year, both properties appreciated 10% and both investors chose to sell. Although both investors had an equal amount of equity tied up in the deal and both experienced the same appreciation percentage, the first investor garnered a total profit of $400,000 (sale price of $4.4 million minus the original $4 million) on the transaction whereas the second investor realized a profit margin of $800,000 (sales price of $8.8 million minus the original $8 million). When it comes to the second investor, the ability to utilize a higher degree of leverage enabled them to acquire a higher valued property and subsequently benefit from the enhanced gross returns with the identical $2 million equity investment. Put simply, leverage affords investors the ability to get more bang for their buck. This significant disparity in profit margin underscores the inherent power of leverage in fueling return on investment. The potential for higher returns is a major incentive for investors to choose higher leverage options.
Determining Appropriate Leverage
Increased leverage equates to a higher aggregate risk profile. For instance, there was an excess of three to five year mortgages issued between 2005 and 2007, just before the major recession, at comparatively high leverage totals of around 90% of the acquisition cost. On top of that risk is the fact that those loans were premised on what is now understood in hindsight as spiked property valuations. As the market fluctuated and property values collapsed in 2008, borrowers were placed in extreme financial stress just as their debts were maturing. Like what occurred in the housing market, some borrowers were in the unenviable position where their outstanding loan balances were significantly higher than what their real estate assets were valued. When faced with this type of predicament, the sole method to retain the asset was to unleveraged them by initiating new, smaller loans on the properties despite the fact that the illiquidity in that period made that almost impracticable and then attempt to pay off the existing balance with newly created equity. Unfortunately, the all-too-common outcome for a significant percentage of borrowers was to turn the keys back over to the bank and cut their losses from extremely debt-burdened real estate assets.
Although the overutilization of debt financing was the main culprit of several ill-fated transactions during the 2008 financial crisis, the risk profile of elevated leverage can be effectively mitigated via responsible business practices. For instance, if an investor client has a building that is fully leased to tenants will outstanding credit backgrounds on long-term leases, they may be justified in choosing to take on more leverage based on the stability of the revenue stream. Investors and lenders can both use leverage analysis as an additional metric to evaluate the risk versus anticipated returns of real estate projects when determining which investment and funding options are ideal. For instance, when comparing one transaction with a goal of 15% Internal Rate of Return (IRR) and with a reduced leverage and another deal that aims for 18% IRR with a higher amount of debt financing, the lower-IRR deal may actually be the better option considering the fact that the added 3% discrepancy in the goal IRR may not sufficiently compensate the client for the increased risk to the lender. This process is typically referred to as “risk-adjusted returns” and can be an invaluable step when integrated correctly in investment/funding decision making cycles. If you are looking to get started in real estate investing or are in need of a hard money loan, get pre-approved today! We can provide you with a loan within day! Head to the “Apply Now” page on our website to learn more.