The Real Estate Investor’s Guide to Negative Leverage

Key Takeaways

• Negative leverage, which is mostly used in commercial real estate, occurs when returns decrease when leverage is added.

• With negative leverage, there are factors investors should consider when determining the cost of debt, including the prospective effect on equity returns as well as the rationale for seeking negative leverage.

• Still, negative leverage is common for a number of reasons, including less upfront cash required, appreciation expectations, possible increased operational cash flows, increased yields when selling the property later, and a lack of focus on cash flow.

Investors in real estate and those interested in entering the market should know what negative leverage is and how it impacts their returns, risks, and various approaches to managing debt and equity. To help, here is the real estate investor’s guide to negative leverage.

What is Negative Leverage?

In real estate, adding debt, or leverage, to an investment, generally raises cash-on-cash returns. Moreover, as much leverage as possible is considered good. However, there are instances in which increased debt can result in decreased returns. When this occurs, the property is deemed negatively leveraged.

Negative leverage, which is mostly applicable in commercial real estate, occurs when returns decrease when leverage is added. This happens when the cost of real estate investing – the loan’s interest rate – exceeds returns generated by the cash flows. The loan’s rate is heavily influenced by any hikes in the Fed’s interest rate.

Negative leverage raises overall risk and lessens the margin for issues with operations. To avoid getting into such a situation, investors should compare the cost of debt to the property’s capitalization rate. The real estate is deemed positively leveraged if the cap rate indicates that returns will be higher than the cost of debt.

Still, negative leverage is common for a number of reasons, including less upfront cash required, appreciation expectations, possible increased operational cash flows, increased yields when selling the property later, and a lack of focus on cash flow.

As an example of negative leverage, if the cap rate is 4%, and is less than the cost of capital, at 4.6%, the cash-on-cash return would be 2.7%.

Types of Negative Leverage

There are various types of negative leverage, including:

• Equity investment. Here, the investor acts as a shareholder in the property in which they are investing. In other words, their stake in the real estate correlates with their investment amount, accounting for factors such as preferred equity, private equity, and partnerships, as well as leverage. Note that preferred equity – a type of investment in which the investor receives specific benefits in exchange for their investment – can provide flexibility and leverage in investment structures.
• Debt constant. Debt constant represents the annual debt service divided by the overall loan amount. Expressed as a percentage, debt constant is calculated as DC = (r * (1+ r) n)/((1+r) n-1) where “r” is the annual interest rate and “n” is the number of annual payments. It is used to evaluate loan options by comparing different loans’ debt levels, factoring in variables such as cap rates and leverage.  Because the debt constant provides the percentage of the loan amount that must be paid annually to service the loan, investors can use the calculation to make investment decisions. 
• Loan constant. Also known as a mortgage constant, loan constant is the percentage of cash the lender receives relative to the outstanding loan balance. Investors frequently compare it to the cap rate to determine whether a property has positive or negative leverage – in other words, whether it is a viable investment. In terms of calculation, loan constant = annual debt service/loan balance. 
• Borrowing costs. There are a number of borrowing costs associated with employing negative leverage, including loan amount, interest rate, and the effect on equity returns, and they can affect the prospective risks and rewards of using negative leverage when investing in real estate. For example, if the Fed continues to increase interest rates, that will likely affect the cost of one’s loan, which will factor into the risks or rewards of using negative leverage. When assessing borrowing costs in a negative leverage situation, it is important to consider factors such as the need for a strategy to pivot to positive leverage, and prospects for higher returns.
• Cost of debt. With negative leverage, there are factors investors should consider when determining the cost of debt. Those can include the prospective effect on equity returns as well as the rationale for seeking negative leverage in real estate investment. Note that the debt amount and its cost over the operating capitalization rate can greatly dilute equity returns.

Calculating Negative Leverage in Real Estate Investments

• Purchase price. When determining a property’s purchase price, considerations should include the prospective effect on equity returns of debt and interest rates. Note that the use of negative leverage in some situations may be justified, such as when the market is uncertain or when rents are generally less than market rates. When the purchase price is discounted sufficiently to offset reduced cash flow or yields, the use of negative leverage may be warranted. Also, during the holding period – the period between when an investment is made and when the property sells – the investor may seek to shift from negative to positive leverage.
• Annual debt service. This essentially is the total amount of debt payments made within a year, including principal and interest. Broken down, debt service comprises scheduled as well as unscheduled payments, in addition to any reserves earmarked for future payments.  
• Cash return. Cash return can be calculated by comparing the income an investment property produces to the initial outlay. In other words, the return evaluates the annual return the investor made on the real estate relative to the mortgage amount paid over the same period. Investors can utilize the cap rate for a single-year analysis and yield rates for a multi-year assessment. 
• Cash on cash return. The formula for calculating cash-on-cash return is annual net cash flow / Invested equity = cash on cash return. For example, if a property is rented for $3,000 monthly, but maintenance and upkeep totals $1,000, then the annual pre-tax cash flow comes to $24,000. If the amount of cash invested is $100,000, the cash return is 24%. The metric can be used to evaluate a property’s profit-earning capacity, which can help investors compare potential investments, even across asset classes. It is also employed during underwriting to demonstrate the prospective cash flow return, as compared with the cash contributed upfront.
• Internal rate of return (IRR). In real estate, a property’s internal rate of return is the projected profit it could earn during the ownership period. The discounted cash flow analysis also shows the break-even point. In a scenario in which leverage is positive, the addition of debt results in a higher IRR. In a negative leverage scenario, however, more debt causes the IRR to drop, which is not good. This occurs when the debt’s interest rate exceeds the property’s cap rate. When analyzing leverage, investors can use the IRR to conduct both single-year and multi-year analyses. Cap rates can also be subject to single-year analysis, and yield rates can be employed for multi-year analyses. 

Real Estate as an Alternative Investment

Positive or negative leverage notwithstanding, real estate continues to be a popular investment. After all, there is an abundance of property types, the potential for consistent passive income, and possible tax favorability, as well as protection from inflation and stock market volatility.

In addition to owning investment properties outright, there are ways to enter the real estate market without physical ownership. For example, there is real estate private equity, which generally targets high-net-worth investors, as well as real estate investment trusts, or REITs. These are attractive to those seek to own real estate passively without assuming responsibility for the property itself.

Real estate also offers another essential purpose – diversification. Building a modern portfolio with varying asset classes, including those that have no direct correlation to volatile public markets, can mitigate overall risk and even improve returns. 

Private Markets and Portfolio Diversification

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, platforms like Willow Wealth provide curated access to private markets for individual investors.   

Investors can get started with minimum investments as low as $5,000 for their first investment (subject to certain exceptions). Willow Wealth offers a curated selection of opportunities across multiple asset classes, ranging from individual investments to diversified funds and automated portfolio solutions. While these investments carry risk, they open the door to opportunities across real estate, private credit, private equity, and more.  

Join more than 500,000 members and start investing in private markets today at willowwealth.com. 

In Summary

Real estate investors can use their knowledge about negative leverage during pre-purchase due diligence. After all, such leverage can affect a property’s annual return. Still, it is important to understand market conditions before investing with borrowed funds.