Understanding Leverage in Commercial Real Estate
Commercial real estate has many tools that can be used to maximize one’s return on investment (ROI). Among the many tools to choose from, leverage is one of the most effective ways to limit (or omit) the amount of personal money you put in a deal, and see the highest return possible.
In order to understand leverage in commercial real estate, you must completely understand what it is, and the main factors that determine if leverage is positive or negative. Unfortunately, if not prepared properly, leverage can completely destroy the income producing capabilities of a property and leave the owner’s income in the red.
Using leverage to your advantage can mean more effective investments every time, either allowing you to do more deals per year, or greatly increase your wealth in a short amount of time.
Leverage is magic in commercial real estate.
Leverage is directly related to the amount of money borrowed on a deal, compared to the current value and potential value of an income producing property. Leverage occurs when money is borrowed at a certain interest rate that is less than the rate of return on a commercial property. Let’s look at this transaction in detail to see how the investor can limit the amount of personal capital put into a deal versus the money returned by the property.
There are many different styles and purposes of purchasing property, and none of them are wrong, or better than another. It is simply reflected by the investor and his or her intentions. However, for the most part, the least possible amount of personal money that can be invested in a deal, the larger the returns.
Why? Because when you borrow $500,000 on a property at a 4% interest rate amortized over 25 years, you are paying the principal amount every month, which is covered by the income of the property. By paying to borrow the money, you can literally leave your money in the bank (or put it to some other asset producing use), have the property pay for both the loan and interest, as well as return a huge sum of cash, which only adds to your personal wealth.
If you had used your personal money, that amount would have to be subtracted from the total amount earned, as opposed to only a fraction of the money borrowed.
Positive leverage is when the interest rate of the money you are paying to borrow is less than the investment’s return percentage. A great amount of cash can be found in this difference. The higher performing the property, the more money is to be made.
In order for this to happen, leverage must be accompanied by a loan with long payment terms and a fixed interest rate that is amortized in equal payments over the life of the loan. It is true that these terms are not always available, however, there are many commercial public and private lenders that are willing to negotiate terms in order to see a sound return.
When a loan has a long life, a fixed rate, and equal monthly payments, the principal reduction increases after every payment, while at the same time, the interest amount is decreased. This occurs when the same amount is paid every month, causing the principal amount to be paid lower, so, in turn, the total amount of interest is decreased. You continue to pay the principal amount at a lower interest payment every month.
When your property is leveraged properly, you have plenty of time to pay off the loan, and cash is generated by the property to pay off the loan as well as give you maximized returns on investment. Your money does not even have to be involved in this process because the income covers the borrowed money, the interest and your return as well.
It is really amazing to see how this simple math can mean such huge results for the commercial real estate investor.
Leverage can be dangerous, however, especially if the property does not perform as intended, and it does not produce the cash necessary to cover the loan, interest, as well and your return on investment. When the investor owes more than the property is worth, the property is considered over-leveraged, and this is a dangerous situation for an investor to be in. Money can be lost, and personal money may have to be used to keep the property performing. The investor may not be able to pay the interest and principal in a timely manner, causing the property to go into foreclosure.
Leverage must be taken seriously, and the mortgage market must be carefully watched, especially if the loan terms are adjustable-rate instead of fixed rate.
Use leverage to your advantage to yield the most money from your investment without investing your own money. However, be aware that leverage can go in a negative direction. Be sure to have accurate and supportive income forecasts so that you know the loan will be covered, as well as the return you expect to gain from the property. Then, you can enjoy the profit and benefits of commercial real estate investing.