Leverage is one of several strategies investors use when investing in commercial real estate. Knowing how to use leverage in investments, and the advantages and risks of doing so, is important when determining how to get the highest rate of return from your money being invested.
What Is Leverage?
In commercial real estate, leverage refers to using debt for the possibility of yielding a higher rate of return on your real estate investment. It is highly unlikely you will pay for an investment property completely in cash. It is more likely you’ll be using leverage, or debt, to buy the property with the goal of increasing your equity through capital appreciation and delivering yield through in-place cash flow.
How Does Leverage In Commercial Real Estate Work?
The idea behind leveraging any kind of real estate is the potential to increase your returns by using other people’s money, meaning you do not have to put as much of your own capital into buying a property. Leverage allows the investor to either purchase a property that costs more than the amount of money they have available or to spread out that cash across multiple properties. It also has the potential to increase returns by allowing investors to purchase more expensive, but potentially more profitable, assets.
For example, an investor may have $1 million in equity to invest, but wants to put 50% leverage on a property, which allows them to buy a $2 million retail building. A second investor in this example might have the same $1 million in equity but chooses to use 75% leverage to buy a $4 million office building. In the first year, both properties appreciate by 10% and both investors decide to sell. Even though both had the same amount of equity and experienced the same percentage of appreciation, the first investor makes a gross profit of $200,000 while the second investor makes $400,000.
The difference between the profits highlights the power of leverage in generating potential returns, if everything goes well. The potential for this type of additional profit creates a strong incentive for investors to use leverage.
Why Use Leverage In Commercial Real Estate?
Investors often choose to use leverage for one of two reasons. The first reason is that they don’t have enough cash, or equity, to purchase the investment property they want. The second is that they want to maximize their potential returns by putting less cash in each property investment.
The amount of leverage an investor takes on in a commercial real estate investment largely depends on the type of deal they’re making. If a deal is more stable, such as a multi-family property in a strong market, there’s a higher possibility an investor can borrow more money. On the other hand, when a deal is riskier, such as offices or retail buildings during the pandemic, it may be harder to secure a deal with high leverage.
The Risks Of Using Leverage
When investors use leverage, the risks and liabilities versus the advantages may balance out depending on several different factors. This is what makes leverage a double-edged sword. If the property does well, the investor may see higher potential profits. If it under performs, the investor runs the risk of being unable to pay for their expenses, including their debt payments, and may lose the property. In other words, investors run the risk that something could go wrong with the investment and leave them with debt they cannot afford, potentially leading to them losing the property or facing bankruptcy.
When using borrowed capital to buy a property, the lender will have a lien on the leveraged real estate. This is usually referred to as a mortgage or deed of trust. If you default on the loan, the lender can foreclose on your property, and you lose your entire investment. In some cases, they may even be able to come after you for any money they are still owed after they sell the property.
Investors benefit from knowing whether their loans are recourse or non-recourse debt. While both types allow lenders to seize collateralized assets if a borrower fails to repay a loan, what the lender can seize is dependent on the type. If the loan is a recourse debt, lenders may go after the investor’s other assets if they have not recouped all that is owed. With a non-recourse loan, lenders can collect the collateral but may not go after the investor’s other assets.
Another risk associated with leverage is the vulnerability it has in relation to the real estate market. If prices fall, the property value of the asset may end up being less than the amount you owe on it. It’s common for commercial real estate loans to have a term of only five years. This means, if a property’s value falls within these five years, an investor may not be able to refinance the property or sell it to pay the loan off.
Loans meant for rental properties or commercial real estate are considered business loans, so investors benefit from conducting detailed due diligence before they decide to work with a lender or sign a loan agreement. Keep in mind that loans that are considered business loans are not federally regulated, so investors don’t necessarily get the same consumer protection when it comes to these types of loans.
What To Look For In A Commercial Real Estate Loan
Every commercial real estate loan is different. When evaluating the terms of a loan, there are multiple factors to consider, including the following:
Interest Rates
Depending on the loan you take out, interest rates can range anywhere from 3% upwards. You want to factor in this cost when evaluating the loan. Also keep in mind the amortization and how it can impact the total cost in the long term.
Other factors to consider are whether the debt is interest-only or not and whether the loan is at a fixed rate or a variable rate. An interest-only loan is one where the borrower solely makes payments on the interest for the first several years of the loan, rather than both the principal balance and the interest. A fixed rate loan is debt that has the same interest rate for the entirety of the borrowing period, while variable rate loans have interest that changes over time. These will also affect the overall cost of your investment.
Loan Terms
Real estate business loans usually have to be paid off within a certain timeframe. Some are short, but terms of 5 to 10-years tend to be the most common. They are usually amortized over 20 to 30-years to keep payments lower, but the entire balance is still due by a certain date. Know your plan for paying off the loan balance before it’s due.
Prepayment Penalties
This is a penalty a lender charges if the loan is paid off early. It’s done to ensure they will earn their expected return on the loan. A prepayment penalty is usually charged as a percentage of the amount that’s prepaid, so consider factoring that into the cost.
Loan Fees
Some loans may come with hefty fees that are either rolled into the loan or charged upfront. There may also be several smaller fees that can add up quickly. An investor benefits from doing their due diligence and learning which fees, if any, there are.
Using financial leverage to purchase real estate may help speed up the process of growing your portfolio and using commercial real estate investments to grow your wealth, as long as it’s done wisely and carefully. Unnecessary risks can lead to problems for the investor further down the line, some of which carry significant consequences. By performing their own due diligence, investors may decrease the likelihood of investing in a bad property or taking a bad loan.
With the right deals and loan terms, leveraging may give investors the ability to invest in commercial real estate in different ways, allowing for portfolio diversification and the potential for higher returns.
FAQ’s
What is the principle of leverage in real estate?
Leverage refers to using debt for the potential of yielding a higher rate of return on your real estate investment. You borrow money through a loan after putting down some of your own capital to finance the purchase of an asset. This allows you to buy a property that you otherwise could not afford.
Does leverage increase ROI?
Leverage can potentially increase the expected rate of return on the asset. It achieves this by allowing investors to purchase properties with potentially higher rates of returns and by giving them access to opportunities they might otherwise be unable to afford.
How do you use leverage?
When an investor takes out a loan to purchase an asset with the hopes of growing their potential income, they are using leverage. In order to use leverage, you must find a lending institution, such as a bank, willing to finance the remaining percentage of the market price after your initial capital payment.
Why should I use leverage?
Leverage can open up more potential investing opportunities for you as an investor. It can also potentially earn you more reward, meaning more capital, even after paying off the debt owed to your financer. Though it comes with increased risk, many investors have found this strategy useful to meet their financial goals.
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Accredited investors are offered the opportunity to purchase equity shares with the potential to receive distributions from in-place cash flow and capital appreciation upon sale. Additionally, as one of the keys to our successful investment strategies, we focus on asset and property management that provides superior service to tenants and guests.
Since our founding in 2013, we have acquired 26 commercial and hotel properties in California, Georgia, Texas, Florida and Ohio, totaling more than 4 million square feet. Contact us to learn more about our current offerings and opportunities.
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