Lending: Underwriting in a negative leverage environment

The phenomenon of negative leverage, which occurs when the cap rate on a commercial real estate property is lower than the interest rate on its underlying loan, has become more prevalent as interest rates have risen over the past six months.

Accounting misconceptions

But calculating negative leverage is more nuanced than simply comparing cap rates and interest rates, says Tim Milazzo, co-founder and chief executive of New Smyrna Beach, Florida-based tech-centered commercial financing platform StackSource.

“While negative leverage results from an interest rate surpassing the cap rate on an interest-only loan, for stabilized loans with amortization, it is the combination of principal and interest payments compared to the cap rate that results in negative leverage,” Milazzo says. “It is a common misconception that you can compare interest rates and cap rates directly in all scenarios in this way.”

Furthermore, lenders are increasingly considering not only the cap rate, but also looking at the current income and the expected return of the property to determine how long a loan might be in a negative leverage situation – or if it could fall into one should a property’s income change. “A value-add deal that might be yielding today might be a different picture a year down the line,” Milazzo explains.

During times of negative leverage, this increased scrutiny of a sponsor’s business plans is critical, according to Warren de Haan, founder, managing partner and co-chief executive officer of ACORE Capital.

Some buyers might even opt for a property with negative leverage with the assumption that that will turn positive quickly – especially when there is scarcity of the property type and heightened demand.

“[In the multifamily sector for example,] there is a desire to deploy capital [with] a lot of capital sitting on the sidelines,” he says.

While de Haan sees the nuances in calculating negative leverage, he also believes it should not be overcomplicated.

“Creating positive leverage is finance 101. Buying with negative leverage is not a sustainable business plan unless the investor can expect rental growth sufficient to create positive leverage in the term-term.”

Clouds on the horizon

It is likely that commercial real estate fundamentals will worsen before they get better, with valuations predicted to fall, interest rates expected to continue to rise and liquidity seen as remaining tight. These factors all mean negative leverage will become more pronounced.

“The more sellers are driven by fear, the worst things will get,” Milazzo says.
The widespread uncertainty around the rate at which interest rates will rise and how long they will remain elevated will have an impact on how negative leverage situations are seen and are resolved.

If cap rates stay at their current level while interest rates rise, this could make it more difficult for borrowers to avoid negative leverage situations, particularly around loan maturities, Milazzo says.

But if cap rates do rise, investors will have a different problem – it will mean the value of their property has fallen. “With interest rates rising, it is bad for commercial real estate in either of those outcomes. But we don’t know which of those outcomes is going to happen in the next three to six months,” Milazzo adds.