Negative leverage: Borrowers’ bridge to the future

Negative leverage is becoming more common in commercial real estate as borrowers need to take on debt that is more costly than the income properties are generating in order to weather short-term problems on assets they believe have long-term potential. But it won’t last forever, market participants tell Real Estate Capital USA.

For the most part, commercial real estate borrowers are currently seeing negative leverage in one of two situations: deals in which the growth of net operating income does not keep pace with increasing borrowing costs, or deals in which the initial unlevered income yield on an acquisition is lower than borrowing costs.

Prior to the covid-19 pandemic, interest rates were low enough that even though properties were trading at historically tight yields levered cash-on-cash returns were still higher than underlying un-levered yields, market participants say. But the impact of a series of Federal Reserve interest rate increases which began in March 2022 has meant that the Federal Funds rate has risen more than 500 basis points to its current target level of 5-5.25 percent. SOFR, the most common floating-rate benchmark, has seen similarly high increases. 

“Recent rate increases, higher loan spreads, and less widening of trading yields in many sectors has meant entering negative leverage situation is more common,” says Jeffrey Fine, global head of real estate client solutions & capital markets at Goldman Sachs.

Every borrower that opts to take on a loan in which there is negative leverage has a reason for doing so, notes Mark Van Zandt, co-head of real estate at New York-based manager King Street Capital Management. 

“Some buyers can stomach negative leverage initially due to their plans to grow out it [as NOI rises] in the near term,” Van Zandt says. 

Even so, their plans may not work out over the long term. “Although property fundamentals remain solid across many sectors, the prospects for near-term income growth have deteriorated due the impact of macroeconomic headwinds and excess supply in some markets,” Van Zandt adds.

Negative nuances

For existing loans, negative leverage is most often in sectors where it is difficult for sponsors to generate meaningful near-term NOI growth. 

This situation is often seen in the office sector, given broader headwinds, but also an issue for multifamily properties, says Dan Lisser, senior director at New York-based advisory, Marcus & Millichap. “In multifamily, the majority of the leases are one year, which offers the best opportunity to quickly raise rents and get into positive leverage.” 

In contrast, high-growth or niche sectors, like industrial or data centers, continue to see strong rent growth and constrained new supply, says King Street’s Van Zandt. “Hotel properties also benefit from the short duration of underlying leases, providing some ability for owners to keep pace with changes in the rate environment,” he says. 

The prevalence of negative leverage is also very property- and geographic-specific, notes Brad Salzer, president of Tampa-based manager Redstone Funding. “In Florida where I live, the in-migration is allowing owners to increase pricing, thus offsetting or expenses, including debt service – propping values up.”

Fine notes there are two situations in which borrowers typically will suffer negative leverage, albeit with different objectives. The first are borrowers who believe a property’s NOI will grow fast enough to tip negative leverage to positive in some reasonable timeframe, often a year or two from the loan’s closing.

“These borrowers tend to focus on favorable property- and sector-specific supply and demand conditions and transact with an expectation that debt sourced today will become accretive based on strong property performance and, possibly, rate compression in the near- to medium-term,” Fine says.

The second are borrowers with loans maturing on challenged assets, where the cost of financing is less relevant than securing sufficient proceeds to survive to a better day. “We expect to see more of these situations in the years ahead, with so much debt coming due on properties facing operational headwinds,” adds Fine.

Not all doom and gloom

The situation is not as gloomy as it appears, says Marcus & Millichap’s Lisser. Capital continues to be available and cap rates are rising, which means that prices are falling. Still, cap rates are still often lower than interest rates, which means borrowers will have to rely on asset appreciation to help achieve targeted returns.

“Cap rates have started to move up, but not enough to create positive leverage,” Lisser adds. “We have been in the market recently looking for five-year loans [for clients] and the best pricing we have gotten for retail is 6.2 percent fixed for five years and 6.1 percent for multifamily. However, when you add on amortization, we are still seeing negative leverage.”

Borrowers have opted to take lower- leveraged loans, which lessens the impact of higher rates. “We have seen borrowers take on negative interest loans on the premise that they will be able to raise rents and get to positive leverage in one to two years,” Lisser adds.

Edward Fernandez, president and chief executive officer at Irvine, California-based manager 1031 Crowdfunding, believes something is going to have to give.

“As far as the negative leverage situation, the only way that real estate transactions will continue to happen is that sellers are going to have to adjust their pricing so that leverages are either at par equal or move into a positive leverage situation,” Fernandez says. 

Market participants know the Federal Reserve’s stance on inflation in unchanged, Fernandez says: “So, the only thing that can change to make deals work is that sellers are going to have to lower their prices.”

The firm is already starting to see situations in which prices have fallen, making it possible for 1031 Crowdfunding to buy properties at neutral or positive leverage. Fernandez cited a situation in which the firm recently purchased latest senior housing property at a 7.3 percent cap rate and anticipates 1031 Crowdfunding will be able to make its next acquisition at a 10 percent cap rate.

“I can borrow money at a 7 percent interest rate as long as I’m buying real estate at a nine cap, I now have positive leverage,” says Fernandez.

Leverage will always play an important role in the commercial property markets and the health of debt capital markets will have an outsized influence on trading volumes and values. However, leverage is less likely to be an amplifier of yields for the foreseeable future, concludes Goldman’s Fine. 

“Frankly, lending is the superior yield-oriented activity in the current environment, but is necessary to reduce equity at risk and amplify money multiples over most borrowers’ underwritten hold periods,” Fine says. 

Eventually, borrowers’ tolerance for negative leverage could change, particularly if expectations of growth moderates, Fine says. “But at the moment, lenders are willing to extend credit at healthy rates as long as basis, debt yields and debt service coverage ratios feel reasonable – and borrowers are willing to pay for the bridge to a brighter future,” he says .