Using leverage, or debt financing is an important investment tool in commercial real estate investing that you should understand. Employing this tactic is a great way to diversify your portfolio with commercial real estate (CRE). Additionally, you can potentially earn high capital gains using other people’s money too. However, there are pros and cons of taking on this debt from others to purchase CRE assets. You can find this list in the article.
Continue reading to learn more about how using leverage can potentially amplify your capital returns, helping you reach your estate planning goals more quickly.
What is Leverage?
Leverage refers to borrowing capital, or taking on debt, from people or institutions so you can invest in CRE assets or funds. You are using other people’s money to help you potentially multiply your capital gains.
By putting down just a fraction of the cost of the total property value and borrowing the rest from lenders, you can control a much larger asset that you may not have had access to obtain before.
Recourse and Non-Recourse Loans Explained
There are two loan types: recourse and non-recourse loans.
Recourse loans hold you personally liable for the debt, while non-recourse loans limit the lender’s ability to seize additional assets if you default on the loan.
According to a report by the Wall Street Journal1 on commercial real estate financing trends, “Nonbank mortgage lenders in the U.S. issued 68.1% of all mortgages originated in 2020, up from 58.9% in 2019, according to industry research firm Inside Mortgage Finance. That is their highest market share on record and their biggest yearly gain since 2014.”.
This indicates that more borrowers are turning towards non-traditional lenders who offer non-recourse loans with flexible terms.
The Pros and Cons of Using Leverage in CRE Investing
Pros of Using Leverage in CRE Investing
1. Increased Returns
Using leverage can potentially increase your return on investment. For example, let’s say you purchase a property for $1 million, with a $200,000 down payment and you finance the remaining $800,000 with a loan at 5% interest rate. If the property appreciates by 10%, your equity will increase to $300,000 ($1 million x 10% – $800,000 loan). This represents a 50% return on investment ($100,000 gain / $200,000 initial investment).
2. Higher Cash Flow
Using leverage can also increase your cash flow by reducing the amount of upfront capital required to purchase a property. By financing a portion of the purchase price with debt, you can reduce your equity investment and free up capital for other investments or expenses. Ensure to do proper due diligence on your risk appetite and the amount of debt you can take on before committing any capital to any investment.
3. Tax Benefits
Interest payments on debt used to finance CRE investments are tax-deductible, which can lower your tax liability and increase after-tax returns.
Cons of Using Leverage in CRE Investing
1. Increased Risk
Taking on leverage increases your risk because there are never guarantees in investing. There are both micro and macroeconomic variables that no one can foresee which can affect your investment in either a positive, negative or neutral way. For example, if the property you invested in value decreases, or if your expected rental income distribution falls short of expectations, you may potentially have difficulty making mortgage payments and could be at risk to face foreclosure or bankruptcy.
2. Higher Costs
Using leverage to invest in CRE typically involves additional costs such as loan origination fees, appraisal fees, and have higher interest rates.
3. Limited Flexibility
Taking on leverage can limit your flexibility on how you can use the funds as some lenders may impose restrictions on how the properties are managed, or that they require approval for major decisions, such as selling or refinancing the assets.
Strategies for Utilizing Leverage in Real Estate Investing
The various assets that makeup CRE investing are diverse and many. From multifamily, hospitality, mixed-use, healthcare and more, every property type requires varying debt-to-equity ratio calculations. Depending on a multitude of factors including analyzing your risk tolerance levels and expected rate-of-return targets among others for example.
Did you know that conservative investments in stabilized properties producing income (Core/Core Plus investments), may benefit your returns as these properties typically hold lower levels of debt compared to riskier, opportunistic investments that can take years to mature and to deliver predictable income distributions to you.
You should ensure to carefully evaluate your investment goals as you determine what level of debt you can realistically take on without putting yourself in a hairy situation later. This may help you not lose sight of your long-term estate planning objectives, while you can still achieve short-term gains by identifying suitable investments that have the best chance to return you the capital gains you’re looking for.
Successful use of leveraging strategies can be observed through various case studies/examples such as Blackstone Group LP’s purchase of Stuyvesant Town-Peter Cooper Village2 apartment complex in Manhattan back in 2015. Blackstone took on nearly $5 billion of debt to go along with the $2 billion of cash they put down on the asset, resulting in Blackstone earning higher returns than they project according to reports by Bloomberg News.
Another example provided by CBRE’s recent U.S. Investor Intentions Survey3 found that “More commercial real estate investors will implement debt strategies in 2023 as they hunt for attractive returns amid tighter financial market conditions.”
Commercial Real Estate as a Hedge Against Inflation
Commercial real estate has historically performed well during times of economic uncertainty as it can help protect against inflation and unpredictable markets. If you’re looking for portfolio diversification, stability and potential investment strategies to hedge these uncertain conditions, CRE, particularly multi-family and other money-generating assets, may be the best defense against it.
According to The Motley Fool4, “REITs have outperformed stocks on 20-to-50-year horizons as well as in the latest full year of data (2021). Most REITs are less volatile than the S&P 500, with some only half as volatile as the market at large.” From 1972 to 2021 the annual return from the S&P 500 is 10.7% and the annual return on REITs in the same time frame is 11.9%.
In conclusion, using debt strategies to invest in commercial real estate can be a powerful tool to amplify returns and increase cash flow. However, it also comes with risks that you should carefully consider before making any investment decisions. By weighing the pros and cons of using leverage, conducting thorough due diligence, and working with experienced professionals, you can maximize your chances of success in the competitive world of commercial real estate investing.
- WSJ report on commercial real estate financing trends: https://www.wsj.com/articles/nonbank-lenders-are-dominating-the-mortgage-market-11624367460
- Bloomberg News article on Blackstone Group LP’s purchase of Stuyvesant Town-Peter Cooper Village apartment complex in Manhattan: https://www.bloomberg.com/news/articles/2015-10-20/blackstone-to-buy-manhattan-s-stuyvesant-town-for-5-3-billion-ifzjecx2
- CBRE Survey Sees Debt as 2023’s Most Attractive Alternative Investment https://www.recapitalusa.com/new-cbre-survey-sees-debt-as-2023s-most-attractive-alternative-investment/
- Motley Fool article on REITs vs Stocks: What does the data say?: https://www.fool.com/research/reits-vs-stocks/
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