Even though commercial real estate has hit a state of negative leverage – in which an investor’s equity is less than the capitalization rate – many investors are choosing to remain in the sector.
Simply put, negative leverage occurs when the debt constant (annual debt service payment divided by debt amount) is more than the cap rate.
With interest rates having spiked to the point the 10-Year Treasury is sitting at 3.0%, up from 1.48 a year ago, many investors have found themselves in negative leverage territory, with finance costs at 4.5%-5.0% on assets with cap rates of 3.5%-4.0%.
The traditional appeal of CRE is its ability to leverage equity and generate high cash-on-cash returns. If an investor carries debt at a 4.0% interest rate with a cap rate of 5.0%, the cash-on-cash return is positive. Other investment formats – such as private equity and hedge funds – rarely, if ever, have this structure, which was generally in place in CRE even as recently as the end of last year.
Even with the dip into negative leverage, many CRE investors remain in the space for any of three reasons.
- They have fund or private placement capital and need to spend it;
- They expect future rent increases to eventually shift their leverage back into positive territory, and/or
- They are looking to CRE as a hedge against inflation.
If cap rates remain compressed, interest rates continue to rise or rent increases don’t happen as predicted, those reasons will be significantly tested. Experts say the results will ultimately depend on the Federal Reserve and whether their attempts to rein in inflation cause them to set interest rates at greater than 3.0%. If that happens, the heavy CRE investment run could well be over. (Source)