The Impact of Leverage in Commercial Real Estate
What is Leverage?
Leverage, or gearing, refers to the use of debt financing in deal structuring for commercial real estate. The premise behind using leverage is that by employing multiple sources of capital, an investor can maximise the potential return generated on their equity and unlock deals at a scale otherwise inaccessible due to capital constraints. Similarly, leverage provides investors with the ability to achieve diversification through allocating capital across various investment opportunities.
The large capital outlay required for direct commercial property investment can be prohibitive for many investors. Leverage allows investors to commit a smaller amount upfront to gain exposure to the asset class. While leverage provides enhanced access to commercial real estate, investors should understand the risks involved and utilise debt prudently to limit downside risk exposure.
Leverage is commonly measured by the ‘Loan to Value Ratio’ (LTV), reflecting the loan as a percentage of an asset’s market value. The utilisation of leverage alters an asset’s ownership structure, as conceptualised by the capital stack. Depending on the capital stack, the priority of repayments and risk/return profile will change accordingly.
Many investors are drawn to commercial real estate due to the widespread and secure use of leverage. Commercial real estate lending is typically considered stable due to the real estate market’s low relative volatility. Commercial real estate debt is collateralised by tangible assets and provides investors with the opportunity to receive risk-adjusted returns and obtain exposure to leverage within a broader investment portfolio. Consequently, the real estate debt market is well-established and highly competitive.
While often accretive to returns, debt also has the potential to compound losses. Under normal market conditions, the cost of debt (interest rate) is lower than the rate of return produced by a commercial property asset. Accordingly, investors seek to arbitrage this spread in order to boost investment returns. However, when this spread reduces through either increased interest rates or reduced rental return, the investment’s margin of safety to meet repayment obligations narrows. As higher rates of leverage are used, the potential for outsized gains or losses is increased.
For example, in the hypothetical investment case for a $10m commercial property, the utilisation of leverage at various levels has a significant impact on the rate of return generated, as shown below.
The above is an over-simplified investment case detailing the impact of leverage on investment returns. By employing a 60% LTV real estate loan at a 3% interest rate, an investor increases their return on equity from 4% to 5.5% when compared to not using any leverage at all. While this increase in return may be attractive at face value, it is crucial to understand the risk underpinning it, particularly when seeking to use this return as a basis of comparison with alternative income-producing investment opportunities.
One means of assessing this additional risk is through the debt service ratio, which expresses the annual net operating income as a ratio to the annual loan interest. In this case, it is important to note that by utilising 60% leverage rather than 45%, the debt service ratio is reduced by 0.74, resulting in an investment with more downside risk.
The return generated by using leverage has a sensitivity to occupancy correlated with the extent of debt used. In a downside case of reduced occupancy, the return on equity when owned outright (without debt) can greatly exceed the leveraged return. The more leverage employed, the greater the reduction in the debt service ratio, which reduces the investment’s margin of safety in continuing to meet debt servicing obligations out of rental income. In severe cases, annual loan repayments may exceed the income generated.
How to Utilise Leverage Effectively
As demonstrated in the example above, leverage is a powerful tool within real estate investing to increase returns when used prudently. However, it can compound losses when used recklessly. The key to employing leverage effectively is finding the right balance between risk and return, utilising leverage to unlock increased returns without incurring excessive exposure to financing risk. Finding this balance requires investment experience and acumen; due to commercial real estate’s unique nature, no single approach is suitable for all assets and investors.
A means of reducing exposure to interest rate risk is by using hedging techniques such as interest rate swaps. An interest rate swap is an instrument used to exchange a series of future interest payments for another. Typically, this occurs through swapping a floating interest rate for a fixed interest rate when the investment manager believes interest rates will increase in the future. These instruments provide investors with increased control over loan repayment obligations throughout an investment period. Doing so benefits investors through an investment income stream that is more predictable.
When making investment decisions relating to leverage, an investor must consider whether the additional return generated is sufficient compensation for accepting the related risk. Achieving that balance involves the consideration of the impact on return on equity and the engaged debt level. In the hypothetical case, the investor would receive an additional yield of 68 basis points for accepting the additional risk associated with a leverage increase from 45% to 60% LTV.
There is no “one size fits all” approach to understanding the implication of these metrics. The analysis is highly subjective and based on an investor’s risk/return profile accounting for their personal opportunity cost of capital.
Leverage is a valuable tool available to commercial real estate investors, providing access to investment scale and diversification. Through leverage, an investor can increase potential returns. However, doing so involves accepting additional risk. Before entering an investment, it is essential to consider the use of leverage in light of the proposed investment strategy due to debt’s impact on risk and return. Jasper investments employ leverage prudently to increase returns with the ability to deploy tools such as interest rate swaps where advantageous.
The Jasper platform is designed to simplify investment in commercial real estate. Jasper seeks to provide investors with quality investment opportunities curated and managed by Jasper’s experienced in-house investment team with lower fees and full transparency.