Negative Leverage
Can someone explain negative leverage to me? Including why a sponsor might actually be interested in a deal with negative leverage.
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Negative leverage is when your borrowing cost is > your going-in cap rate.
Think of your going-in cap rate as the yield you can earn on a dollar. If you could borrow that dollar at 4%, but it could earn you 5%, you’d pocket the spread of 1% via positive leverage.
With negative leverage, you are paying 6% to own a dollar that is yielding you 5% - 5.5%.
Great explanation. Thanks
I think this is a simple version of the explanation but I like to differentiate between negative and dillutive. In general, you use leverage to make your returns accretive, i.e. you buy a deal at a 5% cap with a loan at a 4% interest rate for accretive returns. When the interestest rate is 6% and then it's dilutive to the returns, i.e. makes the 5% cap deal yield less. All are explained above in the previous post.
The only part that becomes negative leverage instead of just dilutive is at a certain leverage point. back to the 5% cap and 6% interest rate scenario, let's say you were borrowing at 50% LTV for example, then you would be receiving a 5% cap income and paying a 3% debt service (6% interest x 50% LTV) on that loan which would lead to a 4% return ((5% cap rate - 3% debt service)/50% equity). Diluting the deal. but now at 83% LTV you are essentially borrowing to a 0% return, 6% interest rate x 83% LTV = 5% so you would have ((5% cap rate - 5% debt service)/17% equity). Diluting the returns down to 0% return. If the LTV is >83% now your returns would be negative, i.e. you would need to cough up more money to service the debt, that is what Negative leverage means, and not just dilutive leverage.
I hope that makes sense, was trying to keep it in simple terms.
Great example of diving deeper into the concept - I would just personally point out that I think most people think of negative leverage as having a negative impact on levered returns vs actually resulting in a sub-1.0x DSCR (negative cashflow). I may be wrong, but when the likes of Willy Walker are on his podcast stating that he's seeing most buyers OK with negative leverage, I don't think he's implying a < 1.00x DSCR.
I.E - "negative" is simply defining the direction in which leverage is accelerating your returns.
yep above is a great example of hashing out the math / mechanics of why / when leverage can be dilutive to equity returns.
alternatively, I usually think of going in cap rates as a proxy for unlevered returns, which by definition is the weighted average returns of both debt and equity holders.
if your unlevered return is 5%, but the debt is priced at 6%, assuming 50% LTV, mathematically the equity has to earn less than 5% to make the unlevered yield equal to 5%. Increase the LTV and the equity suffers even more (which is the point the poster above me was making)
re: when negative leverage makes sense - value add buyers take on negative leverage all the time. if the sponsor thinks they can stabllize the asset and push NOI higher, then the leverage makes sense. the return earned from exit / residual value more than compensates for the negative carry
I like to look at it differently as I often do deals that are not stabilized day 1. Negative leverage is when the cost of debt is greater than your unlev IRR. Utilizing debt in this case will cause a lower lev IRR relative to unlev IRR (dilutive).
What in the world is your cost of capital?
We look at it this way as well in our JVs with unlevered equity partners
Interesting, can you give a simple example? Seems that are most deals today, negative leverage day 1 that are not stabilized so opportunity to add value and bring it to a positive leverage situation but there's risk involved.
Another question on this, when you see rents 10-15% below market today for it's product class and it's being sold by a broker - why are they touting this as value day 1 and why isn't the current owner doing this increase if it's there now. Let's assume it's a more normal rental market and those increases are possible now.
I don't buy the owner is asleep at the wheel and not active, but if you see a deal today that has multi rents 15% below the market for class and vintage are you taking that at face value or saying ok if he could get that much more today he would - I'm taking the current rents and saying we could get a 5% bump on purchase there has to be other factors affecting the asset I don't know yet that the market is seeing.
I've heard from some people who have worked with multi that give the ownership reason, but there has to be more and if it is that easy why has this deal sat on the market for 1, 3, 6 months if that value is there day 1 - curious what other factors you have seen on deals like this.
Generally, I’ve always heard it described as when your NOI return is lower than the interest rate - so the leverage is dilutive to your unlevered returns, but doesn’t necessarily mean your debt payments are higher than than your NOI (as they mentioned, as long as you don’t have too high of an LTV).
While I get premise of looking at it like some of the ways mentioned above, I feel like I’ve never heard a broker mention it that way. Now I’m starting to 2nd guess myself. But you’ll see some core assets trade and the buyer “will take on negative leverage for x years”, and I think that supports the notion that its dilutive to your unlevered returns, but not actually cash flow negative. Since I don’t think anyone would buy core assets with negative leverage if that was the case.
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