The Risks Involved in Purchasing RE with Leverage

Alternative Assets
July 16, 2023

Many investors in commercial property underestimate the risk of employing even moderate leverage in Real Estate deals.

A noted RE investor was recently on CNBC discussing what is currently happening and is likely to continue happening in the healthier segments of commercial RE. To qualify as “healthy”, he was excluding lower quality office buildings and malls that are suffering high vacancy rates and are incurring even larger problems.

The example he gave was a property with a modest LTV (40% cash, 60% loan). In his example, he suggested the cap rate on the property would have risen modestly from 4% to 5% due to higher interest rates and the competition for capital that was created.

To illustrate, assume the purchase price was $100M at a 4% cap rate. That equates to a Net operating Income (NOI) of $4M/annually. The buyer invested $40M and took out a loan for $60M. At the time the loan came due, the cap rate had adjusted upward to 5% due to both higher interest rates and a weaker market for office space. This reduces the value of the property to $80M. The calculation for that is in order to get a 5% Cash on Cash Return (Cap Rate), the new sale price would be $80M. 5% of $80M is $4M which is the current NOI.

If the loan can still be financed at a 40% LTV, the bank loans $48M (60% of $80M) and the owner must invest an additional $12M. That’s the difference between the original loan of $60M and the new loan of $48M.

If the owner doesn’t have an extra $12M, the bank will take possession of the property. If they sell it for the current value, $80M, they will use the first $60M to repay the loan and the borrower will receive the balance of $20M. Since the original investment was $40M, that’s a permanent, 50% loss of capital.

This is not a worst-case scenario. If the original investment was a Class B office building, the loss could be much more significant. There have been a number of buildings owned by large RE investors who have walked away from their office buildings with a total loss.

A former colleague of mine owned a shopping center with moderate leverage. His primary tenant, a large grocery store, decided to move out. They had a long lease, but they found a better location. They continued to pay the rent, but foot traffic at the center dropped off dramatically and he was at risk of losing other tenants who depended on the traffic generated by the supermarket. He was very worried that if he didn’t replace the supermarket by the time his loan was due, he wouldn’t be able to refinance and thus would lose the property.

The lesson here is if you’re already rich, why invest in a leveraged RE project in order to raise your yield a couple percent? If there’s no leverage, there’s no risk of the bank taking over the property. Cap rates could go up and you’ll be sitting on a paper loss, but you have the opportunity to ride out the cycle if/when interest rates, and cap rates decline.