Leverage: A friend in real estate that can turn on you ...Middle East

Leverage is one of those concepts we throw around a lot in commercial real estate.

It sounds sophisticated — like something whispered in back rooms by finance guys wearing French cuffs. But really, it’s simple: leverage means using someone else’s money to buy something you couldn’t afford on your own.

That “someone else” is usually a lender, and the “something” is typically real estate. Whether you’re buying an industrial building, an office condo or a strip retail center, leverage is the reason you don’t need a million bucks in the bank to make it happen.

Let’s walk through it, and then I’ll explain why it’s both powerful and dangerous.

How leverage works

Say you find a building you want to buy. It’s priced at $2 million. You could write a check — if you happen to have a spare $2 million lying around. But most investors don’t.

So you approach a lender. The lender agrees to loan you 65% of the purchase price, or $1.3 million. That means you need to bring $700,000 to the table. With that $700,000, you now control a $2 million asset. That’s leverage.

Why is this useful? Because you get all the benefits of owning the building — rental income, appreciation, tax advantages — without tying up your full net worth in a single deal. But, you’ve borrowed $1.3 million, which must be repaid.

The cash-on-cash return

Now here’s where leverage starts to flex its muscles: cash-on-cash return.

Cash-on-cash is a fancy way of asking, “What am I earning on the actual money I invested?”

If that $2 million building brings in $100,000 in income after expenses and debt payments, and you only put in $700,000 to acquire it, you’re earning roughly 14% annually on your cash. (That’s $100,000/$700,000.) Not bad.

But if you bought the building all-cash and still brought in $100,000 a year, your return would only be 5%. See the difference? ($100,000/$2 million.

That’s why experienced investors love leverage. It makes the return on your money better because you’re using someone else’s money to own more.

When the math goes backward

There’s a flip side to this, and it’s become more common lately: negative leverage.

Negative leverage happens when the cost of borrowing exceeds the return you’re getting on the property. Specifically, when your interest rate is higher than the property’s capitalization (cap) rate. Imagine paying 7% interest on a loan to buy a building that only returns 5.5% annually. That’s a losing equation from day one.

Unless you’re banking on major rent growth, redevelopment or some other value-creation, you’re effectively paying to hold the asset. Your cash-on-cash return goes down, not up. And in that scenario, leverage isn’t helping you, it’s hurting you.

We saw the opposite for years when money was cheap. Investors could borrow at 3% and buy properties at 5%-6% cap rates all day long. But today’s reality is different. Many deals that penciled before don’t anymore, not because the buildings changed, but because the cost of capital did.

Pitfalls of leverage

Leverage works great when things go well: when tenants pay rent, rates stay low and property values rise.

But if vacancy creeps in, or interest rates rise, or your building needs unexpected repairs, that monthly loan payment doesn’t go away. It still shows up every month, like clockwork.

I’ve seen more than a few deals that looked great on paper fall apart in practice because the borrower didn’t leave enough breathing room. That extra margin of return? It can vanish quickly when costs go up or income goes down.

And over-leverage can lead to overconfidence. I’ve watched folks stretch into larger deals just because the bank said “yes.” And when the market turned? That yes turned into a painful lesson.

Using leverage wisely

Leverage is neither good nor bad, it’s neutral. It’s how you use it that matters.

Here are a few guiding principles I share with clients:

—Be conservative. Just because a lender will loan you 80% of the purchase price doesn’t mean you should take it.

—Understand your debt. Know your payments, your interest rate, your amortization period and what happens if rates change.

—Stress-test your deal. If rents drop by 10%, can you still pay the mortgage?

—Watch for negative leverage. If you’re borrowing at 7% to buy at a 5% return, you need a very clear reason for doing so.

—Keep reserves. Surprises happen. Don’t let one roof repair or a missed rent payment jeopardize your investment.

Bottom line? Leverage can be your best friend or your worst enemy. Used with discipline, it can multiply your wealth. Used carelessly, it can multiply your mistakes.

Choose wisely.

Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at [email protected] or 714.564.7104.

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