Beware the Negative Leverage Deal
Would you take out a loan at a 7% Effective Cost of Debt (ECD) (interest rate +loan points+prepayment penalty) to leverage the acquisition of an apartment building with a 6.5% CAP rate? If you did, you would be in a negative leverage deal – at least until rents rose faster than expenses and NOI increased to yield a CAP rate greater than 7%.
Leverage is the process of pairing debt with equity, which increases the Return On Equity (ROE) if the rate of borrowing is less than the unleveraged ROE (aka the ROE at 100% equity – no debt involved); if the rate of borrowing is greater than the unleveraged ROE, leverage reduces the ROE at the margin.
I hear everybody talk about the CAP rate of this or that property as if that one metric alone explains something about the desirability of the asset. In fact, without looking at the Effective Cost of Debt (ECD), you know only half the story. And since most people take out a loan to buy commercial real estate, some unfortunates purchase millions of dollars of real estate not aware that the debt they place on the property is making them poorer.
It’s funny, sophisticated people in all walks of life typically place their equity portfolios in the hands of index funds, mutual funds, or professional money managers to invest for them. But when it comes to buying income property, they carry their “hands-on” approach they employed when buying their home to the world of commercial real estate.
They want to shop deals themselves and don’t realize that looking at limited metrics like CAP rates when buying income property is kind of like personally managing their stock portfolios by looking only at P/E ratios. They know that there is a lot more to picking the right stock than the P/E ratio alone, but have no problem exposing themselves to massive real estate risk on the basis of CAP rates or Gross Rent Multipliers (GRM).
So here is the lesson for the day if you enjoy being an active real estate investor and want to be hands on (apart from reading this blog, of course ): always compare the CAP rate of a property with the Effective Cost of Debt (ECD) of the loan and make sure that the CAP rate is higher than the ECD. My next blog? How to calculate the Effective Cost of Debt (ECD)!