As real estate capital markets evolve, understanding the dynamics of leverage in real estate transactions is paramount. As an individual self-directed investor, you are not responsible for securing financing. However, it’s important to understand the leverage a sponsor intends to use for any investment you may consider.
This article takes a closer look at leverage in real estate transactions, and loan-to-value ratio (or LTV) the primary metric used to evaluate leverage. Let’s dive deeper into these terms to grasp their importance, especially for accredited investors considering real estate investment platforms.
Leverage in Real Estate, Defined
Leverage, in the context of real estate, refers to the use of borrowed funds to purchase or finance a property. The intention behind leveraging is to increase the potential return on investment (ROI). By putting down a fraction of the property’s price as a down payment and borrowing the rest, an investor can control a much larger asset without paying the full price upfront. Using leverage in real estate transactions allows sponsors (the borrower) to take on larger transactions, take on more investments, or both. In each transaction, proper use of leverage allows sponsors to enhance returns. This is because the benefit of reducing going-in cost (by assuming leverage) can be greater in magnitude than the added cost of servicing the debt over time. When modeling returns for a potential investment, sponsors will thus often look at “levered” versus “unlevered” potential returns.
Mezzanine debt can be part of the total leverage of a real estate investment
For a simple example, consider an investor buying a $1 million property. By leveraging, they might only need to pay $200,000 out of pocket (20% down) and borrow the remaining $800,000. If the property’s value appreciates to $1.1 million within a year, the investor gains a $100,000 increase on their $200,000 investment, translating to a 50% multiple on invested capital. Without leveraging, the ROI would have been just 10% on a full $1 million investment.
But remember, while leveraging can magnify returns, it can also amplify losses. If the property’s value decreases, the loan amount remains the same, potentially leading to losses greater than the initial down payment.
Accredited investors looking to explore real estate crowdfunding platforms like equitymultiple.com should understand the leveraging strategies used by these platforms and the associated risks.
Leverage in Real Estate: An Example
Let’s take a look at a quick numeric example of leverage real estate. Suppose an investor has $200,000 available for investment. They could choose to fully buy a property worth $200,000 in cash. If the property appreciates by 5% in a year, the investor makes a return of $10,000.
However, if the investor chooses to leverage their capital, they could use the $200,000 as a down payment for a $1,000,000 property (assuming a 20% down payment is required). If the property appreciates by 5% in a year, the investor makes a return of $50,000. The leverage has amplified the return on the investor’s capital. This enhanced return is often referred to as the “levered return” of the investment.
There are several types of loans that commercial real estate investors can use to leverage their investments, including traditional bank loans, hard money loans, and private money loans. These financing options come with varying interest rates, terms, and approval requirements. In order to maximize financing capabilities across numerous investments, professional real estate investors (sponsors) will often utilize “bridge financing” instruments like mezzanine debt, subordinate debt, or preferred equity to supplement a senior loan from a traditional lender.
Leverage in Real Estate: Risks and Rewards
Leverage also plays a crucial role in the cash-on-cash return calculation, a popular metric used by commercial real estate investors to evaluate the profitability of their leveraged investments. The cash-on-cash return is calculated by dividing the net operating income (NOI) by the total cash investment. By using leverage to reduce the amount of cash invested, an investor can increase their cash-on-cash return.
However, it’s essential to understand that while leverage can magnify returns, it can also amplify losses. If the value of a property declines or if it fails to generate enough income to cover the cost of the borrowed funds, investors in the deal could end up losing money. Moreover, if the sponsor/operator fails to meet their loan obligations, the lender may foreclose on the property. Therefore, investors must carefully consider the operator’s ability to manage the risks associated with leverage.
An example of a capital stack and use of leverage in a real-life EquityMultiple investment.
What is LTV in Real Estate?
LTV, or Loan-to-Value ratio, is a key metric in real estate investing and lending. It expresses the ratio of a loan to the value of an asset purchased. LTV helps lenders assess the risk of a loan. A higher LTV typically signifies a riskier investment, as it indicates that more money has been borrowed relative to the property’s value.
To calculate LTV:
For instance, on a property with a fair-market value of $5M, if an investor borrows $4M, the LTV would be:
LTV=$4M ÷ $5M = 80%
When considering real estate crowdfunding opportunities, individual investors should note the LTVs associated with each deal. A lower LTV typically indicates a safer cushion against market fluctuations, while a higher LTV might mean higher potential returns accompanied by higher risk.
LTV vs LTC
Loan-to-Cost (LTC) is another crucial metric, especially when comparing it to LTV. While LTV focuses on the appraised value of a property, LTC is centered on the total project cost.
In new construction or significant renovation projects, the total project cost encompasses not only the property’s purchase price but also construction, labor, and other associated costs. Therefore, LTC often provides a clearer picture of the loan amount relative to the entire investment in these scenarios. If, for example, you are considering a value add investment, LTC is likely to be highly relevant, as it will capture the near-term capital improvements required for successful execution on the business plan.
For real estate crowdfunding investors, understanding both LTV and LTC is crucial, as it helps them gauge their exposure and potential risk in a deal. Comparing the two metrics can offer insights into the safety margin incorporated into the investment.
What are Negative and Positive Leverage in Real Estate?
Leverage, while a powerful tool, can work both ways. This brings us to the concepts of positive and negative leverage.
Positive Leverage in real estate occurs when the rate of return on the property exceeds the interest rate on borrowed funds. In simpler terms, if an investor borrows money at a 4% interest rate and the property generates a 7% return on net operating income, they’re benefiting from a 3% positive spread, leading to potential cash flow and putting the business plan on sound footing.
On the other hand, Negative Leverage is when the cost of borrowing exceeds the return on a property. Using the previous example, if the property return was only 3% against a 4% borrowing rate, the investor would be at a 1% negative spread, potentially eroding profit. Negative leverage at the outset of an investment may not mean it is a bad investment or business plan. However, many lenders will require borrowers to hold an interest reserve to service debt
Crowdfunding platforms like equitymultiple.com provide ample information on projected returns and the associated leverage. Accredited investors should always compare these figures to the borrowing costs to ascertain the potential for positive or negative leverage in their investment decisions.
Examples of current and past EquityMultiple investments and associated leverage.
Debt Service Coverage Ratio (DSCR)
Debt service coverage ratio (or DSCR) is one of the key metrics utilized in evaluating use of leverage in a real estate transaction, and the soundness of the business plan. At a basic level, the ratio operates in the same way for real estate companies as it does for individuals paying down a mortgage: it is the net income available to service a loan, per unit time. Whether an individual or a company, the ratio is used as a measure of “creditworthiness” or, conversely, as a measure of risk for the prospective loan issuer.
In the case of commercial real estate lending, the ratio can be expressed as DSCR = NOI / Total Debt Service, where NOI is the familiar Net Operating Income figure (Effective Gross Income less Operating Expenses) and Debt Service captures both interest payment and, for amortizing loans, scheduled repayment of principal for the unit of time being considered.
A debt service coverage ratio of greater than 1 indicates that property cash flows are sufficient to service the loan, however most commercial lenders require a significantly higher minimum DSCR in order to originate a loan, typically in the range of 1.15-1.35. Non-bank lenders, or “hard money lenders,” may be somewhat more forgiving of a DSCR closer to 1. In either case, the DSCR at which lenders are willing to lend will depend somewhat on market conditions and macroeconomic trends, all factoring into the perceived risk of the particular loan; in a healthy market during an economic upswing, a lender may be willing to lend at a DSCR closer to 1. Other aspects of the borrower’s situation may also factor into the DSCR required by the lender, such as their track record in sustaining NOI and making timely payments on past loans.
LTV vs LTC & DSCR in Commercial Real Estate Lending
Lenders combine loan-to-cost, loan-to-value, and debt service coverage ratio (DSCR) to assess the risk of the borrower and the borrower’s project. The higher the LTV and LTC, the higher the proportion of the project cost that is being financed by the loan, and thus the riskier the loan. The higher the DSCR, the more comfortably the borrower can service the loan, and thus the less risky the loan. Lenders typically operate with a minimum threshold DSCR, and max LTV and LTC they are willing to lend at, and these ratios are typically instrumental in determining the interest rate offered.
Conclusion
When evaluating potential debt syndication offerings for our platform, the EquityMultiple Investments Team pays careful attention to leverage in real estate investments we consider. Depending on the profile of investment, the LTV, LTC, debt service coverage ratio, and presence of an interest reserve may all come into play.
While these metrics are first considered in the context of a potential loan, they have repercussions up and down the capital stack – equity investors in a real estate project should also take a close look at the leverage situation when considering a potential investment. The more capital the Sponsor contributes to the project – i.e. their own equity – the more skin they have in the game, and the more direct incentive the Sponsor has to diligently execute on their business plan. This “skin in the game” is what’s left over after leverage and LP equity. At EquityMultiple, we typically require Sponsors to contribute at least 10% of the equity in a project.
