Investors in real estate and those interested in entering the market should know what negative leverage is and how it impacts their returns, risks, and various approaches to managing debt and equity. To help, here is the real estate investor’s guide to negative leverage.
In real estate, adding debt, or leverage, to an investment, generally raises cash-on-cash returns. Moreover, as much leverage as possible is considered good. However, there are instances in which increased debt can result in decreased returns. When this occurs, the property is deemed negatively leveraged.
Negative leverage, which is mostly applicable in commercial real estate, occurs when returns decrease when leverage is added. This happens when the cost of real estate investing – the loan’s interest rate – exceeds returns generated by the cash flows. The loan’s rate is heavily influenced by any hikes in the Fed’s interest rate.
Negative leverage raises overall risk and lessens the margin for issues with operations. To avoid getting into such a situation, investors should compare the cost of debt to the property’s capitalization rate. The real estate is deemed positively leveraged if the cap rate indicates that returns will be higher than the cost of debt.
Still, negative leverage is common for a number of reasons, including less upfront cash required, appreciation expectations, possible increased operational cash flows, increased yields when selling the property later, and a lack of focus on cash flow.
As an example of negative leverage, if the cap rate is 4%, and is less than the cost of capital, at 4.6%, the cash-on-cash return would be 2.7%.
There are various types of negative leverage, including:
Positive or negative leverage notwithstanding, real estate continues to be a popular investment. After all, there is an abundance of property types, the potential for consistent passive income, and possible tax favorability, as well as protection from inflation and stock market volatility.
In addition to owning investment properties outright, there are ways to enter the real estate market without physical ownership. For example, there is real estate private equity, which generally targets high-net-worth investors, as well as real estate investment trusts, or REITs. These are attractive to those seek to own real estate passively without assuming responsibility for the property itself.
Yieldstreet, the leading alternative investment platform, offers the broadest selection of alternative, private-market asset classes, including real estate. In addition to real estate private equity, Yieldstreet offers a Growth & Income REIT, which can be entered for as little as $10,000. The trust offers investments in commercial real estate in key markets spanning property types.
Real estate also offers another essential purpose – diversification. Building a modern portfolio with varying asset classes, including those that have no direct correlation to volatile public markets, can mitigate overall risk and even improve returns.
Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.
Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.
In some cases, this risk can be greater than that of traditional investments.
This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.
However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.
Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000.
Real estate investors can use their knowledge about negative leverage during pre-purchase due diligence. After all, such leverage can affect a property’s annual return. Still, it is important to understand market conditions before investing with borrowed funds.
Yieldstreet provides access to alternative investments previously reserved only for institutions and the ultra-wealthy. Our mission is to help millions of people generate $3 billion of income outside the traditional public markets by 2025. We are committed to making financial products more inclusive by creating a modern investment portfolio.