What is positive leverage, and how does it affect investments?
Positive Leverage is where an investor receives a higher rate of return on their investment than the rate they are paying to borrow funds for that investment.
An example of positive leverage is in a real estate transaction where the return on investment without leverage is 8%. This is said to be a CAP rate of 8%. If the loan is 3.5%, then there is positive Leverage. Let's look into this example with a 100k property.
$100,000 X .08 = $8,000 annual profit
$100,000 out of pocket
$8,000 / $100,000 = 8% return
With Leverage (Positive)
100,000 X .08 = $8,000 – $2,800 debt service (interest portion) = $5,200 annual profit
$20,000 out of pocket
$5,200 / $20,000 = 26% return
In this example, the return on equity has gone up 325%. That is quite an improvement on the return. But, of course, getting an 8 cap in today's market is a stretch.
What is Negative Leverage?
Negative Leverage is where an investor receives a lower rate of return on their investment than the rate they are paying to borrow funds for that investment.
Because negative leverage decreases the annual cash flow from an investment, it is rarely a good idea to implement in your portfolio.
One of the favorable aspects of real estate investing is that time is on your side when you have positive cash flow. By implementing negative equity, you are that much closer to time being against you.
What Does Negative Leverage Look Like?
We will look at the same example as above. But this time with a 9% loan.
100,000 X .08 = $8,000 – $7,200 debt service (interest portion) = $800 annual profit
$20,000 out of pocket
$800 / $20,000 = 4% return
As you can see, even a loan that has a 1% higher rate than the annual return of the property can really negatively impact the rate of return on equity when using leverage.
Does it Make Ever Sense to Use Negative Leverage?
There are a few scenarios where an investor might use to try to justify negative leverage. The first is if there are significant tax benefits to the purchase. In which case, the benefit of owning the property will exceed the actual net return.
Another example of a case where an investor might justify investing in a deal with negative leverage is speculating on future rent growth and/or a higher sale price.
The way of looking at this is rather than comparing the annual cash flow rate of return; they might look at the Internal Rate of Return (IRR) instead. With the anticipated sale and anticipated revenue growth, the IRR can be higher than the property's cash flow in the first period.
The problem with evaluating against the IRR instead of the existing cash flow of the property is that the IRR is speculative. It is based on a theoretical sale price and theoretical operating gains.
How Much Leverage Should Be Used?
How much leverage to use is really a personal question that depends on how much financial risk you are willing to take. Many investors recommend your debt-to-equity ratio should not be higher than 70%. This is because being highly leveraged presents more risks in a downturn. One way to mitigate the leverage risk is to assure you have high liquidity on your balance sheet. This could be in the format of cash or cash equivalents.
In real estate investing, lenders are willing to reduce the required ratios to do more business in hot markets. This is where it pays to have a contrarian perspective and consider what might happen when things cool off.
The market is cyclical, so it is prudent to plan for what could happen if the market softens for a few years. One industry-standard metric for stress testing your portfolio is looking at what would happen if the rents you receive are reduced by 20%. Does that reduce your debt service coverage ratio below 1? If so, your portfolio would have a solvency risk during a downturn.
Why Take Leverage At All?
Positive leverage amplifies the return on equity. This can be attractive to investors, especially when looking at the lower risk, high-quality assets, like class-a buildings in commercial real estate.
There is risk in any investment. The argument that you can't lose property without a mortgage is incorrect. You could still lose the property due to delinquent property taxes.
If you are in a capital-intensive business such as real estate, using leverage can help you get the returns you are looking for. However, it might also be impossible or challenging to raise 100% equity to purchase a property.
If you are purchasing real estate with tax benefits in mind, they will be calculated based on the building value and any accelerated cost segregation study based on what materials are in place. When using leverage, you can purchase a larger building with your equity. Because of this, you will have the potential to magnify your tax benefits.
Can You Have Positive Leverage Trading Securities?
When trading with a margin account, it is possible to have positive leverage as well. Just because you have positive leverage does not mean you should do it, though.
With leveraged trading accounts, it is more challenging to determine what your return on capital will be. However, traders with a significant track record might be able to make an educated projection.
One strategy I have seen investors use is low-interest margin accounts to purchase securities with a long track record of issuing a dividend.
How Do Big Wall Street Types Use Leverage?
Hedge funds and private equity companies have made use of leveraged buyouts since they became popular in the '80s. The driving concept of the popularity of a leveraged buyout is that shareholders of publicly traded equity markets require a much higher rate of return than debt sources of capital.
Because they require a lower return, companies utilize a capital structure with a higher debt ratio to equity. This allows them to pay a higher rate to acquire a company than a bidder planning on raising the capital completely on the equity market.
The downside of the leveraged buyout is similar to using leverage in any other investment. This increased leverage can put the company in financial distress during a recession or a lean time in their industry.
How Do Publicly Traded Companies Use Leverage?
Publicly traded companies usually have efficient access to both the debt and equity markets. They can sell their own stock, buy shares of their own stock, issue bonds, or borrow from banks. Deciding what debt-equity ratio to hold is part of the responsibility of treasury management within the company.
CFO's of publicly traded companies are responsible for the same calculations and ratio analysis as any borrower. They are just doing it on a much larger scale. The cost of capital will impact which way they are going between debt and equity.
Under-leveraging, when positive leverage is available, will cause the earnings-per-share (EPS) to drop. If the company's financial performance is weak, the cost of borrowing on the bond market can be expensive for them.
Leverage can be helpful when it is positive leverage but can be harmful to returns with negative leverage. Even with positive leverage, you need to be mindful not to take on too much debt.
Positive leverage is where the return is greater than the interest rate paid.
Negative leverage is where the return is lower than the interest rate paid.