CAN LEVERAGE ACTUALLY BE THE MORE CONSERVATIVE APPROACH TO REAL ESTATE INVESTING?
I would suggest that maybe a realistic level of debt may actually be a more conservative approach in real estate valuations today. I’m not suggesting that one loads up with 80% financing or a paltry debt service coverage of 110% or so, but what I would suggest is that a reasonable 60-65% loan-to-value (LTV) or a 1.3-1.5 debt coverage ratio may actually protect your long term real estate valuation.
Common sense would say that NO debt is more conservative and less risky than leverage. Well, in one sense it is. With no debt whatsoever there is no mortgages to pay and if times get tough with high vacancy and/or reduced rents then no mortgage payment give you that added cushion. Today, however, with record low interest rates for commercial real estate, often well under 5%, now is definitely the time to lock in these super low interest rates for as long as a term as you can. Not only will it provide you with higher leveraged returns on your investment, but it will actually provide you with a buffer from the possible devaluation of your real estate valuations when interest rates finally rise (as we know they surely will).
How does leverage provide you with a buffer? The reason is that when interest rates eventually migrate back up to more historical norms we also know that cap rates (the general gauge of real estate values) will also rise thus compressing the values of real estate. If you have locked in these super low rates (make sure your loan is assumable!) then that will buffer this compression because a future buyer will pay you a premium for your property if you have below market financing already in place. Accordingly the decrease in your property’s value as a result of future increasing interest rates will be partially protected by this financing premium.
The Fed has certainly been actively keeping a lid on interest rates over the past few years in their efforts to boost the nation’s meager economic growth, but eventually their massive pumping up the money supply will result in escalating commodity prices (inflation) which will in turn push the Fed to start raising rates to combat inflation. When that happens long term rates will rise, capitalization rates (cap rates) of real estate will likewise rise, which in turn has the inverse relationship to real estate values…they drop. If you have in place long term historical leverage then this effect will be reduced… not eliminated, but reduced. The key is to have long term financing, even a fully amortizing loan if you can get it, so you won’t get rate squeezed if your loan has the typical ten year loan call (expiration) all while rates have jumped. Even so if you have a ten year balloon, with your lower leverage and having paid down a significant portion of your debt over the term of the mortgage, you should have adequate buffer to avoid most of such a rate squeeze.
Accordingly it can be argued that a reasonable level of debt can actually be the more conservative approach to real estate investment in today’s unusually low interest rate environment.
Dougall McCorkle, MBA
Sales Associate and Commercial Specialist
Premier Commercial, Inc., Licensed Real Estate Brokers
Direct: 239.213.7234
Cell: 239.860.3368
dougall@premiermail.net