Positive and negative leverage
Also called Negative leverage, Positive leverage.
Leverage is positive when the going-in cap rate exceeds the loan constant, so each borrowed dollar earns more as real estate than it costs as debt service and the levered cash return sits above the unlevered one. It is negative when the constant exceeds the cap rate, and then borrowing lowers the current return.
How it works
The test is a single comparison and it is regularly made against the wrong number. A coupon is not the cost of the debt; the loan constant is, because principal repayment is cash leaving the account even though it builds equity rather than being an expense. A 5.40 percent cap rate against a 6.35 percent coupon looks negative by 95 basis points. Against the 7.467 percent constant the same loan is negative by 207.
Negative leverage is not a mistake. It is the standard condition whenever coupons sit above cap rates, and it is what most of the low cap rate market traded on. What it says precisely is that the deal has traded current income for a claim on growth: the return has to arrive through NOI growth, through principal paydown, or at the exit. All three are underwritable, and a deal in that position should underwrite them rather than assume them.
Two consequences catch people out. More leverage makes a negative-leverage deal worse per dollar of equity, which is the reverse of the usual intuition, so a sponsor solving a thin return by borrowing more is moving the wrong way. And a loan that is positive while interest only and negative once it amortizes changes sides part way through the hold with nothing renegotiated, which is why the comparison has to be run against the constant that applies in each year.
Formula
Positive leverage when cap rate > loan constant; negative leverage when cap rate < loan constant- The loan constant carries both the interest rate and the amortization schedule, which is why it is the right comparison
- On an interest-only loan the constant equals the interest rate, so the same loan can be positive early and negative later
- The unlevered yield to compare a levered return against is NOI over all-in cost, not over the purchase price alone
Worked example
The sample property. NOI $3,020,000, all-in cost $56,900,000, all-in equity $20,565,000, a $36,335,000 loan at a 6.35 percent coupon with three years interest only and then a thirty-year schedule.
| Going-in cap rate | 5.40% |
|---|---|
| Unlevered year-one yield on all-in cost | 5.31% |
| Loan constant while interest only | 6.350% |
| Levered cash-on-cash, interest only | 3.47% |
| Loan constant on the thirty-year schedule | 7.467% |
| Levered cash-on-cash once it amortizes | 1.49% |
The unlevered yield is 5.31 percent and the levered return sits below it at both constants, by 184 basis points while the loan is interest only and by 382 once principal starts. That is what negative leverage costs in year one, and the deal earns it back only if growth and the exit deliver.
Conventions worth knowing
- Compare the cap rate to the constant, never to the coupon. The gap between them is amortization, and amortization is cash.
- Leverage amplifies whichever side you are on. On a negative-leverage deal a larger loan lowers the current return per dollar of equity.
The common mistake
Solving a thin return by borrowing more
When a levered return falls short, adding leverage is the reflex, and on a negative-leverage deal it makes the current return worse rather than better: each additional borrowed dollar costs 7.467 percent and earns 5.40. What extra leverage does raise is the sensitivity of the equity to everything else, so the deal ends up with less current income and more exposure to the exit cap rate. If a deal only clears its hurdle at higher leverage, the honest reading is that it does not clear its hurdle on the real estate.
Related terms
- Loan constantThe loan constant is annual debt service divided by the original loan balance, expressed as a percentage. It combines the interest rate and the amortization schedule into one number, which is what makes it the right rate to compare against a cap rate.
- Cash-on-cash returnCash-on-cash return is a year's cash flow after debt service divided by the total equity invested. It measures the current income yield on the money actually at risk, ignoring appreciation and any eventual sale.
- Cap rateA cap rate is a property's net operating income divided by its value or price, expressed as a percentage. It is the unlevered first-year yield on the purchase price and the standard shorthand for what a market is paying for a stream of property income.
- Interest-only periodAn interest-only period is a stretch at the start of a loan during which the borrower pays interest and no principal. It raises early cash flow and coverage, and it ends with a step up in debt service that has to be modeled.
- Debt service coverage ratioThe debt service coverage ratio is net operating income divided by annual debt service. A 1.25x means the property produces $1.25 of income for every $1.00 of principal and interest owed, so net operating income could fall by 20 percent before coverage reaches 1.00x and the loan stops being covered.
- Internal rate of returnThe internal rate of return is the discount rate at which the net present value of a deal's cash flows equals zero. It expresses a full investment, including the timing of every contribution and distribution, as a single annualized percentage.
Keep reading
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.