Leverage is Powerful: Use it Wisely
“When you combine ignorance and leverage, you get some pretty interesting results.” – Warren Buffet
There’s more to perfect commercial real estate loans than a boast-worthy interest rate.
A primary appeal of real estate as an asset class is employing the power of leverage. And since borrowing typically makes up the lion’s share of the capital used in buying property, choosing the right loan is among the most important decisions you make in any purchase.
Consider these five potential pitfalls before jumping into bed with a lender to finance your CRE investment:
Pitfall #1: Too Much Debt
Perhaps the most basic lesson learned in the Financial Crisis of 2007-2008 was that borrowing too much can lead to dramatic losses for real estate investors. And while this seems like a simple pitfall to avoid, novice and experienced investors alike consistently ignore this essential tenet of commercial real estate investing.
A prudent level of debt – namely one that capitalizes on the financial benefits of borrowing without adding undue risk to the project – is unique for each commercial real estate investment. A good rule of thumb is run a downside scenario through your pro forma and see if positive cash flow can still cover your mortgage payments. If not, you may want to back down the leverage a bit.
This balancing act can be particularly challenging if you’re short on capital, where borrowing more can stretch a limited capital base to chase a wider opportunity set. Remember to invest within your limitations, especially if you’re a first time real estate investor.
Pitfall #2: Too Little Debt
That isn’t a typo. To ignore the power of leverage is to disregard one of the primary advantages of investing in real estate compared to other asset classes.
The table below outlines how leverage amplifies the benefits of long-term appreciating property.
From a mathematical perspective, buying more property through the use of leverage increases your numerator over the same denominator. In plain English, this means you get the benefit of an appreciating $400,000 property versus a $100,000 property for the same $100,000 equity investment.
We recently turned down what on the surface seemed like an eye-popping price for a property we bought a little more than a year ago. But since our equity partner opted to fund the entire purchase and phase I of the project with cash, returns would have been mediocre if we had sold. Even a low, extraordinarily prudent amount of leverage at purchase would have earned us and our investors a quick win.
But remember, don’t get so enamored with upsizing your returns that you forget about pitfall #1.
Pitfall #3: The Low Interest Rate Trap
Cocktail party real estate investment discussions often devolve into bragging rights over who just got the best loan. And nine times out of ten, “best loan” is defined as “lowest rate.”
Low rates can be powerful tools for certain types of projects, but the interest rate is only one of many important loan terms to be considered.
Choose loan terms that best match your business plan.
Looking for a quick flip? Make sure your loan doesn’t include a prepayment penalty. Concerned that capital improvements may come in above expectations? Find a lender willing to write a line of credit behind their first lien.
Worried about interest rates rising in the foreseeable future? Consider a slightly higher rate for a longer fixed rate period. Often just 0.15% or 0.20% can buy an extra couple of years of avoiding interest rate risk.
Don’t want to sign recourse? Ask your lender if you can buy out the recourse with a higher rate.
Pitfall #4: Right Loan, Wrong Lender
Savvy commercial real estate investors look at lenders like partners, rather than just another vendor.
During the purchase, a lender that drags its feet or otherwise can’t close as promised can be the death knell of even a promising deal. That cheap rate is worthless if you can’t get the loan in time and have to walk from the deal. Vet lender performance with colleagues, brokers and other references before making a commitment.
And don’t just evaluate lenders on how well they treat you during good times. Because if your project falters, your bank’s call is one you can’t afford to ignore. It’s impossible to know with certainty how lenders will behave in bad times, so look your banker in the eye and ask yourself if this is someone you would want to owe money you can’t afford to pay back. Then trust your gut.
Pitfall #5: Don’t Forget Plan B
You wouldn’t jump out of an airplane without a backup parachute, so don’t remove contingencies on a commercial real estate investment without a backup financing plan.
Consider lining up hard money (expensive debt that can be closed on quickly) in the event your primary lender can’t come through on time. More often than not, good brokers can negotiate an extra few days to allow a lender to finalize its paperwork and close, but non-refundable deposits are exactly that: non-refundable.
When buying a mixed-use property a few years ago, a higher offer came in after we were in contract. We figured that the seller would take any opportunity to take our deposit and cancel the deal if we couldn’t close on time, so we called in a reliable hard money lender as a backup.
We paid a $10,000 commitment fee to have the hard money option on call and ready to fund with 24-hours’ notice. Fortunately, we never needed to make that call, and we never missed that $10,000 for the peace of mind to move forward on what ended up being a terrific investment.
There is no perfect loan for all commercial real estate investments, as each project calls for a borrowing option that matches the business plan and parties involved. Consider terms carefully, focusing not just on the interest rate but things like prepayment penalties, fixed rate periods, interest only options, recourse and fees.
Leverage is a powerful tool, but one which must be wielded with care. Fortunes have been made over the generations by smart commercial real estate investors using prudent loans to amplify returns, but also by bankruptcy attorneys picking up the pieces of borrowing gone wrong.
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