Leverage: The engine that drives commercial real estate
Most of us, given the bank account and the opportunity, would prefer to own several income producing properties rather than just one. The magic wand that can help make this happen is called leverage.
Leverage occurs when the buyer is able to acquire an asset by using his own resources for a portion of the purchase price with the balance contributed by a lender.
To set up an example, if you had $1,000,000 to invest, rather than purchasing a single million dollar property for cash, you would locate four (4) good properties worth $1,000,000 each. Then you would purchase them putting $250,000 of your cash into each transaction and borrowing the remaining $750,000, typically from a bank or possibly from a private investor. In real estate, most leverage takes the form of debt.
CCIM Institute’s Introduction to Commercial Investment Real Estate makes the point that “the shrewd use of debt can increase returns on real estate by reducing the initial investment, providing tax benefits from the interest portion of the loan and by paying back the loan at dollars of potentially lower value than at the time of the original debt.”
The numbers work at all levels. A doctor recently purchased a small building. He used half for his own medical practice and leased half to a tenant to help pay his mortgage. The building cost $600,000; his investment was $150,000. The monthly mortgage payment is about $2,900; his tenant pays $1,900 in rent on a triple net lease. The effective “rent,” therefore, for the doctor’s thriving medical practice, is only $1,000 per month. He can also deduct the interest from his taxes, and he will receive the benefit of building appreciation at such time as he sells the building. Not bad!
Since most of the debt underwriting commercial real estate investments comes from banks, it is useful to review the “5 C’s of Credit;” that is, the five key elements required of a borrower to obtain a loan:
Capacity (sufficient cash flow to service the loan)
Capital (net worth)
Collateral (assets to serve the debt)
Conditions (of the borrower and the overall economy)
Make sure your own “C’s” are in order before contacting a financial institution.
Of course, leverage can have its downside. As we have experienced over the past few years, a general economic downturn can cause a decline in property values which will, in turn, contribute to a decline in rental rates and an increase in vacancies. Lower rents and vacancies will negatively impact the cash flow of a given project and adversely affect the owner’s ability to make mortgage payments, especially balloon payments when they come due.
The good news for our local economy is that banks have begun to demonstrate an active interest in making new commercial loans.
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