Commercial mortgage brokers, for the most part, would agree that leverage in a financing package is a useful and necessary tool for any of their real estate investor clients. Leverage, or the ratio of debt to value, can influence the risk and reward of real estate transactions. The benefits include, among other things, reducing the initial investment required to close the deal, as well as potential tax write-offs on the interest paid on the resulting debt.
Real estate owners and developers rely on leverage in order to maximize their return on investment (ROI). The use of leverage can increase ROI because the cost of financing is usually cheaper than the unleveraged returns a property can generate.
Compare three commercial real estate investors, for example, all with $1 million to invest. One investor utilizes no leverage to buy a $1 million property, another uses 50 percent leverage to buy a $2 million property and the other uses 75 percent leverage to buy a $4 million property. Then, assume 10 percent price appreciation on the property after purchase.
In such a scenario, the second investor with 50 percent leverage would realize a gross ROI double that of the first investor with no leverage. The third investor would realize a gross ROI quadruple that of the all-cash investor and double the gross ROI realized by the second investor. Investors simply get more bang for their buck by utilizing leverage and are able to create additional returns as a result.
Given the potential to expand ROI using leverage, one would think it would be used in most, if not all, real estate transactions. All-cash transactions, however, still account for a large segment of the real estate purchase market.
For the most part, leverage is utilized by most first-time homebuyers in the residential sector. Investors in the residential sector, who are able to finance purchases with commercial loan products, utilize leverage far more frequently, but still not as much as might be expected, given the potential advantages for ROI.
The fix-and-flip market offers a window into the use of leverage in commercial real estate transactions. In that market, investors buy homes, rehab them as fast as possible and then resell the houses, hoping to make a profit on the increase in market value. In second-quarter 2017, only 35 percent of homes flipped nationwide were acquired by flippers using financing, although this percentage was a nearly nine-year high and up from 33.2 percent the prior quarter, according to a report by Attom Data Solutions.
“ Commercial mortgage brokers should seek to maximize their clients’ leverage on less risky investments. ”
When an investor uses all cash, assuming they have the financial viability to do so, the resulting lack of liquidity can stand in the way of additional opportunities. Leverage can take the form of a mortgage on a single commercial property, a blanket lien on multiple properties or a line of credit that can be utilized repeatedly for fix-and-flip residential transactions. It allows real estate investors to diversify and exponentially multiply their ROI. The rise of commercial lenders in the fix-and-flip and buy-and-hold rental segments of the real estate market has expanded financing options for investors.
This development has resulted in many commercial mortgage brokers expanding their areas of expertise to include financing products already afforded to investors for residential properties. One of the products being offered through commercial mortgage brokers and utilized more frequently in the current market is the line of credit, which is normally geared toward the fix-and-flip investor seeking to keep their cash liquid and to capitalize on far more home-flipping transactions.
These lines of credit can finance up to 90 percent of the purchase price and 95 percent of the rehab costs, depending on the lender as well as the experience, liquidity, net worth and FICO credit scores of the borrower. Nonrecourse lines of credit are available to highly experienced real estate investors, which is an attractive incentive for those who qualify. There is increased competition for investors to find value for buy-and-hold or fix-and-flip properties. As opportunities diminish with changing market conditions, however, the need to capitalize on them quickly becomes paramount.
Crunch the numbers
For an investor with limited cash, it can take up valuable time to buy one property at a time, rehab it, and then market it for sale. During that time, other opportunities that present themselves could come and go. These are opportunities that could be taken advantage of with the use of leverage.
A line-of-credit product allows an investor to leverage liquidity by a factor of up to five times, giving those who use it a distinct advantage in the market, given the speed with which they can act on a potential deal thanks to that added liquidity.
Leverage can be a double-edged sword, however. It can lead to higher risk of loan default if not used prudently. While lenders impose certain underwriting guidelines that are designed to limit over-leveraging, it is ultimately the commercial mortgage broker’s expertise that can be one of the best guides for investors on the use and limits of leverage.
Brokers should analyze and compare the internal rate of return (IRR) on a transaction with the investor to determine whether leverage is prudent for a given deal. The IRR is a metric used to determine the potential profitability of a real estate investment. Generally speaking, the higher a project’s IRR, the more desirable it is to pursue the deal. After risk-adjusted returns are calculated, an educated investment decision can be made.
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Commercial mortgage brokers should seek to maximize their clients’ leverage on less risky investments, such as a deal involving a triple-net lease on a property that is in a desirable location and has a highly rated long-term tenant. Maximizing leverage also should be explored for commercial real estate projects or investments proposed in geographic areas with higher yields.
Finally, it is prudent for commercial mortgage brokers to counsel investors about the perils of being over-leveraged, especially with respect to low-yield investments. Recent real estate history is testament to how being over-leveraged during a severe downturn can lead to financial ruin. Weigh the pros and cons of leverage with your clients so that you establish a solid foundation for future business dealings together.