According to an April report from industry giant CBRE, global investors poured $835 billion into real estate in 2014, and they show no sign of slowing down any time soon. What relevance do global trends like this have on individual private investors? The answer is that, when so much money is chasing a single asset class, prices inevitably rise, making competition for assets fierce and the pressure to generate strong returns that much more intense. This usually results in aggressive borrowing.
In market conditions like this, debt financing can be a powerful tool to for investors, especially when interest rates—the cost of debt—are historically low. As any homeowner knows, borrowing increases purchasing power. It can also limit the number of partners needed for a deal, keeping things nimbler. And, as long as the rate of return is higher than the interest rate on the debt, it gives investors a greater yield on their equity (creating what is known as “positive leverage”).
What, then, is the problem with debt in private real estate investing? As long as things are going well, nothing. But if leverage increases the upside of an investment, there are also several ways it increases the risk:
- The capital markets may not be as favorable when the loan matures as they are now. This could reduce cash flow available via a new loan. Or, as we saw in the Great Recession, replacement financing may simply not be available.
- Debt comes with a formal obligation to repay. If a property’s income falls short of expectations (due, for example, to a tenant that goes bankrupt or a vacancy that takes longer than anticipated to fill), investors may risk default and the potential loss of their money unless they can come up with funds to make loan payments
- Property values do not always enjoy uninterrupted ascent. As too many investors learned during the Great Recession, real estate values can fall precipitously. This is bad enough when investors own a property outright; it is far worse when they hold significant debt. In the worst cases, the property’s value falls below the loan amount, making additional investment necessary just to maintain ownership. This is particularly challenging with partnerships.
Before committing to any deal, the wise investor will make sure to investigate the deal sponsor’s planned use of leverage. It has its benefits, but always represents a calculated risk.