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Key Takeaways:
- Negative leverage is present when the Unleveraged IRR is less than the cost of borrowing (debt service)
- The presence of Negative Leverage is a warning sign (red flag) of potential cash flow difficulty
- Positive Leverage should be targeted as soon as possible
- Long term Negative Leverage should give the lender significant pause
What is Negative Leverage and is it a concern in the Year 1 income statement of a real estate project? The short answer to the question is “Yes!”. It IS a concern that negative leverage exists in year 1 of the deal’s cash flows. The presence of “Negative leverage” indicates that the Unleveraged IRR is less than the cost of borrowing (debt). The cash flows are not sufficient to cover the cost of borrowing. In this situation, the introduction of debt (leverage) will do nothing but push cash flows lower by reducing operating income (after debt service) below what it would be with no debt present. This would essentially defeat the purpose of obtaining debt, which is to increase the performance of the equity. I equate negative leverage situations as a “Race to the Bottom” where a project will reach financial insolvency in a more rapid and dramatic fashion than if the deal involved zero debt/leverage.
So, are there situations where negative leverage in a deal is acceptable? Well, if the equity providers were satisfied with the return of a deal with 100% of the capital provided by equity, then negative leverage would not play a role in their decision. This would assume that the equity provider did not have a better use of the capital portion which could be financed, in another investment. It would also, likely, involve a scenario where the cost of debt was unusually high, thus creating negative leverage which would ordinarily (under a normal cost of debt situation) not exist.
Negative leverage could be an acceptable risk to a lender, if they felt the cash flows would quickly recover and create positive leverage. Perhaps the investment is a vacant office building in transition, and the first year of ownership is spent under construction with a repositioning strategy. In this scenario, the year 1 cash flows will present negative leverage, as very little (if any) leasing has taken place. However, leasing activity upon repositioning and value increase upon stabilization, may be robust enough to warrant the risk of year 1 negative leverage. In any case, the lender will need to be assured that the underlying asset is a sound investment. The lender could potentially wind up “inheriting” a negative leveraged property as the result of a foreclosure.
A low cash flow and negative leverage scenario would indicate the presence of a low (or negative) debt service coverage (DSC) ratio, for the lender. This represents an increase in risk that the borrower will default on their obligations. A lender approached with such a proposition should proceed with caution.
- Can the borrower sustain a negative leverage situation or even a negative cash flow scenario?
- If so, for how long?
- How long will the property take to get into positive leverage or will it ever do so?
These are questions to which the lender should have clear answers.
Questions?
Should you, or anyone that you know, have any questions related to this post, please do not hesitate to reach out via phone, email, or text. I am passionate about helping others along their real estate journey.
– Nick Schlekeway
