Negative Leverage: Good or Bad?

Let’s jump right into the topic of negative leverage.

The reason we use leverage (debt), or use other people’s money, is the ability to get a higher return for that money invested.

Let’s say you purchase a property. The going in cap rate, or the trailing NOI divided by the purchase price, is the rate of return on the property. So if the cap rate is 5% then that’s your rate of return based on the purchase price.

So hypothetically, if your interest rate on the deal will be 6.5%, this deal would have negative leverage.

Simply put, this is saying it would be cheaper to pay cash for the property since your yield will be less using leverage.

Negative Leverage = Loan Interest Rate > Cap Rate

So does this mean buying a deal with negative leverage is automatically bad? I would say it depends…

Positive Leverage 

Positive leverage occurs when the operating cap rate from a deal is greater than the interest rate of the debt placed on the asset.

In this scenario, using debt can actually improve the annualized yield on equity because the debt costs less to service than the cash flow received from the leveraged portion of the project.

Negative Leverage 

Conversely, negative leverage occurs when the operating cap rate is lower than the interest rate of the debt.

So, in this scenario, using debt can actually decrease the annualized yields on equity because the debt costs more to service than the cash flow received from the leveraged portion of the project.

Why would a sponsor buy a deal with negative leverage?

  1. Banking on Huge Appreciation – Sponsors would be more willing to pay more for a deal knowing the market will significantly appreciate in the coming years. (This is very risky!)
  2. Accept Lower Return – Some buyers have lower return requirements. They might have a 1031 exchange or other tax-motivated ambitions and they are not as concerned with cash flow.

Don’t automatically pass on a deal with negative leverage…

Here’s the best reason to consider a deal that potentially has negative leverage: 👉 Potential Upside

If you were buying a deal and knew for a fact there were ways to significantly increase rents, improve operational inefficiencies, and increase the NOI of the asset, would you accept a lower return for the first few years?

We would. And most real estate investors do all the time. We are willing accept a lower yield in the beginning for the property because we know there is significant upside potential.

So just because the going in cap rate may be lower than the interest rate in the beginning (this is still not ideal), I would not automatically pass on the deal without doing further analysis.

The cap rate (return on investment) could be significantly higher after the right business plan is completed.