Leveraging is one of the critical ways investors can increase their potential returns. This is especially common in the commercial real estate (CRE) industry.
In recent years, investing in the CRE industry has become increasingly popular, especially as it becomes more accessible and affordable through free commercial real estate listings.
Leveraging investments in any industry is considered very risky and volatile, but investors are rewarded with higher property values when it works out.
How Leveraging Works: The Basics
Leveraging in CRE is accomplished by using borrowed money to increase the property’s equity and value. Since it’s mostly the investor’s money out of pocket, it essentially finances with debt.
Let’s take a look at an example. If an investor has $200,000 in their bank account and decides to invest all that money in a rental property, the property value would increase by 10% in two years. The property would now be worth $220,000.
Leveraging With a High-Value Property
However, it may be more beneficial to use that $200,000 as a down payment on a property worth $1 million. The investor would have to take out a mortgage to pay for the rest.
As in the previous example, there would be a 10% value increase after two years.
Ideally, the investor would then sell this property after two years. They will make $100,000 before other fees and expenses are accounted for if they do that.
Therefore, investors are more likely to receive a higher return in a situation where they end up taking out more money than in one where they just use the cash they have. This is what makes leveraging so risky.
The Risks of Leveraging
Leveraging is often described as a double-edged sword. While it is possible to increase returns, it’s likely to fail. Here are some of the things that could negatively affect someone’s leverage:
- Tenant vacancy;
- Property vacancy;
- Declining real estate values.
When multiple units are involved, any potential financial issues grow even more. Since CRE investors will typically try to put down as little money as possible, the goal is to take control of the assets completely while putting down only 20% of the property’s value.
So when an investor uses the cash flow from one property to leverage more properties, a decline in income could lead to foreclosures on every property that the investor owns.
Avoiding These Risks
Leveraging will have a decreased risk when someone has solid knowledge of the CRE industry. Of course, some factors are out of the investor’s control, like the economy and potential vacancies, but even the vacancies can be properly addressed.
Some tenants are riskier than others. For example, a tenant with strong credit will be more likely to make reliable rent payments.
It’s important to evaluate potential tenants to see if they can handle payments in the current financial climate and build a positive brand image as a landlord in the minds of tenants and other investors.
Commercial Real Estate Property Values During Economic Decline
The occupation of commercial properties has changed quite a bit since the beginning of the COVID-19 pandemic as remote working became more popular.
Because of these changes, investors are changing their strategies. Some investors have shifted their interests to unoccupied properties since their prices are much lower.
When business returns to normal, this could be a good investment in the future.
As long as a property is occupied, it will remain stable even during an economic downfall.
CRE investors can reconsider properties that would typically be out of their price range during times like these.
The Economic Benefits of CRE Investments
In general, commercial real estate has been beneficial for the economy. According to the NAIOP Research Foundation, the CRE industry supported eight million American jobs in 2020.
The commercial real estate industry even restored one million construction jobs by November 2021 after roughly one million jobs were lost in March and April of 2020.
How Investing and Inflation Go Hand in Hand
Because commercial real estate is not impacted the way other industries are during inflation, commercial real estate investments help hedge against higher inflation.
Commercial real estate also allows outsize returns for some situations.
Here are some of the ways that CRE investments can protect against higher inflation:
- Rental income will rise with inflation, therefore increasing property values;
- CRE leases have clauses to regularly increase rent prices throughout the lease’s term, which also increases property values;
- Property shortages bring price increases that can outpace inflation, leading to higher returns.
Higher returns during inflation will compensate for the economy’s volatility and any lower returns that investors with CRE properties in their portfolios receive.
How Rising Interest Rates Affect CRE Leverage
Interest rates may begin to rise because of the inflation seen in late 2021 and early 2022. CRE investors will have a major adjustment once these prices truly begin to rise, as they’ve been working with low-interest rates for a long time.
Higher interest rates mean that investors want higher returns even more than ever and will have to make suitable adjustments to these new, higher rates.
Even though the interest rate will be increasing, it should still be low by a historical standard. So, despite a rise, the rates will still be relatively low since interest rates have been declining for a while.
Positive Outlook Still Remains
Even though interest rates are likely to increase further, the Federal Reserve is predicted to do it carefully and slowly to not overwhelm investors.
Commercial real estate should still see positive trends despite higher interest rates for a few reasons:
- Low cost of capital;
- Strong interest in real estate from domestic and foreign investors;
- High demand for housing and industrial real estate.
Real estate has remained the best alternative for stocks and bonds for domestic and foreign investors. Plus, investing in the United States has become more appealing to foreign investors due to the Russian and Ukrainian conflict and the high distribution of vaccines in America.