What Is Negative Leverage in Real Estate?

Real estate can be a great way to earn money outside of your annual salary and retirement accounts. As with many large purchases, however, you might not have the cash on hand to buy an investment property in full upfront. In this instance, you’ll need to take on debt to make the acquisition. While debt is often seen as a dirty word, borrowing money for a real estate investment could be beneficial in the long run. “Could be” is the key phrase here because debt must be managed properly to make the financial risk worth it. Otherwise, you could wind up in a negative leverage situation.

Landing there could cost you and any fellow investors their money if or when you decide to sell the property. While negative leverage does not mean the investment is a failure—there actually are times it can be beneficial—it’s crucial to be in that situation temporarily.

Keep reading to learn what exactly negative leverage in real estate is, how it works, and what scenarios negative leverage can be good for your investment.

What Does Negative Leverage in Real Estate Mean?

Negative leverage in real estate happens when the debt assumed to acquire a property is more than the returns the property’s cash flow generates. Different scenarios can lead to negative leverage. The loan's interest rate might have exceeded the property’s returns. Maybe not enough cash was required upfront. Perhaps appreciation did not meet expectations, the operational cash flow increased, or there was a lack of cash flow in general.

When interest rates are more than operating cap rates, assuming debt is considered a negative because it decreases investors’ annualized cash flow. Instead, that money must be put toward paying for higher debt costs. This puts investors in a situation where they have to hope for a big profit when the property is sold so they can get the returns they were expecting when they first invested in the property.

If the property sells at a profit, then the negative leverage doesn’t hurt. However, the longer negative leverage remains with a property, the longer the opportunity to gain positive returns remains at risk because generated cash flow is being put toward debt instead of back to investors. One way to potentially avoid negative leverage is for investors to compare the debt cost to the property’s capitalization (cap) rate. When the cap rate shows a return that exceeds debt costs, the property has positive leverage.

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Positive Leverage vs. Negative Leverage Real Estate

Since negative leverage exists in real estate, it only makes sense that leverage can be positive in real estate, too. Positive leverage occurs when a property’s current yield or cap rate exceeds the mortgage’s interest rate. You can divide the property’s net operating income (NOI) by the acquisition price to calculate the cap rate. Revenue-generating factors—such as parking, amenity fees, and rent—make up a real estate property’s NOI.

When structured correctly, positive leverage can be a key real estate investing tool—it can boost your equity yields given that your borrowed funds are less than the income the property generates. Positive leverage can lead to consistent cash flow and a higher return on investment when it is maintained over a long period of time.

As we now know, negative leverage in real estate is the opposite of the aforementioned scenario. With negative leverage, a property’s yield is lower than the mortgage’s interest rate. In this situation, the property needs to generate even more income to cover the debt’s costs. Unfortunately for investors, the lender typically benefits more in negative leverage situations. Additionally, investors face the challenge of meeting their debt obligations, which could lead to financial stress or even losing the property.

When Is Negative Leverage Acceptable in Real Estate?

Believe it or not, negative leverage can sometimes work in a real estate investor’s favor. One example is when rent prices are lower than the typical market price or the market is uncertain. Using negative leverage could also be acceptable if your property purchase price is discounted significantly, which could help offset decreased cash flow or cap rates. Additionally, during those times when rents fall below market, it’s possible that a property could go from negative leverage to positive during the holding period (the time from when an investment is made to when the property is sold).

While there are openings for negative leverage to work to your benefit, you will need a plan to get back to positive leverage during the holding period. If you believe the negative leverage is temporary, you could try to remain patient as you move back toward positive leverage. The ride might be bumpy, but there’s potential for a bigger return once the property is sold, thanks to the discounted price you initially paid.

What Is an Example of a Negative Leverage?

Remember, negative leverage in real estate occurs when the debt assumed to purchase a property exceeds the investor’s rate of return. For example, if you purchased a commercial real estate property with a projected 6% cap rate but your mortgage rate is 6.5%, you’re facing negative leverage. On the other hand, a property with a cap rate of 6% and a 5.5% mortgage rate would put you in a positive leverage deal scenario.

There are also different types of negative leverage in real estate to consider. For example, equity investment allows an investor to act as a shareholder in the property in which they have invested. Their piece of the property is tied to how much they have invested and accounts for factors like preferred equity, partnerships, and leverage.

Borrowing costs is another form of negative leverage in real estate. The loan amount, interest rate, and impact on equity returns are just some of the borrowing costs that are tied to negative leverage. These costs can have a significant impact on the risks and benefits that come with using negative leverage as a real estate investor. If interest rates continue to go up, for example, the increases will likely impact how much your loan costs. Again, a loan that costs you more than the amount of money the property is bringing in is exactly how you end up with negative leverage.

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The Bottom Line

When a term contains the word “negative,” it’s easy to assume it’s a bad thing. That’s not necessarily true when it comes to negative leverage in real estate, however. Negative leverage can work in a real estate investor’s favor—as long as it’s used properly. Understanding market conditions and ensuring that the negative leverage will be temporary is key to making a term that sounds bad lead you to a positive real estate investing experience.

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