The Federal Reserve engineered a recovery from the 2008 financial crisis by creating the cheapest credit environment that the world has ever seen. The ultimate positive leverage scenario was created for anyone acquiring assets by dropping the overnight federal funds rate to 0.0% and pumping “liquidity” into the market. These actions led to interest rates changing and not returns not adding up. Here’s why.
Positive Leverage
Positive leverage is a fancy way to say, “the cost of using debt is cheaper than using cash.” For example, take a real estate investor in 2010 who bought an investment property using debt:
- Let’s say that the property cost $1,000,000
- The loan on that property is 75% of the value of the building
- The interest rate is 4.0%
- The property generates $80,000 a year in rental income
The mortgage on the property would be approximately $43,000 a year (used to pay principal and interest at a 30-year amortization). Cash flow off the delta, assuming no other annual landlord expenses, would be $37,000 ($80k – $43k), or a 14.8% cash on cash return ($37k divided by $250k).
With 15% cash-on-cash returns and a banking system looking to lend, demand for assets grew while the supply was constrained as great investment properties offerings could not keep up with demand. The imbalance of supply and demand is resolved through prices–ECON 101–which we saw with massive real estate value appreciation over the past decade, and especially in the last several years. This price appreciation resulted in cap rates (rental income as a percent of the purchase price) dropping as demand outpaced supply until the gap between interest rates and cap rates closed to only a small benefit of positive leverage.
The booming economy created by the looser-than-normal monetary policy was like an addictive drug, and the Fed never went into rehab, allowing for more than a decade of bargain interest rates, arriving at historically low cap rates of less than 5% in many markets and asset classes. With post-Covid inflation, the party is over and that 4% interest rate is over 6.0%, and many bankers and economists are advising to get used to these rates as the new normal.
Negative Leverage
The problem is that real estate values and cap rates won’t respond as quickly as the Fed changes rates, and we arrive now at a negative leverage environment. In negative leverage scenarios, as you borrow more you erode the return on your equity. Today’s investor is looking at opportunities to purchase a 5 CAP property with an interest rate over 6.0%, which actually results in negative cash on cash return if you borrow 75% of the purchase price. This negative leverage effect is why we are seeing investors borrow less and the resurgence of all cash purchases. This environment disadvantages the constrained private investor as their buying power is shrunk and they are priced out of quality commercial real estate properties and must settle for lesser options that fit in their all-cash price range.
An Alternative Solution
Millcreek Commercial Properties (MCP) provides a compelling alternative. MCP allows investors to acquire a proportionate share of a quality NNN leased property, giving access to quality properties for cash-constrained investors. Since its inception in 2017, MCP has centered its product strategy on an all-cash offering. While in 2021, their conservative approach was disadvantaged compared to the returns projected by highly levered offerings, in 2022 their returns are only improving while every other option is scaling back.
Millcreek Commercial is proud to be a solution for investors of all budgets. Visit our website www.millcreekcommercial.com to explore different commercial properties that will provide you will the perfect property for your needs.
