“It is the debtor that is ruined by hard times.” -Rutherford B. Hayes
For my entire career in commercial real estate, I understood leverage as a good thing, and the more the better. However, the recent credit crunch and downturn in the real estate markets have taught me the dangers of too much leverage and have led me to consider the appropriate place for leverage in a real estate portfolio.
On the one hand, leverage is an important and useful tool for a real estate investor. Because real estate is fixed and tangible, it has a relatively stable value. For that reason, most real estate assets are readily financeable. Leverage allows a real estate investor to diversify the investor’s portfolio easily. For example, an investor with $1 million to invest could purchase a 15-unit apartment building for all cash, or, using leverage, could purchase three 10-20 unit apartment buildings in different neighborhoods, a small strip center, and a small office building and end up with a diversified portfolio with a value of $5 million. Leverage also permits an investor to multiply the return on the investor’s investment. For example, if the assets described above appreciate at an average annual rate of 5%, the value of the all-cash property at the end of ten years would be almost $1,650,000, while the value of the leveraged portfolio at the end of ten years would be nearly $8,250,00.
On the other hand, leverage increases risk. If property values decline, as they have recently, an investor may be required to contribute additional equity before refinancing a property. If the investor cannot raise the additional equity, the investor may face foreclosure and the loss of the asset. The loss of one asset can have a domino effect, and there are many examples of savvy investors who have lost all or most of their portfolios in the recent downturn. An all-cash owner does not need to worry about refinancing and may even be able to leverage the owner’s assets to acquire distressed assets at fire sale prices during a downturn.
Leverage definitely has a place in a real estate investor’s toolbox. However, there is a downside to leverage, and a wise investor will always pay attention to the amount of leverage in the investor’s portfolio.