Understanding The Risks of Commercial Real Estate Investing and How to Mitigate Them - Leverage Risk

Uber Freight - Rogers, AR

Leverage Risk

Leverage is a risk that most real estate investments carry, and because it’s so common, most investors believe they fully understand the risks associated with leverage. We will touch on those risks briefly, but we’ll also cover some lesser-known risks that can adversely impact CRE investments. These “surprise” risks can be quite painful if not properly considered.

When we think about leverage risk, we typically think about how it magnifies changes in value. Much like its physics namesake, leverage allows the control of a large asset with a small amount of capital for a relatively small real cost. A property that increases by 10% and is levered 50% will yield a 20% gross return to the owner, less the cost of the leverage. That same property levered 80% will yield a 50% gross return, less the leverage cost. This, of course, works the same way when assets decline in value. The 50% levered property would lose 20%, in addition to the cost of leverage, and the 80% levered property would lose half of the investment, in addition to the cost of leverage.

Besides this magnifying effect, there are other risks to leverage that aren’t always fully considered. One of the most problematic is recourse. Many investments made at lower leverage rates do not require a person to guarantee the debt, but as leverage ratios get higher, it is more likely that a personal guarantee will be required for the loan. The risk differential between one with recourse and one without is stark. For an investment without recourse, the maximum that can be lost is the amount invested, but with recourse, the maximum loss can be many multiples of the initial equity. Investors with recourse who are invested in partnership with other investors often attempt to limit their recourse to their percentage owned, but this is an imperfect solution. If an owner owns 10% of a property in a partnership and has a 10% prorated guarantee, and the property ultimately sells for 20% less than the loan amount, that individual owner can be held responsible for their full guarantee of 10% of the loan balance, not just 10% of the shortfall. On a $1 million loan, that’s the difference between owing $20,000 and $100,000.

Beyond recourse risk, leverage adds execution risk to both purchase and sale transactions. On the purchase side, there is typically a point in the purchase process where the buyer must waive their purchase contingencies and proceed to closing. At this point, the buyer’s earnest money is no longer refundable, except in extreme cases, such as the building being materially damaged. But lenders often have much more flexibility to forego planned loan closings, and in periods of extreme market dislocation, such as March 2020, September 2008, and even a handful of less memorable periods of tumult, they do just that, leaving potential buyers with a substantial loss. Similarly, sellers have risks related to buyers' financing as well as their own. If a buyer’s lender fails to fund and a seller’s loan is due, the failure to close can cause serious complications. On the other hand, a buyer with a purchase contract that allows for a financing contingency has an effective call option on the property for the term of the contract, leaving the seller vulnerable to any downside developments while the buyer benefits from any positive news. For this reason, purchasers with no financing contingencies typically negotiate noticeably better terms than those whose offers include them.

Perhaps the least considered risk associated with leverage is the possibility of the loan disappearing altogether. Often, investors will finance a long-term investment hold with medium-term debt, planning to refinance the balance later. This can be a good strategy to preserve flexibility and keep interest rates low, but it also introduces the risk that the bank may not renew or may only do so on much more adverse terms. Even if they’ve taken this risk with eyes wide open, many investors don’t realize they also face the risk that the loan may be called before the end of its term. Boilerplate loan documents often have “insecurity clauses” allowing the bank to call the loan if they feel increased concern about the borrower’s ability to repay. Similarly, “cross-default” clauses can trigger a lender’s ability to call the loan on a fully performing investment if a borrower has a covenant or payment default on another loan. It's important to note that these scenarios can, and often do, occur when there is still significant remaining equity value in the investment. But unless replacement financing is found within the limited window provided by statute or agreement, that value is forfeited by the investor.

Dan Andrews
CEO