Why Negative Leverage Deals Make Sense — and Why They Don’t
By Nitin Chexal August 3, 2022 12:00 pm
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As the cost of capital rises in reaction to the Federal Reserve’s efforts to beat back inflation, multifamily investors are borrowing money at higher interest rates than the capitalization rate of the asset being purchased.
Known as negative leverage, it’s a strategy that few buyers of commercial real estate could have envisioned amid the accommodative monetary policy over the last decade. But the Fed’s pivot to quantitative tightening has pushed the key federal funds rate up significantly this year, and the central bank is also beginning to trim its $9 trillion balance sheet.
Whether the Fed actually follows through on all of its plans remains to be seen. To date, however, capitalization rates have not materially adjusted to higher interest rates, leaving multifamily investors who are intent on putting money to work in the highest-quality assets with little choice but to make negative leverage wagers.
The seeds of negative leverage are planted when asset prices and interest rates rise at the same time, and, as a result, borrowers initially make less money on an investment than lenders. The deals are risky and harken to the days preceding the 2008 financial crisis, when investors were overpaying for a wide range of assets, from single-families to office buildings.
Back then, deals depended on hefty amounts of debt, loose underwriting and projected rent growth. Today, lender discipline has negated the first two variables. But negative leverage buyers are again betting that continued strong rent growth in the apartment sector will fuel bigger returns down the road and turn leverage positive.
By the first quarter of next year, we should have a good idea as to whether the strategy has worked. Here are arguments as to why it may, and why it may not.
A worthwhile risk
Gambling on continued rent growth is not unreasonable. As of the end of May, multifamily rental rates in the U.S. were 15.3 percent higher than 12 months earlier while the vacancy rate remained relatively flat at 5 percent, according to Apartment List.
Demand for apartments should remain strong considering the fact that escalating home prices, higher mortgage rates and difficulties securing a mortgage continue to keep younger generations in rental housing. John Burns Real Estate Consulting notes that renters leased 700,000 apartment units over 12 months through the end of March in large communities alone, a surge that was more than double the historical norm.
A mass exodus from apartments and into the home sales market isn’t going to happen any time soon as inflation erodes the ability to save, which, in turn, should help maintain high occupancy rates amid a rental housing shortage.
As a result, landlords in strong growth markets such as Austin, Nashville, Miami, Phoenix and Las Vegas — all of which have experienced rent growth greater than the national average — should continue to command healthy rent increases, although most likely not at the impressive levels that they’ve enjoyed over the last 12 to 18 months.
These and similar growth markets typically provide rental housing options that are priced at around 28 percent of a person’s income, a general measure of affordability that could help renters absorb increases even in a slowing economy. To meet that threshold for a one-
bedroom apartment, for example, a renter in Austin would need to make about $52,750 a year, while a renter in San Francisco would need to make $118,118, according to Smart Asset.
Hazards flashing
When assessing why the negative leverage gambit might fail, it’s hard to ignore a 40-year-high inflation rate and an economy on the precipice of recession, if not already over. In particular, with fuel at $5 a gallon, consumers are paying more than double at the pump than they were two years ago. Food costs have risen over the last year, too.
Feeling the squeeze, people have altered shopping habits and travel plans. Notably, Target recently warned that it would discount merchandise to help spur sales and reduce excess inventory as consumers have cut back on discretionary spending.
Layoffs and hiring freezes announced at Tesla, Facebook, Robinhood, Wells Fargo, Netflix and other companies could spread further into the economy if slow or negative GDP growth follows the negative GDP performance in the first and second quarters, and the stock market continues its downward trajectory. Retail investors in crypto have seen the value of their holdings slashed, adding additional downward pressure. More troubling, nearly two-thirds of Americans were living paycheck to paycheck in April, including about one in three of those earning at least $250,000 annually.
The question is, given these headwinds, at what point will rent increases drive people to look for more affordable housing?
Nitin Chexal is CEO of Palladius Capital Management.
