3 Ways to Overcome Negative Leverage

release edition [091]

read time [4 minutes]

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Today at a Glance:

• Negative Leverage: 3 Strategies
• Weekly Listen: Peter Linneman

Negative Leverage

In simple terms, negative leverage is when the going-in cap rate of an asset is below the interest rate of the debt.

Today's environment for acquiring Multifamily is challenging because many investors will not accept negative leverage and therefore need the going-in cap rate to exceed the loan's interest rate.

To accomplish this, the going-in cap rate would need to exceed 6.00% in almost all cases given that the 5-yr UST is at 5.00% + a relatively aggressive 100bps spread equates to an all-in coupon of 6.00%.

Despite the challenge, it's not insurmountable if you know what to look for in an acquisition opportunity.

Here are three variables to consider for overcoming negative leverage in Multifamily acqusitions.

1/ Loan Assumptions

This is the most no-brainer of the three, and for good reason. Assuming existing debt that translates to positive leverage at acquisition (i.e. 4% interest rate and 5.5% cap rate) is a defensible strategy in today's higher for longer capital markets environment.

That said, loan assumptions become dangerous when a buyer effectively pays for the loan by paying more for the asset because of the cheap assumable financing than they would pay at today's prevailing interest rates and available leverage. The loan assumption should be accretive to the acquisition, rather than a mechanism for justifying it.

Also, ensuring the viability of the refinance scenario when the loan matures is critically important, both from a total dollars and DSCR perspective.

2/ Growth

The more opaque but often utilized strategy for overcoming negative leverage is betting on growth.

This bet on growth can look many different ways, and it's not guaranteed, but it is a viable strategy if there's a strong enough conviction or a compelling thesis to support it.

For example, the current resurgence and outperformance of rent growth in San Francisco is a great example.

It is no secret that new supply in SF is extremely limited for various reasons, and incomes are relatively strong, so an investment thesis could be formed around the deduction that a SF multifamily rebound would occur following a demand boom like it is currently experiencing.

The tricky element, of course, is timing. In most cases, it's difficult to predict when a market will outperform due to an unpredictable and dynamic macroeconomic environment, ongoing technology advancement, and regional or local GDP expansion.

3/ Untrended Yield on Cost

Of the three strategies, this is the most defensible but does have some important nuance to be considered.

Essentially, the untrended yield on cost is the stabilized NOI excluding organic growth divided by the total yield on cost (debt + equity + capex).

Why does this help to overcome negative leverage? Let's look at a quick example

Suppose you're purchasing a property from a long-term owner that has managed for cash flow, not value. This translates to a low in-place cap rate (i.e. 5.00% on the Seller's T3/T12 financials) simply because the NOI is defensively low relative to where it should be based on the proven market competitive set.

Even though interest rates are at 6.00%, it can be justifiable to pay a 5.00% cap on the Seller's in-place numbers because there's a clear and defensible path to stabilizing above the 6.00% interest rate on an untrended stabilized basis simply by burning off lost-to-lease and marking the units to market based on the competitive set.

This strategy works when there's some combination of low in-place rents, limited or non-existent other income, or heavy operating expenses. Again, there's a lot of nuance to the strategy, but buying negative leverage can be okay if the a stabilized yield on cost is defensibly achievable through the execution of the business plan.

This is not to say that buying multifamily in a negative leverage environment is easy, but it is doable with the right strategies.

How are you thinking about acquisitions in this environment? Anything that you're doing to mitigate or offset the negative leverage perception with your team or investors?

Hit reply and let me know.

Weekly Listen

This week's listen is The Walker Webcast, “The Most Insightful Hour in CRE, Part 27,” hosted by Willy Walker with economist Dr. Peter Linneman.

Linneman walks through why the Iran conflict and how the move in oil knocked him off his two-to-three-cuts call for 2026 and onto a hold, why he thinks effective rents improve as concessions burn off (with a possible rent spike in 2027), and where he’d invest money today.

You can listen to the full episode here.

Wrap Up

That's it for today. I hope you found this edition of The Multifamily Download insightful.

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Thanks for reading. See you next week!

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