Why Negative Leverage Deals Make Sense – And Why They Don’t – Trade Observer

As the cost of capital rises in response to the Federal Reserve’s efforts to fight inflation, multifamily investors are borrowing money at interest rates higher than the cap rate of the asset purchased.

Known as negative leverage, it’s a strategy few commercial real estate buyers would have considered under the accommodative monetary policy of the past 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 starting to shrink its balance sheet by $9 trillion.

Whether the Fed actually implements all of its plans remains to be seen. To date, however, cap rates have not materially adjusted to higher interest rates, leaving multi-family investors who intend to put money to work in the highest quality assets with little choice but to make negative leverage bets.

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 date back to the days before the 2008 financial crisis, when investors overpaid for a wide range of assets, from single-family homes to office buildings.

Nitin Chexa. Photo: Palladius Capital Management

At the time, transactions depended on heavy debt, loose underwriting and projected growth in rents. Today, lender discipline has negated the first two variables. But negative-leveraged buyers are again betting that continued strong rental growth in the apartment sector will fuel higher yields going forward and turn leverage into positive.

By the first quarter of next year, we should know if the strategy worked. Here are arguments for why it can and why it can’t.

A risk worth taking

Betting on the continued growth of rents is not unreasonable. At the end of May, multi-family rental rates in the United States were 15.3% higher than 12 months ago, while the vacancy rate remained relatively stable at 5%, according to Apartment List.

Demand for apartments is expected to remain strong as rising house prices, rising mortgage rates and difficulties in obtaining a mortgage continue to keep younger generations in rental housing. John Burns Real Estate Consulting notes that tenants rented 700,000 apartments over the 12 months to the end of March in major communities alone, an increase that was more than double the historical norm.

A massive exodus from apartments to the home sales market won’t happen any time soon, as inflation erodes savings capacity, which, in turn, should help keep occupancy rates high in a context of a shortage of rental housing.

As a result, landlords in high-growth markets such as Austin, Nashville, Miami, Phoenix and Las Vegas — all of which have seen rent growth above the national average — should continue to demand healthy rent increases, although probably not at the impressive levels they have enjoyed over the past 12 to 18 months.

These growth markets and others like them typically offer rental housing options priced at around 28% of a person’s income, a general measure of affordability that could help renters absorb increases even in a slowing economy. To reach this threshold for a-
one-bedroom apartment, for example, a renter in Austin is expected to earn about $52,750 per year, while a renter in San Francisco is expected to earn $118,118, according to Smart Asset.

Flashing Hazards

When assessing why the negative leverage scheme might fail, it’s hard to ignore 40 years of high inflation and an economy on the brink of recession, if not already over. In particular, with fuel at $5 a gallon, consumers are paying more than double at the pump than two years ago. Food prices have also increased over the past year.

Feeling the pressure, people changed their shopping habits and travel plans. Notably, Target recently warned it would provide merchandise discounts to help boost sales and reduce excess inventory as consumers cut discretionary spending.

The layoffs and hiring freezes announced at Tesla, Facebook, Robinhood, Wells Fargo, Netflix and other companies could spread further through the economy if slow or negative GDP growth follows negative GDP performance in the first and second quarters, and the stock market continues its downward trajectory. Retail crypto investors have seen the value of their holdings reduced, adding further 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 a year.

The question is, given these headwinds, when will rent increases cause people to seek more affordable housing?

Nitin Chexal is CEO of Palladius Capital Management.