Colorado’s property market could see some interesting changes this year, depending on what the 2024 legislative session produces. We were considering some of those potential changes in relation to Colorado hard money leanding when the idea of negative leverage came up. As a property investor, do you know what negative leverage is? Do you know how it affects borrowing and lending?
Only time will tell how Colorado’s property market will fare this year. We will continue to offer hard money loans to investors interested in obtaining properties in Denver, Boulder, and throughout the rest of the state. In the meantime, investors unaware of negative leverage would do well to study up on it.
The Basics of Negative Leverage
Negative leverage in real estate investing is a scenario in which financing a new property acquisition decreases the return on investment (ROI) enough to make the property not worthwhile. Positive leverage is just the opposite. It is a scenario in which financing actually boosts returns.
Understanding negative leverage begins with understanding three important terms:
- Net Operating Income (NOI) – The actual amount of profit the property generates after all expenses have been paid.
- Capitalization Rate (cap rate) – The rate of return on a property if acquired without debt. It is determined by dividing net operating income by purchase price.
- Loan Constant – A measurement of how much the investor is paying to borrow. It is determined by dividing the service amount (principal and interest payments) by the loan amount.
Negative leverage occurs when the cap rate is lower than the loan constant. This means that you are paying more money to service the debt than the property is returning in NOI. You ultimately have a cash flow problem until the scenario is corrected.
Why Negative Leverage Is Risky
Though there are limited circumstances under which negative leverage would be reasonable and tolerable, negative leverage is normally considered a bad thing in property investing. It is rare to be able to justify the negative cash flow created by it. Above and beyond negative cash flow, there are three risks to take seriously:
- Limited cash flow could ultimately undermine your ability to service the debt attached to your property. We do not need to tell you where that could lead.
- Negative leverage can significantly increase losses if the property in question is subject to a decline in value.
- Negative leverage will reduce your ROI for as long as you remain in negative territory.
Again, there may be special situations when negative leverage is okay. In most cases, they would be scenarios in which the investor believes negative leverage will only be temporary. But such scenarios are the exception to the rule.
How It Impacts Financing
How does all this impact financing? Assuming positive leverage, financing property acquisitions with hard money loans is a good deal. Hard money means quick acquisition and the ability to grow your portfolio with less cash up front. By financing with hard money, you can spread your cash out to cover more deals. On the other hand, a negative leverage situation is different.
Negative leverage suggests that you acquire the targeted property with an all-cash deal rather than taking on debt. You utilize more cash up front, but you also protect your ROI. Sometimes that is the better way to go.
We will be keeping an eye on Colorado’s property market in the coming months. We encourage you to brush up on negative leverage if it is not a principle that you are familiar with. Also remember that Actium Partners has hard money ready to go for investing in attractive Colorado properties.
