How To Leverage Commercial Property Equity To Ignite Additional Investment Opportunities
March 9, 2022
Property investment remains a highly lucrative avenue, as proven by the rising rates of real estate assets, especially in the commercial market. The average investment growth for a commercial property is at an estimated 9.5 percent, on par with many major equities. The commercial real estate market serves as a significant driver of the economy in the US, with over $16 trillion worth of global value.
Additionally, individuals with a well-established investment strategy can leverage their commercial property equity to expand their portfolios through several proven methods. Leveraged commercial property equity enables investors to scale and diversify portfolios.
The Benefits of Leveraged Commercial Property
Leverage enables investors to unlock multiple opportunities for further property investment. A leveraged investment strategy generally involves various sources of capital. Through leverage, investors can commit a smaller upfront cost while gaining access to an asset class. As such, investors may re-categorize commercial equity to expand their portfolios.
Real property investors may measure leverage in a loan-to-value ratio (LTV) where a loan represents a fraction of the commercial asset’s market value. Generally, commercial real estate investors are more confident in leveraging property equity since they deal with a more stable market than residential investments (i.e., low relative volatility).
However, investors need to understand the inherent risks of leveraging commercial property. While leverage compounds profits, the same applies to losses. Therefore, commercial property investors should take heed when balancing risks and returns. Specifically, investors should increase returns while avoiding excessive financing challenges.
Leveraging Commercial Property Equity
Well-established leverage enables investors to profit from a loan with a lower value than the investment rate in a commercial property relative to the cash-on-cash return for the deal. Gradually, a leveraged property accrues equity upon settling the loan principal.
Additionally, investors can depreciate the total property cost by leveraging a commercial real estate investment, amounting to tax deductions. Essentially, investors can look forward to more investment opportunities with tax benefits more significant than the initial financing.
Generally, commercial property investments can see an uptick in response to rising rates of interest. At the time of this writing, the economy is on a recovery trajectory, with an improvement in employment, which may suggest better cash flows, interest income and significant success in a leveraged portfolio.
Commercial Property Leverage at Work
With the right approach, leverage enables investors to build equity without paying an upfront cost and is a vital part of an effective investment strategy. For example, an individual can make a down payment of $300,000 for a $1.1 million property and pay for the rest through a mortgage.
Gradually, there is a chance of the property value rising from market demand and economic changes. Investors can make a bigger profit and have the opportunity to invest in additional properties with the extra amount, specifically with the rising rates of commercial equity.
Interest Rate Swap
An interest rate swap could apply to leveraged investments. Essentially, interest rate swaps occur when two parties agree to a derivative contract that swaps streams of interest payments over a given period. Commercial property investors may access interest rate swap services as part of a bank lenders’ fixed-rate financing offerings.
As with any leverage method, an interest rate swap comes with risks and a set of necessary considerations that include:
- Availability – Borrowing investors may collaborate with multiple banks that underwrite credit for a swap through an unsecured arrangement. As such, banks may require collateral to authenticate the swapping process.
- Proper documentation – Borrowers require industry-standard documentation such as Schedule and ISDA to finalize a swap. Lenders turn to these documents as a means of polishing contractual language that avoids defaults on the swap and related financing.
- Prepayment Arrangements – Interest rate swaps may include prepayment clauses that apply to the early termination of an asset sale. The value of prepayment differs according to the holding period and payment rates.
A poorly performing (i.e., constantly vacant) property may lose investment money as quickly as a leveraged increment. In most scenarios, investors will have a better chance of borrowing more capital for stable commercial property, such as a multi-family rental or industrial building.
On the other hand, investors will likely face difficulty securing a loan for less popular property types (i.e., office spaces during the post-pandemic landscape).
While leverage can help unlock new opportunities in a commercial property strategy, investors should always consider the risks and measures involved, which include:
- Vacancy issues for rental properties. Overleveraging a vacant unit can quickly result in hitting a loan’s minimum DSCR ratio (i.e., the minimum sum to service an equity’s debt).
- Consult a proven expert in the preferred asset class or deal size. A robust commercial property strategy depends on understanding the trends and opportunities of the market.
- Apply conservative underwriting. First-time investors using leverage should focus on making reasonable market cap assumptions and forecasting exit rates by closely accounting for factors such as timelines and well-researched market volatility predictions.
Leverage is an effective catalyst in any high-performing commercial property strategy, enabling investors to expand their portfolios without spending more from their pockets. However, commercial property investors who decide to apply leverage should conduct thorough market research to assess the long-term profitability of a property before going ahead.