Negative leverage has reared its ugly head in CRE investing, as interest rates have risen, and cap rates have remained compressed. One of the most important axioms of a successful real estate investment and development program is to acquire or build real estate with positive leverage. Positive leverage occurs when the cap rate is greater than the cost of debt, which means the return on equity will be greater than the cap rate. Negative leverage is just the opposite and defined as when the cap rate on a property acquisition is less than the cost of debt or debt constant and therefore, the cash-on-cash return is less than the cap rate. The debt constant is the annual debt service (principal and interest) payment divided by the amount of the debt. 

When negative leverage occurs, this means the cash-on-cash return or return on the investor's equity is less than the cap rate and this is a big "No-No" in CRE. This is happening with more frequency in this robust CRE market because interest rates have shot up with the 10-Year Treasury currently at 3.0% and up from 1.48% only a year ago. Apparently, this has caught many real estate investors, even some of the largest and most astute private equity firms in the business, by surprise, as the property they signed a contract to purchase at a 3.5% or 4.0% cap rate only a few months ago, has to be financed with debt that now cost 4.5% to 5.0% or more.

Let's say an apartment property is purchased for $50 million, with a net operating income of $2 million or a cap rate of 4.0%. If the property is financed with a permanent loan at 70% or $35 million, with an interest rate of 4.50% interest only, the annual mortgage payment would be $1.575 million. The annual debt constant is therefore 4.5% ($1.575M/$35M), the same as the interest rate since there is no loan amortization. Since the cap rate of 4.0% is less than the debt constant of 4.5%, the cash-on-cash return falls to only 2.8% (NOI of $2.0M less the debt payment of $1.575M, equals the cash flow to equity of $425K, divided by the equity of $15M, equals a return of only 2.8%) and this is negative leverage.