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Negative Leverage


What is Negative Leverage?

Understanding Negative Leverage in the Current CRE Market


In commercial real estate (CRE), negative leverage occurs when a deal’s debt constant exceeds its unlevered rate of return. This concept has become increasingly relevant in today’s market, especially after the Federal Reserve raised interest rates 11 times in an attempt to control inflation, which was exacerbated by supply chain disruptions following the COVID-19 pandemic.


The Federal Reserve’s Rate Hike Cycle and Its Impact on Debt


The Fed’s interest rate hikes began in March 2022, when they increased the rate from 0% to 0.25-0.5%. By July 2023, the Fed Funds rate had risen to a range of 5.25-5.50%. The Fed Funds rate is crucial because it serves as the benchmark for floating rate loans and influences long-term rates across financial markets. This rate dictates borrowing costs, thereby impacting asset demand and capital flows in the global economy. When the Fed raises rates, borrowing becomes more expensive, which, in turn, affects the demand for assets traditionally financed with debt, such as real estate.


The Role of Debt and Equity in Real Estate Investing


In commercial real estate, investors often use debt (leverage) to enhance returns that they wouldn’t be able to achieve with equity alone. To understand how this works, it’s important to first grasp some basic financing principles. Real estate investments are often seen as an alternative to traditional vehicles like stocks, bonds, and cash. Investors looking to diversify their portfolios into real estate evaluate potential returns by assessing the financial performance of an asset and its submarket. They forecast future cash flows and use these projections to determine a target return that meets their investment goals. Capital in real estate deals typically comes from two sources: debt and equity. Debt is generally cheaper than equity because it carries less risk. Lenders, who are the providers of debt, are paid back first if a deal faces challenges, making their position less risky. Equity investors, on the other hand, bear a higher risk, including the possibility of total loss. For this reason, they expect a higher return on their investment.


Valuation and the Role of Cap Rates


To determine the value of a commercial real estate asset, investors look at its net operating income (NOI) — the income remaining after operating expenses have been paid. The NOI is divided by a capitalization rate (cap rate) to calculate the asset's value. The capitalization rate can be viewed as an inverse of the P/E ratio, or multiple on earnings.

Cap rates reflect the return an investor would expect from an all-cash purchase, without the influence of leverage. A higher cap rate generally signals a riskier investment, while a lower cap rate indicates a less risky investment. When investors add debt to the deal, they aim to generate a return that exceeds the cap rate and to measure this, they compare the debt constant (the interest rate adjusted for amortization) with the unlevered return (the cap rate).



The Impact of Rising Interest Rates on Property Values


The Federal Reserve's series of rate hikes has significantly impacted commercial real estate valuations by increasing the cost of debt. When debt becomes more expensive, the amount of leverage lenders are willing to provide decreases. Lenders typically require a debt service coverage ratio (DSCR) of 1.25x over the asset’s NOI. As interest rates rise, lenders reduce the loan amounts to ensure this cushion, which in turn lowers the loan-to-value ratio for the asset. This poses a significant problem in the current market: as leverage shrinks and asking prices remain relatively unchanged, equity must step in to fill the gap. Since equity investors demand higher returns than debt providers, this makes sellers’ old pricing expectations (when rates were much lower) more difficult for buyers to meet their required return thresholds.


The Disconnect Between Buyers and Sellers


Sellers, who have held onto asset values that were determined before the interest rate hikes, are now facing a market where buyers can’t justify these prices given the higher cost of debt. In many cases, debt constants are now higher than cap rates, resulting in negative leverage for most transactions. Buyers are unable to meet their return expectations because they cannot leverage debt in a way that makes sense under the current interest rate environment. As a result, there is a disconnect between sellers, who are reluctant to adjust their asking prices, and buyers, who are constrained by higher borrowing costs. While the gap between seller expectations and buyer offers has narrowed, it is clear that more adjustment is needed for transactions to occur on a broader scale.


What Needs to Happen for the Market to Move Forward?


For the CRE market to regain momentum, one of the following would need to ocurr:


  1. Price Reductions: Sellers may need to accept lower prices to align with buyers' expectations, making transactions viable once again.
  2. Interest Rate Reductions: If interest rates were to decrease, buyers could more easily meet their equity return expectations without requiring further price reductions.
  3. Increased Net Operating Income: A rise in NOI could help offset higher borrowing costs, potentially restoring positive leverage.


However, given the current economic cycle, options two and three appear unlikely to materialize soon. As a result, the most probable scenario is that prices will need to come down to facilitate transactions.


Looking Ahead: The Potential for Price Adjustments


As debt maturities increase, it is likely that more sellers will be forced to accept lower prices to avoid defaulting on their loans. These price reductions could help bring the market back into balance, enabling transactions to resume. The key challenge will be bridging the gap between seller expectations and buyer realities in an environment where higher interest rates and reduced leverage have fundamentally altered the dynamics of commercial real estate investing.

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Why Residential?

By Christian O'Neal • February 13, 2025
The fundamental need for housing is universal—everyone requires a roof over their head. In the United States, however, we are facing a significant shortage of housing. According to the National Multifamily Housing Council, an additional 4.3 million units will be needed by 2035 to meet growing demand. Much of this demand is driven by migration to expanding lower cost cities and away from high tax, high cost metros, a trend accelerated by the widespread adoption of remote work during the pandemic. This trend has reshaped the housing landscape, creating a compelling opportunity for investors. While there are numerous investment strategies available, each with its own set of risks, residential real estate stands out. Over the past three decades, multifamily rentals have consistently delivered the highest risk-adjusted returns in commercial real estate. Why? Because housing is an essential need, regardless of economic conditions. At AEG, we are strategically developing both for-sale and rental housing, allowing us to adapt our approach to changing market dynamics and maximize returns while mitigating risk. Here’s why we are confident in the strength of residential housing as an investment: Land is Finite: Unlike many other asset classes, land cannot be created or expanded. The supply is fixed, and the demand for housing continues to grow. In the foreseeable future, virtual spaces like the metaverse will not replace the fundamental human need for physical shelter. Residential Housing is Non-Discretionary, and It's Supported by Government Liquidity: Housing is the only non-discretionary asset class. If it weren’t, we would see similar government support for other sectors like retail, office, or industrial real estate, but we don't. The federal government provides liquidity to the multifamily housing market because it is a fundamental need. This support drives down the weighted average cost of capital (WACC), making housing assets attractive to investors. This consistent access to capital compresses cap rates, creating a floor on the market (to an extent), fueling long-term growth and demand from investors big and small. Rents Tract with Inflation, and It is Rare to See Negative National Rent Growth: Rents reset every year as cost increases are passed off to tenants via annual lease contract resets. Since the beginning of recorded history, national rents have only gone negative year over year three times: the Spanish flu of 1918, the Great Financial Crisis, and during the Covid-19 pandemic. While yearly gains in rental cashflow streams will not make you wealthy, they are without a doubt very stable cashflows, historically speaking. There is no similar liquidity for for-sale housing, but its non-discretionary nature still gives it a strong investment profile. In growth markets like South Carolina's tertiary cities, the influx of new residents is fueling demand across all price points, further strengthening the residential sector. We believe in our residential investment thesis for both macro and local fundamental reasons. If interest rates remain high, new construction will slow even further. Meanwhile, homes in desirable locations will remain in high demand as many homeowners—especially those with low-rate mortgages—are unlikely to sell. According to the latest third-quarter data from the FHFA, 73.3% of U.S. mortgage borrowers now have an interest rate below 5.0%, a decline of 12.2 percentage points since Q1 2022. This significant shift in mortgage rates creates a unique dynamic: many homeowners are effectively "locked in" to their current homes, preventing them from moving and creating a looser supply in the for-sale market. As a result, home prices are expected to remain elevated in high-demand areas. While values may remain relatively flat in real terms over the next few years, on a nominal basis, they are expected to rise, particularly in growing markets. If interest rates decrease or economic growth drives up rental demand, build-for-rent communities could become more viable. However, they are not yet penciling out as attractive investments because growth has stalled - but, that is about to reverse. Thanks to our strategy and access to land—often without burdening our balance sheet or stretching our resources—we are able to remain nimble and pivot towards the most attractive risk-adjusted yields. As we navigate an uncertain economic environment, several factors support the ongoing strength of the residential housing market: slow housing starts, higher interest rates, and a large percentage of homeowners sitting on mortgages with sub-4% rates. These dynamics, along with strong demand in high-growth areas, reinforce our belief that residential real estate will remain a compelling investment in the years to come. At AEG, our focus is on developing attainable, high-quality housing, from custom spec homes, to mini-farm tracts, to higher density townhome projects. This flexibility allows us to serve a wide range of income levels and tailor our strategy to market conditions. With a commitment to quality finishes and high end products, we appeal to buyers regardless of economic conditions, providing us with a tighter, more predictable cash conversion and days on market cycle, unlike some of our competitors. By seeking out individually parceled deals, we reduce overall risk and remain agile in our decision-making.
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