One problem with leverage

Right now, with interest rates at historic lows, buyers are being tempted to use a lot of leverage when they buy apartment buildings. As we’ve discussed before, leverage magnifies outcomes, both good and bad.

Today, I want to look at how one downside of leverage can manifest itself on larger apartment buildings. But you need to understand a few things about how 5+ unit properties are financed before we can delve in:

  • Banks generally  determine how much they’ll lend by looking at the value of the building and the amount of free cash flow it will throw off under different lending scenarios. (Read this and this for more info.)
  • The loans amortize over 30 years (in other words, if you don’t pay off the loan early by selling the building or re-financing and you make all your payments, you will have paid off the loan after 30 years)
  • Unlike on smaller 2-4 unit properties, the interest rate is usually only fixed for 3, 5, 7, or 10 years, not the full length of the loan
  • After the fixed period is over, the interest rate adjusts based on prevailing rates at that point in time. So, if the prevailing rates are higher than your fixed rate was, your loan payment adjusts upwards (usually within some defined parameters – there is often a ceiling and a floor on the rate)

Can you see how the above conditions can create a problem for the owner? To understand it, you need to understand how higher interest rates and lower rents change building values:

  • With rents down (say, because the economy is in recession), the value of the building decreases, because buildings are valued on a multiple of their rent rolls
  • Higher interest rates also reduce building values, since, if you can earn higher rates by keeping your money in the bank, there’s less temptation to go out and buy a building to get yield.

OK, now imagine you’re trying to re-finance a loan on a building you bought three years ago with a 75% LTV mortgage. Your building’s value has decreased, meaning you probably don’t have the 25% equity the bank would need for the building to pass the LTV test. Your cashflow is reduced because rents are down AND rates are up; reduced cashflow makes it harder to pass the debt service coverage ratio test.

Bottom line: It’s going to be hard to re-finance, so you’re going to be stuck either selling the building at a loss or else paying the higher, adjustable rate from your initial loan for a while.

Fortunately, the government usually helps you out of this bind by lowering interest rates when the economy gets bad, making those adjustable rate payments go down and therefore making it easier to for your building to service the existing debt. That’s why there were very, very few foreclosures of larger apartment buildings during this last bust.

But the above scenario is why I usually push my clients not to borrow the absolute maximum they can get, even if it notionally produces the highest returns. Better to accept a slightly lower return up-front but have a margin of safety in the event the world goes to hell.