Heresy - according to a dictionary I found on-line, is a word that means
Any belief or theory that is strongly at variance with established beliefs, customs, etc.
I think it has become heresy to advocate a lot of leverage - at least for “conservative investors” in investment funds. But I am going to do exactly that, at least in part.
Hopefully you will at least hear me out before you stop reading. By the way, many years ago, I was a math major although I admit I can’t remember anything about it.
This article has two parts. First, there is the kind-of obvious part of my analysis, for which I suspect most people will agree with me. And second there is the more subtle thinking, which I suspect is more thought-provoking and subject to more disagreement.
First - the obvious thought process:
Let’s say you bought a property about three years ago for $50,000,000 and it is now worth $75,000,000.
Let’s say that when you bought it you took out “conservative” 60% leverage of $30,000,000. This means you wrote a check for $20,000,000.
Let’s say the property is in a stable type of asset - e.g. multifamily - where the cash flow is unlikely to be lumpy over a long period of time.
Let’s say that you intend to hold the property for a total of roughly 5 to 7 years and you are hoping for future additional appreciation.
Let’s say that there is long-term debt (e.g. 10 years or even 30 years) available at historically low fixed interest rates - and in some instances 85% (and maybe even 90%) leverage is also available.
Let’s say you are a conservative investor type who generally believes leverage over 60% is “too much”.
In this instance, I think the conclusion that leverage should be limited to 60% should be challenged. Please consider the risk/reward of taking the following action:
Right now, leverage up the investment to 85%.
This returns to you $63,750,000 (less the $30,000,000 you borrowed) = $33,750,000.
You invested $20,000,000 at the beginning so you now have all your capital back plus $13,750,000.
You now still own the asset - albeit with high leverage on it - but at a low interest rate - and your debt doesn’t come due for a long time. My belief (explained below) is that, for an asset without lumpy cash flow, lower leverage with a shorter maturity is actually more risky than higher leverage with a longer maturity - so you have actually lowered your risk by the foregoing actions. But either way this is relatively moot since you just took out all the money you invested anyway.
You might be concerned about prepayment penalties for long-term debt; however, if interest rates rise prepayment penalty risk is not really that big a concern - and if interest rates fall then you will probably obtain more upside from property appreciation than you will lose from a prepayment penalty. Also, you can - and should - mitigate the prepayment risk by negotiating assumability for the loan and the ability for the buyer to put on mezz debt or preferred equity (admittedly difficult to negotiate at times), so hopefully there will not be a need to prepay in the first place.
If all this can be done, then isn’t this too good to be true? Shouldn’t you in fact take the long-term cheap money and the highest leverage possible as long as this market anomaly (i.e. interest rates below long-term norms) exists?
Of course I made up these numbers, but even if the numbers are a lot worse, it would seem that if your asset is of the type that permits long-term leverage on these terms you might consider the above proposition and run the numbers. I already admitted (above) that I can’t do the math myself anymore; however, my former-math-major brain believes that this will enhance your IRR’s quite a bit in some situations.
Second - the more subtle thinking:
Now let’s continue to assume you are a “conservative” investor, i.e. someone who wants to be “conservative” in the use of leverage. Let’s play around with what this means.
Generally, this means that you don’t use a lot of leverage right? But why not? In the not-sorecent-any-more Global Financial Crisis, what happened? My general view is the following:
Those who were conservative in the years leading up to the Financial Crisis did worse than those who were aggressive. This is because those who were aggressive (obtaining, say, 90% leverage), by definition, made more upside as the market rose than those who were conservative (obtaining say 65% leverage).
Then when the Financial Crisis hit property values generally dropping - in the short run – anecdotally about 35% or even more. And even math-challenged people know what this means - it means, alas, that both the conservative guy and risk-prone gunslinger were wiped out. Sadly, in the end there was no reward given to those who were more conservative. Each ended up with nothing.
But look at my preceding paragraph - there are two words there that I deliberately didn’t emphasize but I think tell the real story. Those are the words “short run”! What happened after the “short run” ended? After the short run ended prices bounced back up and in only a few years for many asset classes prices had risen to the same, or even a higher level, than before the Financial Crisis.
What does this tell us? I will tell you what it tells me. It is that (for non-lumpy cash flow assets) there is a lot more “risk” in short-term debt than there is in high loan to value ratios. Those who had long-term debt in place before the Financial Crisis had only “paper losses” and if they waited a year or two or three were just fine. Those who had short term debt, and unforgiving lenders, faced disaster.
So if I am not crazy - which of course I myself cannot be sure about - it looks to me that investors looking to manage their risk in the context of leverage should be looking at maturity at least as much, and maybe more, than loan to value.
To conclude:
I am probably overstating my points here a bit to make a point, but my points are as follows:
If you own significantly appreciated property -- with non-lumpy cash flow - with high leverage available - that can be long-term in nature, then take out as much as you can, and negotiate to preserve your ability to (i) transfer the property subject to the debt and (ii) put mezzanine debt or preferred equity in place.
If you are buying new property, don’t limit yourself to a “rule" that you "always” have to limit leverage to, say, 65% of loan to cost; instead, for property that does not have lumpy cash flow, consider raising the percentage of leverage and lengthening the maturity and, again, negotiate to preserve your ability to (i) transfer the property subject to the debt and (ii) put mezzanine debt or preferred equity in place.
None of us has an actual crystal ball of course; however, my sense is that the above courses of action are destined to increase your likelihood of obtaining higher IRR’s in markets that go up and down with frequency.
Finally, if you think I am missing something in this analysis I would certainly like to hear about it.
Point of Interest From Adler & Stachenfeld:
We have started a very active “GP Capital” or “Sponsor Capital” practice going on at Adler & Stachenfeld right now. This is because there are more and more sponsors that need help putting up their share of the equity in larger-sized real estate projects and, at the same time, there are more and more funds and institutions focusing on this niche area.
If you are a provider of GP Capital or Sponsor Equity – or if you are in need of such equity for a deal – I suggest you give me a call and we can see about making the appropriate connections to our clients.