Don’t Over-lever Your First Commercial Deal
The ability to leverage a commercial real estate investment is one of the most attractive things about the asset class. The premise: use less money, get just as much real estate. If the interest rate on on the loan is less than your predicted investment returns, then leveraging should make those returns increase.
That said, one critical mistake, especially for a first commercial real estate investment, is overextending yours equity with leverage.
There are a few ways that over-levering your deal could come back to harm you.
How having too much leverage can hurt
Fail to close the necessary high leverage loan
Many investors starting out do not yet have a large amount of equity capital to invest, meaning the deal may be small. If that’s the case, small commercial loans typically will be harder to procure at high leverage.
For the smallest multifamily assets, Fannie Mae and Freddie Mac, who guarantee many multifamily loans up to 80% LTV, typically won’t guarantee loans less than $1 Million. For those and other commercial assets in the sub $1 Million range, neither would CMBS or life companies be interested. For that reason, the available lenders at competitive rates will be limited to local and regional balance sheet lenders (banks and credit unions). These types of lenders typically don’t like very high leverage loans, especially for newer investor, so if you’re entering a contract to purchase an asset where you’ll need to stretch the LTV higher than 70–75%, you may come up empty trying to find a lender that can help you close the deal on time.
Keeping the leverage more conservative will ease the process of getting a strong bank or credit union loan.
Vacancy puts Debt Service Coverage in peril
One compelling reason to invest in multifamily or commercial real estate, instead of buying single-family homes, is the ability to preserve high occupancy with multiple units. When you have one unit (a home) and your tenant leaves, you suffer 100% vacancy until it can be leased again.
While it’s true that more units = less vacancy factor per unit, some starter investments may still not be large enough to weather a lot of vacant units (or a single tenant leaving in commercial). If you’re over-leveraged, your loan’s minimum DSCR ratio (which requires a certain amount of monthly income to safely cover debt payments) could come into play quickly.
Mistakes can put your loan “underwater”
You’ll likely make the most mistakes on your first deal. Make your mistakes in a safe scenario where you won’t lose a property to a bank. Whether due to unforeseen vacancy, or rent not hitting expectations as laid out in your financial pro forma, having more equity in the deal can act as a buffer from a loan default. Experience is very meaningful in real estate investing, so make your first deal as much about gaining experience as it is about realizing a return. A moderately successful deal that doesn’t default is worth a whole lot more than an optimistic deal that ends up going sideways.
The right leverage point?
Here are two quick tips to find the right leverage point for your deal:
- Use conservative underwriting, not best case. Leave your deal room to outperform.
- Find out what is “market” and why — talk to experts in the asset class, city, and deal size that you are pursuing. Find out what to expect as far as rental rates, cap rates, and financing terms. Structure your deal toward the middle or bottom of those expectations, so that no lender or capital partner will believe that your inexperience gives you rose-colored glasses.
Don’t be discouraged. If you’re ready, then get in the game. Just don’t over-leverage that first deal!
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