How High Leverage Makes Real Estate More Vulnerable
With contributions by Charles Bowyer.
Given the recent crisis in financial markets, investors should be asking themselves how well their portfolios are able to withstand market shocks. We want to take a look at real estate, to illustrate the potential problems with over-leveraging in times of market turmoil.
The image above depicts the hypothetical impact of a decreasing loan to value ratio, and demonstrates why leverage matters. Let’s say you borrow $55,000 to buy a building for $100,000. That gives you an initial loan-to-value ratio of 55%. And let’s say the contract you signed to borrow that money and buy that building stipulates you can’t exceed a loan-to-value ratio of 60%.
That’s all fine and good, right? You’re below the 60% threshold. Until the market shifts and the value of this building drops to $85,000, which puts your loan-to-value ratio closer to 65%, in breach of the 60% requirement.
In order to not break the covenant, you may have to sell the building. Because you’re over-leveraged, you might then end up taking a net loss on the building to avoid defaulting – you would be selling that building into a down market, the time when one should be hypothetically buying.
Let’s take a closer look at how different loan-to-value standards perform in varying degrees of a market sell-off.
Each set of 3 bars describes a hypothetical scenario of market declines from 5% to 30%. The dark horizontal bar represents the standard upper limit of 60% on leverage ratios.
Under normal circumstances, public real estate companies will generally have low enough leverage that the risk of default is relatively small. But most of these real estate companies have unsecured debt with a contract stipulating that leverage won’t exceed 60%.
That might become a problem when we enter a crisis, particularly one that hits real estate hard – like the one we’re in now.
As you can see in the chart above, the higher the loan-to-value ratio, the less of a market drop is required to put you into a potentially adverse situation. Having disproportionately high leverage might make you less resilient and more susceptible to market shocks, especially once we get into correction (a drop of 10% or greater) territory.
In order to avoid breaching covenants, a real estate company may be forced to sell their assets into a down market, which may mean losing money: If you buy a building at a certain value, and the value of that building then declines by 15% – forcing you to sell it lest you breach the covenant – you would theoretically be losing money.
Investors should ask if the real estate funds they’re invested in are disproportionately over-leveraged, and by extent may be at a higher risk from large market declines.
Originally published on Townhall Finance.
Jerry Bowyer is a Forbes contributor, contributing editor of AffluentInvestor.com, and Senior Fellow in Business Economics at The Center for Cultural Leadership.
Jerry has compiled an impressive record as a leading thinker in finance and economics. He worked as an auditor and a tax consultant with Arthur Anderson, as Vice President of the Beechwood Company which is the family office associated with Federated Investors, and has consulted in various privatization efforts for Allegheny County, Pennsylvania. He founded the influential economic think tank, the Allegheny Institute, and has lectured extensively at universities, businesses and civic groups.
Jerry has been a member of three investment committees, among which is Benchmark Financial, Pittsburgh’s largest financial services firm. Jerry had been a regular commentator on Fox Business News and Fox News. He was formerly a CNBC Contributor, has guest-hosted “The Kudlow Report”, and has written for CNBC.com, National Review Online, and The Wall Street Journal, as well as many other publications. He is the author of The Bush Boom and more recently The Free Market Capitalist’s Survival Guide, published by HarperCollins. Jerry is the President of Bowyer Research.
Jerry consulted extensively with the Bush White House on matters pertaining to the recent economic crisis. He has been quoted in the New York Times, The Wall Street Journal, Forbes Magazine, The International Herald Tribune and various local newspapers. He has been a contributing editor of National Review Online, The New York Sun and Townhall Magazine. Jerry has hosted daily radio and TV programs and was one of the founding members of WQED’s On-Q Friday Roundtable. He has guest-hosted the Bill Bennett radio program as well as radio programs in Chicago, Dallas and Los Angeles.
Jerry is the former host of WorldView, a nationally syndicated Sunday-morning political talk show created on the model of Meet The Press. On WorldView, Jerry interviewed distinguished guests including the Vice President, Treasury Secretary, HUD Secretary, former Secretary of Sate Condoleezza Rice, former Presidential Advisor Carl Rove, former Attorney General Edwin Meese and publisher Steve Forbes.
Jerry has taught social ethics at Ottawa Theological Hall, public policy at Saint Vincent’s College, and guest lectured at Carnegie Mellon’s graduate Heinz School of Public Policy. In 1997 Jerry gave the commencement address at his alma mater, Robert Morris University. He was the youngest speaker in the history of the school, and the school received more requests for transcripts of Jerry’s speech than at any other time in its 120-year history.
Jerry lives in Pennsylvania with his wife, Susan, and the youngest three of their seven children.