Currently, I’m hearing a lot of talk in real estate investment circles about using lower leverage; leverage being the term we use for the percentage of debt to the purchase price of the property. In the current climate, people are preaching that to be conservative, you have to go low-leverage: around 60-65% or even lower! In many real estate asset classes like retail, industrial, or office, that would most certainly be the case. Multifamily, on the other hand, if done well is unique.
In multifamily real estate, you can still reduce risk at higher amounts of leverage, like 70 or even 80%. This is due to the fact that the borrower can lock in the interest rate for a significantly longer term. Banks will typically lock in the rate for 5 to 7 years; sometimes longer but they’ll often charge a premium on the rate to do so. Instead by using Fannie Mae, Freddie Mac, or FHA debt the savvy borrower can lock in loan terms of 10, 12, and 15 years; and with HUD (another name for FHA) even 35 and 40 year rate locks are possible! Some call this free money! So, a lot of big multifamily shops and people who’ve been in the business a long time are less concerned with the percentage of leverage when they can push out the maturity and rate lock. At this point it becomes more about debt coverage than leverage. Debt coverage is simply net operating income divided by debt service. An easy example is 1.2 million of NOI and 1 million of debt service is a coverage ratio of 1.2. Of course, we look for deals above 1.5 debt coverage.
That’s why, even in this late stage of the growth cycle we’re okay taking on higher leverage. The result is simple: BAM can buy newer, nicer assets which are fetching a higher sales price because we’re leveraging it and using appropriate debt. The result is that the return to the investor stays strong.
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