In commercial real estate financing, leverage is the result of using borrowed money to fund your investment and generate higher returns on that investment. Leverage is essentially an investment strategy through the use of borrowed money. Commercial real estate investors use leverage to increase their ability to purchase property.
A leverage ratio, therefore, is a way to calculate how that leverage is working for your business.
What Are Leverage Ratios?
A leverage ratio is a financial ratio of any kind that shows a person or business’s debt against their balance sheet, income or cash flow. Leverage ratios indicate how much a company’s assets and expenses are financed using debt or equity, and these ratios can determine how much a bank is willing to lend.
Lenders use a leverage ratio to limit the amount of proceeds of a loan based on definable and or projected assumptions. Lenders typically apply a sizing ratio to both cost and value to determine the size of a loan because cost and value are not always the same.
For instance, in situations where a person is buying something off-market, the purchase price (or cost) could be higher or lower than the actual market value, which would be more accurately determined by a wide marketing process. So lenders need to look at both the cost and value of a property.
List of Leverage Ratio Formulae You Need to Know
There are a few different types of leverage ratios that all calculate different aspects of a person’s finances. Depending on who is conducting the analysis (lenders, borrowers, investors, etc.) and what information you need, one type of ratio might apply more than another.
- Debt-to-assets ratio = total debt / total assets
- Debt-to-equity ratio = total debt / total equity
- Debt-to-capital ratio = total debt / (total debt + total equity)
- Asset-to-equity ratio = total assets / total equity
- Cost-to-value ratio = total cost / total value
- Capital ratio = current assets / current liabilities
- Equity ratio = shareholders’ equity / total assets
- Debt ratio = total debts / total assets
What Are the Types of Leverage Ratios?
When making various leverage calculations, there are two different types of leverage that come into play.
Operating leverage ratio determines the ratio of fixed costs to variable costs. The operating leverage measures how much a company can increase income by when there is an increase in revenue. If the business generates a high gross margin (net sales revenue minus cost of goods sold) with low costs, that business has a high operating leverage.
The financial leverage ratio determines the amount of debt a company has used or will use to finance its business. There are pros and cons to using borrowed money to finance commercial real estate investments.
On the one hand, taking out a loan allows for a greater investment, which can increase the return on investment and raise the business’s equity and profit. However, if the financial leverage is too high — usually determined with the debt-to-equity ratio — this structure puts a business at risk of bankruptcy. It’s best to talk to a financial advisor to determine what level of financial leverage is best for your business venture. Investment advisors will take into account your cash flow, equity and assets using multiple ratios, as they all have their limitations.
3 Examples of Leverage Ratios in Action
There are a number of situations in which lenders and buyers utilize ratio formulas in commercial real estate deals.
1. Cost Differs From Value
If a buyer is purchasing a property off market — perhaps the cost is different from the actual value — lenders will look at that ratio to determine how big of a loan to issue.
A lender might agree to give you x percent of all of the costs, so long as they do not exceed a certain ratio compared to the value.
2. Value Is Projected to Increase Over Time
In other scenarios, a property’s value could have a projected increase over time, therefore changing the loan-to-value leverage ratio over time. For example, when a property manager is creating a value add plan, an investor might buy a property, make improvements and then, at the end of the improvements, the property value is higher. In this scenario, loan-to-value ratio goes down because the value increases and the amount of the loan stays the same.
If the loan amount stays the same and the value goes up, the leverage ratio goes down, but if the loan amount increases as you execute a business plan — for instance, during construction there’s an initial funding, and then every month there are additional loan fundings — the leverage ratio changes during the life of the loan.
Lenders will also look at loan-to-cost and debt-to-assets ratio, keeping in mind projected value as well. Looking at these ratios helps lenders determine the amount of risk involved in giving out a loan.
Leverage ratios also come into play when refinancing a loan. In the event of a refinance, usually, a person has owned a property for some length of time. Sometimes that means the value of the property has increased. If you’ve owned a property for 20 years, for instance, then most likely, due to inflation and/or general market value increases, your property is worth much more than it was at the time of purchase. In this case the cost is no longer relevant as the current market value.
In the event of a refinance 20 years down the line then, the lender is going to look at value and not cost. When cost is no longer taken into account, your equity, asset value matters more than your original historical cost. These leverage ratios all play a role when a lender is determining the terms of your refinance.
What Are the Risks of High Leverage Ratios?
There’s a good amount of risk involved in having high operating and financial leverage ratios.
High operating leverage is an indication that a business is generating little profit but has high costs. For instance, maybe you own a residential building, and maintenance costs are high, but you’re unable to fill all the units in your building. This result is lower income for you and insufficient profit to cover those costs.
A high financial leverage occurs when your investment cash flow isn’t enough to cover your loan interest. This scenario could ultimately lead to financial collapse, unless you’re able to generate more profit somehow.
The higher the leverage ratio, the higher the risk for both the lender and the borrower because if the lender has to take the property over, they have less downward margin from what the value of the property is to what they have to sell it for to recoup their principal loan balance. When you have a lower leverage ratio and that margin is higher, you have a lot more cushion to absorb a market decrease in value.
Leverage Ratios Are One Way Lenders Determine Loan Amount
Leverage ratios come into play most when you’re seeking out a loan for your property or investment. Banks will look at leverage ratios when determining whether to lend. Typically, for a lender, the lower the leverage ratio, the better.
However, it’s important to understand that leverage ratios are just one metric that lenders use to size a loan.
Leverage Ratio: FAQs
Is Leverage an Effective Business Tool or Not Worth the Risk?
Leverage in and of itself is viewed positively in commercial real estate, as it allows you to increase your returns on your equity investment, and it allows you to spread your equity out across more properties. Without leverage, most commercial real estate ventures would be difficult.
However, too high of a leverage ratio could put your investments at risk. For this reason, it’s always a good idea to talk to a financial advisor in order to assess how much debt you can feasibly take on to keep your leverage ratios manageable.