What the smart, savvy cre investors are doing in this slow market
In the current high-interest rate environment, the positive leverage spreads that many savvy commercial real estate investors are accustomed to securing can be like hunting for a diamond in the rough. The positive leverage spread, or the difference between the property’s capitalization rate and the financing rate, is crucial for generating positive cash-on-cash returns.
Positive leverage spread explained in an example: If the cap rate on a property is 7%, and the interest rate on the debt is 5%, the spread would be 200 basis points or bps (7% - 5%). A spread like this typically yields positive cash flow, assuming other factors like operating expenses are managed well.
The strategies we see successful long-term clients deploying most often include a combination of the following:
1. Increase Net Operating Income (NOI)
Rent escalations or rent increases: Pay close attention to rent escalators in the lease. Renegotiate or increase rent upon lease renewals, particularly in a rising demand market. This directly improves NOI and thereby, the cap rate.
Reduce expenses: Implement cost-cutting measures such as improving energy efficiency, optimizing property management, or improving occupancy rates.
Renovations and upgrades: Execute renovation strategies to allow higher rents to be warranted and/or attract higher quality credit tenants.
2. Study Demographics, Property Type and Location:
Pay close attention to the growth trajectories of population, employment drivers and household incomes which often extrapolate into higher demand and rent growth.
Core assets in primary markets often have lower spreads due to lower risk, while higher spreads are often found in secondary or tertiary markets or for value-add properties. Evaluate the risk/reward proposition. More risk-tolerant investors might accept a smaller spread if they believe in future value appreciation.
3. Refinance at Lower Interest Rates
Plan for exit options: Consider making flexible prepayment a focal criteria point for any loan request to allow the investor to refinance the debt at a lower interest rate to decrease financing costs, if/when market conditions allow.
As existing loan maturities continue to accelerate into 2025, make your plan now to execute swiftly when market conditions improve. By implementing these strategies, investors can improve their leverage spread, leading to better cash-on-cash returns and overall investment performance.
