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.