Using leverage to finance a commercial real estate property can offer several advantages to an investor compared to purchasing the property all cash. Some of these advantages are:
Increased Purchasing Power: Leverage allows an investor to purchase a larger commercial property than they could with all-cash. This can provide greater potential for cash flow and appreciation.
Diversification: Using leverage to finance a property can allow an investor to diversify their portfolio by investing in multiple properties with the same amount of capital.
Increased Return on Investment: If the property appreciates in value, the return on investment for the investor is amplified because they are only putting down a portion of the total cost of the property.
Tax Benefits: The interest payments on the loan are tax-deductible, which can provide significant tax benefits for the investor.
Preservation of Cash: Using leverage can allow an investor to preserve cash for other investments or to maintain a cash reserve for unexpected expenses or market downturns.
It is important to note, however, that using leverage to finance a commercial real estate property also comes with additional risks, such as the potential for higher interest rates, default risk, and potential for property value declines. Therefore, investors should carefully evaluate the risks and benefits before deciding whether to use leverage to finance their real estate investments.
Potential Risks of Using Leverage to Finance a Commercial Property:
Higher Interest Rates: Interest rates on commercial real estate loans can fluctuate and increase over time. If an investor has a variable interest rate loan, their monthly payments could increase significantly if rates rise. This can negatively impact the investor's cash flow and reduce their ability to make necessary repairs or improvements to the property.
Default Risk: If the investor is unable to make their monthly loan payments, the lender may foreclose on the property. This can result in the loss of the property and the equity invested in it.
Property Value Declines: Real estate values can fluctuate based on market conditions, economic factors, and changes in the local area. If the value of the property declines, the investor may owe more on the loan than the property is worth. This can result in a negative equity position and make it difficult to sell or refinance the property.
Limited Liquidity: If an investor has a high level of leverage on a property, it can be difficult to sell the property quickly if necessary. Potential buyers may be hesitant to purchase a property with a high loan-to-value ratio, which can limit the investor's ability to sell the property and realize their profits.
Increased Risk During Market Downturns: During economic downturns or recessions, property values can decline, and vacancy rates can increase. If the investor is heavily leveraged, they may be at a higher risk of defaulting on their loan if their cash flow is negatively impacted by the economic conditions.
If you have any questions about this article or would like to discuss a scenario of your own with our team, please feel free to contact Colin Dubel at colin@harborwestcommercial.com or 949-735-6415.
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