Leverage is neither ‘good’ nor ‘bad’ for investors, and should not be described in moral terms, writes Ben Habib
The injudicious use of debt from 2004-07 was central to the causes of the credit crunch. Borrowers in developed western economies had used leverage very effectively for the previous 30-40 years (give or take a few setbacks) to boost returns from virtually all asset classes. But its use, particularly in the run up to the peak of the boom in 2007, in many cases went horribly wrong.
As a result, the use of debt is now often shunned by investors. It has almost taken on an immoral dimension. This attitude is not only wrong, it is very likely to prevent investors from achieving high returns in what is the lowest interest-rate period since the Bank of England was formed.
The use of debt is neither good nor bad. It is merely a financial instrument. If used well it should boost rates of return. Negligent use can lead to disastrous consequences. The way debt was used in commercial property investment in the 2004-07 period was flawed, mainly because the yield available on property investments then – when the value of properties was high – was not sufficient to service the debt. Investors justified the use of debt at that time on the assumption that capital values would go on rising but little heed was given to the actual income available on an investment to pay interest bills and repay the loan itself. The industry became focused on internal rates of return (IRR), a significant component of which requires an assumption on the exit value of a property investment and hence capital gain. The running rate of return – or return on equity (RoE) – available from income earned on a property became a secondary consideration to IRR forecasts, even though it is RoE that services debt.
The correct quantum of debt to apply to a given property depends primarily on the amount of sustainable income the property generates and the longevity of this income. Properties must yield enough income to comfortably pay interest on debt secured against them, other operational costs (including taxes) and a respectable amount of annual debt repayments. During the life of a loan, the property must be able to generate enough income to reduce the amount of the loan to a level where it should be capable of being refinanced and would not force a sale of the property (a potential cause of stress) – whether or not the original intention is to sell the property at that time.
It is not sensible to adopt a fixed loan-to-value (LTV) policy when investing. The key is to determine the correct LTV for a given property dependent on the income profile of that property. Often, because of the higher yields available, good secondary properties are better subjects for leverage than prime property. I have heard of prime property, leveraged at 30% LTV, becoming stressed. Yet, at First Property Group, we have direct experience of applying higher levels of debt to higher-yielding secondary properties that have continued to perform well through the credit crunch. Prime properties are typically low-yielding and do not generate sufficient income to sustain and repay significant loans.
For a long-term investor, capital value movements in the property being leveraged, prior to its sale, are only relevant to the extent that these might cause an LTV loan covenant breach. The apparent accentuated movements in capital value, as a percentage of invested equity, created by the use of leverage make no difference to the actual amount by which the value of an investment rises or falls. In purely commercial terms, as long as an LTV covenant cannot be used against a borrower, it makes more sense to risk the debt provider’s capital than your own. If only suitable assets are leveraged (that is, assets with adequate, sustainable income streams), the higher income streams should dampen the effects of capital-value movements. Furthermore, as debt is paid down, the apparent volatility should, in any event, reduce.
LTV loan covenants have to be managed carefully. But this is possible. Ideally one should try to avoid entering into such a covenant. If a covenant must be entered into, the borrower should achieve some, or all, of the following:
• An LTV covenant set at a level above the actual initial LTV;
• A loan amortisation rate that affords the borrower protection from the covenant (the need for income is self evident);
• Agreeing less punitive consequences for a breach. A cash-trap is far more preferable to an acceleration of the loan. And if the income level is suitably high, the cash-trap should rectify the LTV breach within a reasonable period.
Property is illiquid. Therefore, loans should be for as long as possible. This enables the borrower to pick the moment to sell the property while also allowing enough time and accrual of income to reduce the actual amount of loan outstanding. Short-term funding of illiquid assets is a notorious recipe for disaster. Generally, one should seek the longest loan periods available, even if the business plan for a property assumes an earlier sale. The longer loan period provides protection.
Interest rates need to be hedged, at least for the earlier years of an investment (before income has had an opportunity to reduce the amount of loan outstanding) to ensure that the cash-flow projections made at the time of purchase can be more accurately determined. Interest rate caps are generally a better way to hedge interest rates than fixing rates of interest, because their cost is certain and, unlike fixed rates, they do not introduce rigidity into the investment structure. However, with long-term interest rates lower than I have ever known them, at close to zero, the partial use of fixed rates, perhaps in conjunction with interest rate caps, does make sense.
The impending imposition of Solvency II on capital requirements appears to be pushing institutions away from leverage, primarily as a result of the proposed extra capital reserves required to be made against investments, determined on a gross basis, including leverage. Perhaps, paradoxically, institutions should be reacting the other way. If, pursuant to Solvency II, a capital reserve has to be made, it is better to use leverage with the investment because it would maintain total returns and the institution would, in any event, have an in-built cushion of capital.
The use of an appropriate amount of leverage, in association with suitably high-yielding investments, affords a purchaser the ability to fund the purchase of a property with that property’s own cash flow. It is a tremendous way to acquire property.
Interest rates are historically low and property prices are also generally low. This is, therefore, a good time to consider using leverage to boost rates of return earned from sustainable income streams. If the loose monetary policy of Western central banks does result in demand-led inflation, the use of long-term leverage, with appropriately structured LTV covenants and hedged interest rates, to acquire income-producing hard assets would prove to have been a superb investment strategy.
Leverage is, in itself, neither ‘good’ nor ‘bad’, and should not be described in moral terms. Used poorly it can cause problems. Used well it can be a financial tool to boost rates of return and acquire properties. The key is to pick the target assets carefully, treat the leverage with respect and structure it carefully.