Negative Leverage

What is Negative Leverage?

Understanding Negative Leverage in the Current CRE Market

In commercial real estate (CRE), negative leverage occurs when a deal’s debt constant exceeds its unlevered rate of return. This concept has become increasingly relevant in today’s market, especially after the Federal Reserve raised interest rates 11 times in an attempt to control inflation, which was exacerbated by supply chain disruptions following the COVID-19 pandemic.

The Federal Reserve’s Rate Hike Cycle and Its Impact on Debt

The Fed’s interest rate hikes began in March 2022, when they increased the rate from 0% to 0.25-0.5%. By July 2023, the Fed Funds rate had risen to a range of 5.25-5.50%. The Fed Funds rate is crucial because it serves as the benchmark for floating rate loans and influences long-term rates across financial markets. This rate dictates borrowing costs, thereby impacting asset demand and capital flows in the global economy. When the Fed raises rates, borrowing becomes more expensive, which, in turn, affects the demand for assets traditionally financed with debt, such as real estate.

The Role of Debt and Equity in Real Estate Investing

In commercial real estate, investors often use debt (leverage) to enhance returns that they wouldn’t be able to achieve with equity alone. To understand how this works, it’s important to first grasp some basic financing principles. Real estate investments are often seen as an alternative to traditional vehicles like stocks, bonds, and cash. Investors looking to diversify their portfolios into real estate evaluate potential returns by assessing the financial performance of an asset and its submarket. They forecast future cash flows and use these projections to determine a target return that meets their investment goals. Capital in real estate deals typically comes from two sources: debt and equity. Debt is generally cheaper than equity because it carries less risk. Lenders, who are the providers of debt, are paid back first if a deal faces challenges, making their position less risky. Equity investors, on the other hand, bear a higher risk, including the possibility of total loss. For this reason, they expect a higher return on their investment.

Valuation and the Role of Cap Rates

To determine the value of a commercial real estate asset, investors look at its net operating income (NOI) — the income remaining after operating expenses have been paid. The NOI is divided by a capitalization rate (cap rate) to calculate the asset's value. The capitalization rate can be viewed as an inverse of the P/E ratio, or multiple on earnings.

Cap rates reflect the return an investor would expect from an all-cash purchase, without the influence of leverage. A higher cap rate generally signals a riskier investment, while a lower cap rate indicates a less risky investment. When investors add debt to the deal, they aim to generate a return that exceeds the cap rate and to measure this, they compare the debt constant (the interest rate adjusted for amortization) with the unlevered return (the cap rate).

The Impact of Rising Interest Rates on Property Values

The Federal Reserve's series of rate hikes has significantly impacted commercial real estate valuations by increasing the cost of debt. When debt becomes more expensive, the amount of leverage lenders are willing to provide decreases. Lenders typically require a debt service coverage ratio (DSCR) of 1.25x over the asset’s NOI. As interest rates rise, lenders reduce the loan amounts to ensure this cushion, which in turn lowers the loan-to-value ratio for the asset. This poses a significant problem in the current market: as leverage shrinks and asking prices remain relatively unchanged, equity must step in to fill the gap. Since equity investors demand higher returns than debt providers, this makes sellers’ old pricing expectations (when rates were much lower) more difficult for buyers to meet their required return thresholds.

The Disconnect Between Buyers and Sellers

Sellers, who have held onto asset values that were determined before the interest rate hikes, are now facing a market where buyers can’t justify these prices given the higher cost of debt. In many cases, debt constants are now higher than cap rates, resulting in negative leverage for most transactions. Buyers are unable to meet their return expectations because they cannot leverage debt in a way that makes sense under the current interest rate environment. As a result, there is a disconnect between sellers, who are reluctant to adjust their asking prices, and buyers, who are constrained by higher borrowing costs. While the gap between seller expectations and buyer offers has narrowed, it is clear that more adjustment is needed for transactions to occur on a broader scale.

What Needs to Happen for the Market to Move Forward?

For the CRE market to regain momentum, one of the following would need to ocurr:

Price Reductions: Sellers may need to accept lower prices to align with buyers' expectations, making transactions viable once again.
Interest Rate Reductions: If interest rates were to decrease, buyers could more easily meet their equity return expectations without requiring further price reductions.
Increased Net Operating Income: A rise in NOI could help offset higher borrowing costs, potentially restoring positive leverage.

However, given the current economic cycle, options two and three appear unlikely to materialize soon. As a result, the most probable scenario is that prices will need to come down to facilitate transactions.

Looking Ahead: The Potential for Price Adjustments

As debt maturities increase, it is likely that more sellers will be forced to accept lower prices to avoid defaulting on their loans. These price reductions could help bring the market back into balance, enabling transactions to resume. The key challenge will be bridging the gap between seller expectations and buyer realities in an environment where higher interest rates and reduced leverage have fundamentally altered the dynamics of commercial real estate investing.

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Building to Hold vs Building to Sell

By Christian O'Neal • July 31, 2025

Why Building and Holding Real Estate for the Long- Term Delivers Superior, Tax-Efficient Yield

Rent Control - Does it Work?

By Christian O'Neal • July 31, 2025

Rent Control: A Well-Intentioned Policy That Misses the Mark In the debate over affordable housing, few policies stir as much emotion—or controversy—as rent control. Advocates see it as a way to shield tenants from rising rents. Critics argue it does more harm than good. When you examine the economic evidence and real- world outcomes, the conclusion becomes clear: rent control is a deeply flawed solution to a real problem. What Is Rent Control? Rent control is a policy that limits how much landlords can increase rent, either through caps tied to inflation or fixed annual percentages. On paper, it sounds compassionate: protect renters from displacement and make cities more affordable. But in practice, rent control reduces the supply of available housing, discourages new development, and often hurts the very people it's meant to help. Why Rent Control Backfires 1. It Discourages New Construction Developers are less likely to build in markets where future rent growth—and thus returns—are capped. Why take the risk of developing multifamily housing in a city where your upside is limited and your operating environment is politicized? 2. It Drives Property Owners Out of the Market Faced with strict rent regulations, landlords may convert rental units to condos or remove them from the market altogether. Fewer units mean more scarcity, which ultimately drives prices higher for everyone else. 3. It Distorts Housing Allocation Rent control encourages long-term tenants to stay in apartments they might otherwise outgrow or vacate. This locks up valuable housing stock and prevents more dynamic turnover, often freezing lower-cost units in place for higher-income tenants. 4. It Creates a Two-Tiered Market Markets with rent control often develop into two separate ecosystems: regulated apartments that are underpriced and hard to find, and unregulated units with inflated prices to compensate for suppressed supply. The California–New York Split: A Tale of Two Approaches Historically, California and New York have been peers in over-regulating rental housing. But recently, they’ve taken different paths: California's Recent Steps Forward:  Voters rejected rent control expansion (Prop 21 and earlier Prop 10)  Streamlined approvals and reduced CEQA abuse to promote new development New York's Recent Moves Backward:  Passed “Good Cause Eviction” law—effectively rent control in disguise  Political calls for rent freezes and demonization of landlords If you’re an open-minded apartment developer evaluating both markets today, California’s message is increasingly: We need you. New York’s? Not so much. To be fair, both are still difficult places to build housing, and cities like Los Angeles and Berkeley remain deeply anti-development. But California has shown progress by recognizing that you can’t claim to be pro-housing while simultaneously vilifying those who create and operate it. A Misalignment of Incentives A core problem with rent control is that it treats housing supply as fixed and ignores the private sector's role in expanding it. If developers and operators are stripped of potential upside—and burdened with unpredictable political risk—they simply stop building. Even well-intentioned pro-development plans (like NYC’s "City oare undermined when operators believe they’ll be punished after delivery through hostile regulation or public scorn. You can't be truly pro-development unless you're also pro-operator. Policies that foster collaboration, not scapegoating, create the conditions for long-term affordability. The Real Way Forward Instead of imposing artificial caps, cities should focus on increasing housing supply through zoning reform, expedited approvals, and public-private partnerships. The more units that come online, the more pricing power shifts away from landlords and toward tenants—naturally. Rent control is seductive in its simplicity but devastating in its consequences. It’s a policy that tries to solve a supply problem with demand-side restrictions—and in doing so, it often makes things worse. At Alpha Equity Group, we believe that smart, sustainable development is the key to housing affordability. And that requires sound economics, not political theater.

Into the Future – Making Sense of Rates in a World That Doesn’t

By Christian O'Neal • June 24, 2025

In the world of capital markets, clarity is often fleeting — and today, it feels downright elusive. The Federal Reserve’s latest June dot plot offered little in the way of certainty. While the median projection sees the Federal Funds Rate in the mid-3% range by the end of 2026 , the dispersion among voting members is striking. Seven members predict no rate cuts in 2024 , reflecting just how divided the committee remains in the face of conflicting data. This latest update marks a 25-50 basis point shift downward from May , but the overarching theme is one of caution, not conviction. That sentiment is mirrored in the economic projections. Core PCE inflation , the Fed’s preferred inflation measure, is now expected to end 2025 at 3.0% , 30 basis points higher than earlier forecasts. Meanwhile, real GDP is forecast to slow from 2.3% in Q4 2024 to just 1.7% in 2025 — another sign that the lagged effects of monetary policy are expected to begin to show. At the same time, the Fed’s balance sheet has shrunk dramatically, from a peak of $9 trillion in April 2022 to just $2.3 trillion today . That quantitative tightening, coupled with a lack of consistent inflation suppression, leaves both equity and bond markets vulnerable to further volatility. This all feeds into an uncomfortable truth: rates are likely to remain higher for longer , and the market is struggling to price that reality. The VIX index , a 30-day forward-looking gauge of volatility in equities, is trending higher. When volatility rises even as indices fall, credit spreads widen , liquidity tightens, and financing risk surges. For commercial real estate investors , this has enormous implications. As we explored in our recent article on CRE Price Discovery , the market remains in flux. The bid-ask spread in real estate is still somewhat wide, and most transaction activity today is being driven by maturing debt — not opportunistic investments banking on future growth. This means valuations are being forced downward, especially for assets that were purchased or refinanced at ultra-low rates in 2021–2022. Consumer behavior is also in transition. Household formation is slowing, and personal savings rates are slowly ticking up although they are significantly down from longer term averages – which could reflect folks bracing for economic turbulence. U.S. household formation currently stands at 1.058 million, down 7.68% from last month’s 1.146 million and down 47.73% from 2.024 million a year ago. Looking globally, demand for U.S. Treasuries remains a critical economic indicator that has trickling effects on the economy . A strong bid-to-cover ratio — like the 2.67x seen at the June 11th 10-Year Treasury auction , with nearly 88% of bids from foreign banks — is encouraging. It suggests continued faith in U.S. fiscal credibility and currency strength despite market apprehensions in our strength, such as the US credit rating being downgraded by Moody’s. This equilibrium is rather fragile. Should the U.S. continue to run massive budget deficits with a debt-to-GDP ratio north of 120% , investors may begin to demand higher yields — or worse, seek refuge in alternative stores of value. Gold is one such store. The World Gold Council recently reported that 76% of central banks expect to increase their gold holdings over the next five years , up from 69% in 2023. This flight to real assets reflects growing concern about the long-term value of fiat currencies — and a desire to hedge against systemic risk. The Bottom Line Rates are likely to remain high through 2025 and into 2026 Inflation remains persistent but progress has been unclear Growth is slowing, and volatility is rising Real estate is repricing around debt maturity events Global capital is shifting cautiously, looking for safety At Alpha Equity Group, we believe this is a time for discipline, not risk-taking. We’re staying patient, watching the data, and investing defensively — focusing on secured debt positions and capital preservation. While others chase uncertain upside, we’re building long-term value through downside protection while we wait out the convergence of dozens of factors completely outside our control.