Financial leverage refers to the use of borrowed funds to acquire an investment. There are a number of reasons to use debt financing to purchase real estate but for the purposes of this discussion I will focus on the impact that leverage can have on before-tax and after-tax returns.
The 3 types of leverage are:
- Positive or favorable leverage
- Neutral leverage, and
- Negative or unfavorable leverage
Positive leverage is when the costs of funds is lower than the expected return on an investment. Neutral leverage is when the cost of funds is equal an investment’s expected return. Negative leverage, therefore, is when the costs of funds exceeds the expected return. When leverage is positive/favorable investors will use debt financing to acquire an asset because, if projections are accurate, the leveraged return will exceed the unleveraged return.
There is risk involved with using debt financing. Risk increases with leverage and, therefore, so does an investor’s expected return on equity to offset that risk. Because investment performance is based on projections an investor’s actual return may be less than expected in which case the use of leverage can have dramatic impacts.
The examples below show how both positive and negative leverage can affect an investment’s return compared to the unleveraged yield.
- Purchase Price: $1,000,000
- Cap rate: 6%
- Net Operating Income (NOI): $60,000/year (constant over holding period)
- Holding Period: 5 years
- Sales Price: $1,000,000
Unleveraged
The unleveraged return is for this investment is 6%.
Positive leverage
- Cost of Funds: 5% (interest only)
- Loan to Value: 75%
The return when using favorable leverage increases to 9%.
Negative Leverage
- Cost of Funds: 7% (interest only)
- Loan to Value: 75%
The return when using unfavorable leverage drops to 3%.