How to Leverage Debt in Real Estate

In the context of real estate, leveraging can be ‘high risk, high return’. But why does Dr. Jefferson Duarte call it a double-edged sword? Although borrowing money to invest in property (or leveraging) can lead to much greater returns, the flip side is that when things don’t go according to plan, it can also lead to much heavier losses. 

Transcript

So what happens when you have to borrow money to acquire property? How does it affect your risk and return?

In finance, leverage is a term used to describe the levering effect of debt in your capital structure. Suppose you invest $100 of your own money and expect to receive $10 as a return. This means that your return is 10 percent in expectation.

Now, suppose we invest $40 of your own money and borrow the other $60. The underlying investment is expect to earn the same $10 return and you pay 5 percent interest on the $6 that you borrow. The value of your return is therefore $10 minus the interest expense of 5 percent, multiplied by $60, which is equal to $3. That is your return is now $7.

You can see the percentage of return increases from 10 percent when you were only investing your own money to 17 and a half percent when you include the $60 of borrowed money in that investment. This levering effect increases as you borrow more money, as you can see in this table.

If borrowing money to invest yields much greater expect returns, then why not always borrow as much money as possible when making an investment? The answer is that leverage is a double-edged sword. While it does enable much higher returns, it can also result in more significant losses.

Let’s go back to the example of investing $100 for your own money. Only this time, let’s assume that you lose $10 instead. The underlined investment loss in percentage terms is therefore 10 percent. However, if you use $40 of your own money and borrow the other $60, what is your loss in percentage terms? 

So as you can see, the percentage of return decreases from minus 10 percent when you’re only investing our own money, to minus 32 and a half percent when you include the $60 of borrowed money in that investment.

As with the positive effect of leveraging, the effect is amplified on the negative side as well. When it comes to risk, the effect of leverage results in much higher volatility. The upward swings are much larger, but so are the downward swings.

When you choose to borrow money for your investment, you are creating a split between debt and equity. The underlying value of the asset equals the debt or loan value, plus the value of your money or equity.

Leveraging increases both the potential returns and the potential loss of an investment. This increased volatility leads to increase risk and higher expected returns.

There are a number of considerations to take into account when deciding whether or not to incorporate leverage into an investment. For example, is the interest expense tax deductible?