Positive and negative leverage
Leverage means using borrowed money to buy an asset. It lets an investor control a property worth far more than the cash they put in. Leverage cuts both ways: it magnifies gains, and it magnifies losses.
The basic idea
Compare what the property earns with what the borrowed money costs.
| Situation | Name | Effect on the investor's return |
|---|---|---|
| Property earns more than the debt costs | Positive leverage | Return on the investor's cash goes up |
| Property earns less than the debt costs | Negative leverage | Return on the investor's cash goes down |
| The two are equal | Neutral leverage | No change |
"What the property earns" here is the property's return before financing: NOI divided by price. "What the debt costs" is the loan's interest rate (or, more precisely, the annual debt service as a share of the loan).
A worked example
A building costs $500,000 and produces net operating income (NOI) of $40,000 a year. Paying all cash, the investor earns:
$40,000 ÷ $500,000 = 8%
Positive leverage. Now the investor borrows 75% ($375,000) on an interest-only loan at 6% and puts in $125,000 of their own cash.
- Interest: $375,000 × 0.06 = $22,500
- Cash left after the loan: $40,000 − $22,500 = $17,500
- Return on cash invested: $17,500 ÷ $125,000 = 14%
Borrowing at 6% to buy something that earns 8% raised the investor's return from 8% to 14%.
Negative leverage. Same building, same loan amount, but the rate is 10%.
- Interest: $375,000 × 0.10 = $37,500
- Cash left: $40,000 − $37,500 = $2,500
- Return on cash invested: $2,500 ÷ $125,000 = 2%
The investor would have done better paying cash. If NOI slipped below $37,500, they would have to pay the difference out of pocket.
Why leverage is a risk
The loan payment is fixed. Rent is not. When a leveraged property loses tenants or values fall, the owner still owes the lender the full payment, and a falling market can leave the owner owing more than the property is worth. That is the leverage risk from the previous lesson, and it is why highly leveraged owners are the first to get into trouble in a downturn.
Amortizing loans
Real loans usually include principal as well as interest, which raises the annual payment. Exam problems will give you either the interest rate on an interest-only loan or the annual debt service directly. Use whatever annual payment the problem gives.
Exam tips
- Leverage does not change what the property earns. It changes what the investor's cash earns.
- If the problem asks whether leverage is positive or negative, compare the property's return with the cost of the debt.
- The more an investor borrows, the bigger the swing in either direction.