POSITIVE LEVERAGE
Positive leverage is an important means for enhancing real estate investment returns, especially for property investors shooting for double digit-returns. For this reason it is important for real estate investors to understand how to one can evaluate whether borrowing can help increase the return of a property investment.
The other metric required to asses whether using borrowed funds will increase investment performance is the rate of return on total capital (ROR), which is actually the unleveraged income return of a property investment. The formula for the rate of return on total capital is: ROR = Net Operating Income (NOI) / Purchase Price By comparing the estimated ROR with the mortgage constant of the particular loan that will be used to finance part of the investment cost, the investor can assess whether borrowing under the particular terms of the loan, will increase the return of the investment. However, such a comparison will not reveal by how much investment return will be enhanced by using borrowing. In order to answer this question the return of the investment needs to be calculated taking into account the impact of borrowing on the property cash flow, or in other words the leveraged return. For an extensive discussion, with all the formulas used and numerical examples of the assessment of whether borrowing enhance the return of a property investment, see the article Using Borrowed Funds to Finance Property Investments.
Brueggeman and Fisher (1993) indicate that borrowing will contribute to positive before-tax leverage if the unlevered before tax IRR is greater than the effective cost of the loan, which in addition to the loan interest rate reflects and additional costs such as points, prepayments, etc.
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