Positive leverage in the world of real estate investing describes the situation in which borrowing helps increase the return of a property investment compared to the return that would be achieved if the investor did not use any borrowed funds for acquiring or developing a property.
Positive leverage is an important means for enhancing real estate investment returns, especially for property investors shooting for double digit-returns. However, borrowing does not always enhance the return of a real estate investment. On the contrary, if the appropriate conditions are not met, borrowing can have a negative effect on the return of an investment. For this reason, it is important for real estate investors to understand how one can evaluate whether borrowing can help increase the return of a property investment.
Assessing the Effect of Borrowing on Property Returns
Wurtzebach and Miles (1994) indicate that borrowing will enhance investment returns if the mortgage payment as a percentage of the loan amount is smaller than the income return offered by the investment under consideration, if no borrowed funds are used (unleveraged income return). The mortage payment in percentage terms, in the case of fixed-rate loans, is constant and is provided by the metric referred to as mortgage constant. In the case of
adjustable rate loans, the cost of financing is variable through time in percentage terms. This variation through time needs to be taken into account when trying to assess if borrowing will enhance returns or not.
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 enhances 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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