The Impact of Leverage on Real Estate Returns

The goal of any investor is to find opportunities that generate the highest return possible with the least amount of risk. One key metric that investors need to pay close attention to when comparing real estate deals is the amount of leverage used in the capital structure. In other words, how much debt is being used to finance the property and generate the returns? Simply put: more leverage means more risk. Debt can enhance returns when projects go according to plan, but it also works in reverse.

Let’s use a hypothetical example to show the impact to equity when we finance a project with 85% debt versus 70% debt. The property is acquired for $20 million and held for two years, after which it is sold for $25 million. The cost of interest on both loans is 4% and we are going to ignore amortization for the sake of simplicity. The project financed with 70% debt requires $6 million of equity, while the project financed with 85% debt requires only $3 million of equity.

The property leveraged with 85% debt will generate a profit of $3,640,000 on a $3,000,000 investment, resulting in a total return on equity of roughly 121%. The property leveraged with 70% debt, will generate a profit of $3,880,000 on a $6,000,000 investment, resulting a 65% total return on equity.

However, real estate leverage works both ways. If the market were to decline by just 5%, investors using 85% leverage would lose 79% of their invested capital, while investors who levered at 70% would lose only 35%.

While money was lost in both examples, the higher-leveraged scenario represents a more substantial loss. Additionally, the project capitalized with 70% leverage would be in a better position to weather an economic downturn, allowing for a higher possibility of restoring profitability after market conditions improve.

Highly levered projects shouldn’t necessarily be altogether avoided; investors should ensure that they understand the amount of leverage used and are adequately compensated for the level of risk. Continuing on the example above, investors in the 85% leveraged deal should be rewarded far more than investors in the 70% leveraged deal, all other things being equal. Also, when the investment plan is executed and the property is sold, investors should make sure that they receive a majority of the profits until they have achieved an acceptable return for the risk, before splitting the upside with the sponsor.

Unfortunately, there is no set rule or scale that dictates the exact incremental return one should expect to receive for a higher leveraged investment over another. The great equalizer when comparing investment opportunities to one another is to look at them on an unlevered basis. The unlevered IRR removes the noise created by debt and simply evaluates the gross investment performance of the asset. If one property has a 10% unleveraged internal rate of return while another project has an 8% unleveraged internal rate of return, then the former is likely the better opportunity. That being said, it is hard to compare deals between two managers on one metric alone because of the number of variables that go into creating a financial model.

(Article continues below video)

Watch Marc Turner explains why highly leveraged investments can be dangerous, despite the potential for higher returns.

The impact of fees is also something to be aware of. It is not uncommon to see sponsors dialing up leverage, while also dialing up fees. This is simply a way of stacking the cards in favor of the sponsor, shifting the bulk of the reward to the manager and the majority of risk to the investor. An investor should be focused on the return they’ll receive after fees.

The use of high leverage also provides insight on the fundamental disciplines of the project’s sponsor. At the very least, it shows the sponsor is not afraid to increase the risk for their investor’s capital, which means investors should consider inquiring as to where else in their underwriting the sponsor may be assuming outsized risk. Further, sponsors who use high leverage may be compensating for a lack of investment capital or simply naïve that market conditions do not stay constant.

In summary, it’s crucial for investors to understand the amount of leverage used in any real estate project they are considering investing in, to realize that a higher-leveraged scenario could represent a more substantial loss in the event of a market downturn, and ensure they are adequately compensated for the level of risk taken.