Penalty interest rates on savings and turbulent stock markets are leading more and more people to invest money in real estate. Good returns are still on offer here without too much risk. With a simple instrument, the leverage effect, real estate returns can be increased – albeit not without risk. In this article, you can find out exactly what the leverage effect is, how it works and what opportunities and risks are associated with it.
Attention: Please note that all information is provided without guarantee and this article does not constitute advice on returns. For detailed information on your individual circumstances, please consult a personal advisor.
What is the leverage effect and how does it work?
The term leverage comes from the English language and means leverage effect. The leverage effect is the leverage effect of borrowed capital on the return on equity when investing in real estate, for example. The leverage effect plays an important role in various investments. For example, the purchase of shares can be financed with borrowed capital. As a rule, companies always use debt capital to improve their return on equity.
Other terms are leverage effect of the capital structure or leverage effect of the debt ratio. In principle, the leverage effect means nothing other than that a certain amount of debt can increase the return on equity when investing in real estate. However, it should be noted that the leverage effect can have both a positive and a negative impact on the profitability of a property purchase.
How is the leverage effect calculated?
There is a simple formula for calculating the leverage effect:
RE = RG + FK / EK x (RG – I)
In this formula, RE stands for the expected return on equity. RG is the return on total assets. I is the interest rate on borrowed capital. FK is the debt capital and EK is the equity. This formula originates from financial mathematics. In practice, a different formula is usually used to calculate the return on equity. This formula is
Return on equity = (total return – financing costs) / equity x 100 %
How the positive leverage effect works
The positive leverage effect works if the interest to be paid on the borrowed capital is lower than the total return on the property financed with this money and your equity. If your expected total return on capital is greater than the interest you have to pay on the borrowed capital, the return on capital increases linearly with the so-called debt-equity ratio. This means that the higher the debt-equity ratio, the higher the return on the equity invested can be. In this case, we speak of a leverage opportunity.
How the negative leverage effect works
However, the leverage effect also works in the opposite direction. If the interest on the borrowed capital is higher than the total return on the property, the return on the equity invested falls. The return decreases linearly with the debt-equity ratio. This situation is known as the negative leverage effect. If the interest on the loan taken out to finance the property is higher than the total return on the property financed with this money, this is also referred to as leverage risk.
Leverage effect: how the increase in returns on a property works
To illustrate how the leverage effect contributes to increasing returns when buying a property, here are three examples. The first example shows the return on the purchase of an apartment without external financing.
For this example, let’s assume you buy a condominium in a good location for 300,000 euros. You pay the purchase price entirely out of your own pocket. The net rent for this apartment is 800 euros per month. In total, you generate rental income of 9,600 euros per year. This results in a return on equity of:
9,600 euros / 300,000 euros x 100 % = 3.2 %
In the second example, you buy the same apartment, but finance 25% or 75,000 euros through your house bank. You pay 2% or 1,500 euros per year for this loan. This results in the following return on equity:
(9,600 euros – 1500 euros) / 225,000 euros x 100 % = 3.6 %
By borrowing 75,000 euros to buy the apartment, the return on equity in this example can be increased to 3.6 %. However, the prerequisite for this increase in return due to the leverage effect is that you achieve constant rental income.
The increase in the return on equity due to the leverage effect becomes even clearer if you reverse the debt and equity components in this example. This means that you would finance 225,000 euros via the bank, pay 4,500 euros in interest and raise 75,000 euros in equity. All other assumptions remain the same. In this case, the return on equity would be as follows:
(9,600 euros – 4,500 euros) / 75,000 euros x 100 % = 6.8 %
You can achieve an even higher return on equity if the value of the purchased property develops positively over the years. In this case too, the leverage effect can significantly increase the return on equity, depending on the amount of borrowed capital.
If you assume an annual increase in value of 2% for the apartment mentioned in the example, this apartment will be worth around 360,000 euros 10 years after purchase. You can therefore achieve an additional capital gain of around 60,000 euros. This means that your equity from the second example will have increased to around 285,000 euros after ten years. This corresponds to a return of around 26.7 %. If, on the other hand, you had financed the purchase entirely yourself, your equity would have increased to 360,000 euros, but the return would only be 20%.
Leverage effect: these are the opportunities and risks of real estate financing
The leverage effect in real estate financing is associated with opportunities, but also risks, which we present to you in the following sections.
Opportunities
The leverage effect can significantly increase the return on equity when purchasing real estate. Provided that the property achieves the expected total return and, in the best case, an increase in value over time. However, the leverage effect also has its limits. Theoretically, when investing in real estate, the equity component can be completely replaced by borrowed capital. In this case, the return on equity would be infinite. But only in theory. In practice, investors will hardly find a bank that will finance 100% of the purchase of a property except for owner-occupation and a very good credit rating. As a rule, you will always have to provide a certain amount of equity.
Risks
If the overall profitability of a property or the interest rates on borrowed capital change, this has a direct impact on the return on equity. The leverage effect can have a negative impact if interest rates on loans rise and overall profitability falls. As soon as the cost of borrowed capital exceeds the profit from the property, losses are incurred. The overall profitability can deteriorate, for example, if the property cannot be let as planned, if there are vacancies or if costly repairs or maintenance measures have to be carried out. At the very least, the risk of having to pay unexpected expenses for the property over the years should be taken into account before buying a property with borrowed capital.
The risk of loss increases with the amount of borrowed capital in real estate financing. In addition, there is a risk that the property may lose value over time, which cannot always be ruled out. This risk depends on various factors, in particular the location of the property. For example, the value of a property can fall drastically if a bypass is built behind a residential property on the outskirts of a town or if an industrial estate is built opposite. There is a low risk of loss of value in prosperous regions, especially in popular cities such as Berlin, Munich or Hamburg. For properties in prime locations, banks are also more willing to provide a large proportion of the financing.
The leverage effect is a double-edged sword when financing real estate. It can significantly increase the return on equity with a high proportion of borrowed capital. However, the leverage effect can also destroy equity if the value of the real estate or the total return develops in the wrong direction. No one can say today how the real estate market will develop in the next 2, 5 or 7 years. Before considering a property as an investment property and financing it partly with debt, you should examine the property carefully. The location, the surroundings and the condition of the property have a considerable influence on the overall yield. Seek detailed and comprehensive advice before financing the purchase of a property with a high proportion of borrowed capital in order to take advantage of the leverage effect for a higher return on equity.
