How Financial Leverage Impacts Real Estate Investors
Financial leverage is a term associated with financing that refers to the use of borrowed funds to acquire investment property. When compared to the value of the property, the amount of leverage increases as the amount of borrowed funds increases, and conversely, decreases when the amount of borrowed funds decreases because the more of the bank's money used to make the investment the higher the investor's financial leverage.
For example, a real estate investor who borrows $80,000 to acquire a rental property valued at $100,000 would be getting a higher financial leverage than an investor who borrows a lesser amount (say only $70,000) to purchase a rental property also valued at $100,000.
Fair enough. So let's look at the three types of financial leverage real estate investors face when they are considering a rental property acquisition and the impact they have on the investor.
1) Positive leverage
Positive leverage occurs when borrowed funds are invested at a rate of return that is higher than the cost of these funds to the equity investor. In other words, positive leverage simply means that the returns generated from the property are greater than the cost of financing the property.
The result of positive leverage is an increased yield to the equity investor over the amount that would have occurred without borrowing. The investor benefits both from the investment's yield on equity and from the difference between the cost of funds and the earnings on those borrowed funds for each dollar borrowed.
In this case an investor can be making money on every dollar borrowed.
2) Neutral leverage
Neutral leverage refers to an investment situation where the cost of funds to the investor is exactly equal to the yield of the investment into which they are invested.
In this case the borrowed funds have no effect on the yield to the equity investor, nor does it change with the amount borrowed for investment.
3) Negative leverage
Negative leverage occurs when borrowed funds are invested at a rate of return that is lower than the cost of those funds to the investor. The result of negative leverage is a decreased yield to the investor over the amount that would have occurred without borrowing.
In this case the investor is losing money on each dollar borrowed.