Leverage effect and leverage risk — how the leverage effect influences the return on equity
What is the leverage effect? - The definition
The Leverage effect, also known as leverage effect, describes a method in which real estate investors increase their return on equity through the use of debt capital. Investors specifically use loans or other borrowed funds instead of raising full equity for investments. Leverage occurs when the total return on investment of a project exceeds the interest rate on borrowed capital. The principle is: The higher the debt, the stronger the leverage effect on the return on equity.
note: The leverage effect only has a positive effect if the total return on capital achieved (e.g. the net rental income in relation to the purchase price of the property) is higher than the interest on borrowed capital.
How do you calculate the leverage effect?
Die computation The leverage effect is based on a formula that shows the relationship between return on equity (ECR), return on total investment (GKR) and return on debt (FKR).
instance: An investor invests CHF 300,000 equity in a project with a planned total return of 4%. In addition, it takes out a mortgage of CHF 300,000 at 2% interest, thus increasing the total investment to CHF 600,000. After one year, thanks to the leverage effect, the investment developed as follows:
- Project value: The total return is 4%, meaning that the project generates CHF 24,000 per year.
- Credit costs: The loan of 300,000 CHF generated interest costs of CHF 6,000 per year.
- upshot: After deduction of mortgage interest, CHF 18,000 remains, which means a return on equity of 6%. The leverage effect here increases the original return by 50%!
What are the risks of the leverage effect?
The leverage effect can increase a company's return, but it also entails risks. Leverage risk occurs when the return on total capital falls and falls below interest on borrowing capital. In such cases, the leverage effect has the opposite effect: It reduces the return on equity and, in the worst case, leads to losses.
instance: If the total return falls to 1.5% in our example, interest costs exceed profit and the investor would have to cover losses from equity. This scenario illustrates how important it is to use the leverage effect only when the income is certainly above the borrowing costs.
Leverage effect vs. leverage risk
For real estate investors, the leverage effect can be a useful way to increase the return on equity, particularly because real estate generates relatively stable income and fluctuates only slightly in value. However, the effect also entails risks, which is why moderate indebtedness and a clear risk assessment are crucial. Investors and banks often evaluate real estate portfolios with a consistently high debt capital ratio more critically.
tip: Use the leverage effect carefully and constantly monitor income in relation to financing costs. A balanced financing structure protects your investment from negative leverage, while the risk in real estate is lower than with other investments.
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