![]() ![]() Simply, if the leveraged IRR is higher than the unleveraged IRR then the use of debt will result in positive leverage, while if the leveraged IRR is lower than the unleveraged IRR the use of debt will result in negative leverage. Once the leveraged IRR (which takes into account the use of the loan) and the unleveraged IRR ( which assumes no loan is used) are calculated, it is easy to evaluate whether the use of the particular loan will result in negative or positive leverage. This analysis will take into account the loan amount at the acquisition time, the periodic loan payments, and the payment of the remaining loan balance from the resale proceeds of the property upon the exit from the investment. However, a more thorough and accurate analysis of the effect of the use of a particular loan on the return of a property investment can be done through the calculation of the leveraged and unleveraged IRR based on the expected annual or quarterly cash flows of the property over the holding period. If the mortgage constant is higher than the unleveraged return expected to be made on the investment then the use of the loan will result in negative leverage. Wurtzebach and Miles (1994) argue that a preliminary assessment of whether borrowing will result in positive or negative leverage can be carried out by comparing the mortgage constant of the loan considered with the unleveraged return of the investment. How to Evaluate if the Use of Debt Will Result in Negative or Positive Leverage If you would like to discuss any questions you may have regarding this article or how to use a particular set of data to carry out calculations or analysis discussed in this article, click on the button below to schedule an online tutorial/consulting session with Dr. Notice that the periodic cost of a loan is a function of the interest rate, its duration, and the loan amount. The main cause of negative leverage is the high cost of the loan relative to the cash flow and the return generated by the property. The unleveraged return is the return and more specifically the internal rate of return (IRR) that a property investment would achieve without the use of borrowed funds. The term negative leverage refers to the situation in which the use of the borrowed funds reduces the overall return on the investor’s equity capital relative to the unleveraged return. ![]() However, funding most of or the entire purchase price (that was happening a lot before the global financial crisis) with borrowed money entails risks. How to Identify the Optimal Property Financingįinancing property investment acquisitions with borrowed funds can be very enticing as it reduces significantly the investor’s own capital contribution. Loan-to-Value Ratio and Property Investment
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