Most commercial real estate investments are financed because of the benefits financing offers and the long-term nature of the investments.
Financing an investment also is called leveraging an investment.
Investors tend to use a lot of debt when purchasing a real estate investment, but this also increases the investment’s risk. How do you determine whether the use of leverage is favorable? How do taxes impact the benefits of leverage? What are the factors that impact whether the leverage is favorable? How does leverage relate to risk? Leverage can enhance returns, but investors also must consider how it impacts risk.
Financial leverage measures the degree to which debt is used to finance an investment. This usually is done by investors in an attempt to increase their expected return on equity. As leverage increases, the investor is using more debt relative to equity.
Leverage can be favorable or unfavorable. When leverage is favorable (positive), investors expect a higher return on equity than if they purchased the investment on an all-cash basis. When leverage is unfavorable (negative), investors expect to receive a lower return on equity than if they had paid all cash.
Rational investors normally expect leverage to be positive to compensate for the risk involved in borrowing money. Risk increases with leverage. As investors use more leverage, they expect a higher return because they are taking on more risk. However, the investor’s actual return may be less than projected, and leverage may be unfavorable, resulting in a lower return than if debt had not been used. This is the nature of the risk that investors take when they use debt financing.
Investors might decide to borrow money for many reasons:
The most obvious reason to use debt financing is because an investor does not have enough available cash to pay for an investment in full and thus requires an outside lender to provide equity financing.Debt financing allows investors to make investments that might not be possible otherwise.
Debt financing can be part of an investor’s broader investment strategy. Although they have enough equity to buy properties in full, investors may deliberately choose to raise debt financing. This enables them to use the excess equity to retain capital for other uses or to buy other properties. In the latter case, because equity capital is being spread over several properties, investors can reduce the risk of their total portfolios if one investment fails. That is, the investor can diversify his portfolio by using leverage to purchase more than one type of property.
If the financial leverage is favorable (positive), the use of debt financing also increases the investor’s expected return on equity. When leverage is favorable, the investor’s return on equity invested exceeds the return that would be earned without the use of debt financing, although the risk also increases.
Due to the tax deductibility of interest paid on debt, investors also might decide to borrow money to enhance the leverage of after-tax equity returns. The benefits of leverage often are magnified when evaluating the investment on an after-tax basis.
Financing an investment also is called leveraging an investment.
Investors tend to use a lot of debt when purchasing a real estate investment, but this also increases the investment’s risk. How do you determine whether the use of leverage is favorable? How do taxes impact the benefits of leverage? What are the factors that impact whether the leverage is favorable? How does leverage relate to risk? Leverage can enhance returns, but investors also must consider how it impacts risk.
Financial leverage measures the degree to which debt is used to finance an investment. This usually is done by investors in an attempt to increase their expected return on equity. As leverage increases, the investor is using more debt relative to equity.
Leverage can be favorable or unfavorable. When leverage is favorable (positive), investors expect a higher return on equity than if they purchased the investment on an all-cash basis. When leverage is unfavorable (negative), investors expect to receive a lower return on equity than if they had paid all cash.
Rational investors normally expect leverage to be positive to compensate for the risk involved in borrowing money. Risk increases with leverage. As investors use more leverage, they expect a higher return because they are taking on more risk. However, the investor’s actual return may be less than projected, and leverage may be unfavorable, resulting in a lower return than if debt had not been used. This is the nature of the risk that investors take when they use debt financing.
Investors might decide to borrow money for many reasons:
The most obvious reason to use debt financing is because an investor does not have enough available cash to pay for an investment in full and thus requires an outside lender to provide equity financing.Debt financing allows investors to make investments that might not be possible otherwise.
Debt financing can be part of an investor’s broader investment strategy. Although they have enough equity to buy properties in full, investors may deliberately choose to raise debt financing. This enables them to use the excess equity to retain capital for other uses or to buy other properties. In the latter case, because equity capital is being spread over several properties, investors can reduce the risk of their total portfolios if one investment fails. That is, the investor can diversify his portfolio by using leverage to purchase more than one type of property.
If the financial leverage is favorable (positive), the use of debt financing also increases the investor’s expected return on equity. When leverage is favorable, the investor’s return on equity invested exceeds the return that would be earned without the use of debt financing, although the risk also increases.
Due to the tax deductibility of interest paid on debt, investors also might decide to borrow money to enhance the leverage of after-tax equity returns. The benefits of leverage often are magnified when evaluating the investment on an after-tax basis.
COMMERCIAL REAL ESTATE
TRANSPARENCY | CAPITAL PRESERVATION | INCOME STREAM | TAX SHELTER | HEDGE AGAINST INFLATION
VALUE APPRECIATION | PRIDE OF OWNERSHIP
TRANSPARENCY | CAPITAL PRESERVATION | INCOME STREAM | TAX SHELTER | HEDGE AGAINST INFLATION
VALUE APPRECIATION | PRIDE OF OWNERSHIP
