Based on the impact of leverage on the return on equity invested, the concepts of positive and negative leverage exist in the real estate sector.

Three main parameters influence this effect:

  1. The profitability of the real estate asset (IRR);
  2. The interest rate on the loan;
  3. The income tax rate (since interest is deductible as an expense).

Initially, when leverage is low, it is possible to obtain loans at lower interest rates. However, as leverage increases, creditors demand higher interest rates, which may eventually exceed the asset’s IRR.

Leverage is positive when the loan’s interest rate, after accounting for the tax benefit, is low enough that increasing leverage leads to an increase in the equity IRR.

For example, let’s assume we purchase a property to rent out and sell after five years under the following conditions:

In this case, the cash flows (both pre- and post-tax) would look like this:

Under these circumstances, the more of the investment financed by a loan, the higher the return on the equity invested.

Now, let’s assume the interest rate is 14% instead of 10%. In this case, we encounter negative leverage, meaning that increasing the loan amount leads to greater losses.

There is a Break-Even Rate, at which the after-tax IRR becomes insensitive to the amount of leverage. This occurs when:
Loan Interest Rate = After-Tax IRR of the property / (1 – Tax Rate).

In this case, regardless of the level of leverage, the after-tax return on equity remains constant (in our example, 9.69%)

Below is a graph illustrating different levels of leverage. The vertical axis shows the after-tax IRR (ATIRR), and the horizontal axis shows the loan interest rates. You can see that when the loan interest rate is 12.17%, the curves representing various leverage levels intersect at a single point, providing the same return.

Finally, we conclude that, all else being equal, it is worthwhile to increase leverage as long as it remains positive.

Excel File

Adapted from:
Real Estate Finance & Investments by William B. Brueggeman and Jeffrey D. Fisher