What is Positive Leverage?
Positive Leverage in real estate refers to the occurrence where the return on an equity investment exceeds the cost of debt attributable to financing the property purchase.
In this case, the decision to fund the purchase of a real estate investment with debt, and the financing obligations associated with the borrowing, are less than the expected return on the property investment.
Table of Contents
- How Does Positive Leverage Work in Real Estate?
- How to Create Positive Leverage and Maximize Returns?
- Equity Cap Rate vs. Cash on Cash Return: What is the Difference?
- Positive vs. Negative Leverage: What is the Difference?
- Positive Leverage Formula
- Positive Leverage Calculator
- 1. Positive Leverage Calculation Example
- 2. Real Estate Positive Leverage Analysis Example
How Does Positive Leverage Work in Real Estate?
In real estate, positive leverage refers to the state whereby the equity yield earned on a property investment is greater than the cost of debt.
The funding structure of most purchases in the real estate market — both on the residential and commercial side — are financed using debt, or borrowed capital from lenders.
But of course, the debt capital provided by the lender comes at a price:
- Periodic Interest → The periodic interest payments owed on a loan, which is a function of the outstanding balance.
- Principal Amortization → The gradual paydown of the loan principal, which can be partial amortization (i.e. remaining balance at maturity paid off in a lump sum “balloon” payment), or full amortization.
If the cash on cash return (or “equity yield”) on an investment exceeds the cost of the debt – the concept of positive leverage in real estate – that implies the rental income generated by the property can sufficiently offset the borrowing costs.
In effect, the real estate property is likely more profitable and will produce a higher return on behalf of the landowner.
Therefore, positive leverage is the target outcome on a property investment since the operating cap rate is higher than the interest rate, or cost of borrowing.
Note: The concept of analyzing positive and negative leverage is only applicable for fixed-rate loans. The annual debt service must remain constant over the maturity term.
How to Create Positive Leverage and Maximize Returns?
So, how can one determine the appropriate amount of leverage to use in real estate investing to maximize the potential return?
In short, leverage enables a real estate investor to acquire properties that could not be purchased by using only cash.
However, the primary reason is not always from a lack of funds – especially in the commercial real estate (CRE) market — instead, the reliance on leverage pertains more to enhancing the potential returns earned on a property investment.
The contribution of debt from lenders reduces the equity contribution of the investor, causing the equity yield to increase — all else being equal.
At the end of the day, the incentive to purchase a property is to generate a positive return. Therefore, unless the owner intends to personally live there, the property is a monetary investment.
If the equity cap rate exceeds the loan constant post-investment, the outcome is positive leverage (and the reverse if the loan constant is greater).
- Positive Leverage → Cash on Cash Return (Equity Yield) > Loan Constant
- Negative Leverage → Cash on Cash Return (Equity Yield) < Loan Constant
- Neutral Leverage → Cash on Cash Return (Equity Yield) = Loan Constant
Equity Cap Rate vs. Cash on Cash Return: What is the Difference?
In the hold period of the property investment, the underlying rules remain the same, however, the cash-on-cash return (or “cash yield”) is used, rather than the equity cap rate.
Conceptually, the two measures are virtually identical in terms of intent.
The only difference between the two is that the income component of the cash-on-cash return metric is the annual cash flow after debt service (CFADS) on a rolling basis.
On the other hand, the equity cap rate measures the post-stabilization unlevered return on a real estate investment, i.e. the potential return in Year 1.
