Financial leverage is a tactic to multiply gains and losses, calculated by a debt-to-equity ratio. At its simplest, leverage is a tactic geared at multiplying gains and losses. Leveraging existing assets to get exponentially more return can be a risk intensive process, and represents a significant aspect of financial strategy and capital structure.
Achieving leverage can enable significant competitive advantages despite the risk, however, as it can accelerate the speed of revenue acquisition exponentially.
In order to borrow substantial amounts of capital, firms must pursue a variety of financial sourcing and be able to back up their debts with valuable assets collateral. Even with a great deal of collateral, borrowing big means risking big. Interest rates ensure that the strategic discussions around expanding leverage take into account the risk and return trade offs. In finance, the best definitions come in equation format.
The standard definition of financial leverage is as follows:. In short, the ratio between debt and equity is a strong sign of leverage.
As you may already know, equity is ownership of the organization and pays out fairly significant dividends. Debt is often lower cost access to capital, as debt is paid out before equity in the event of a bankruptcy thus debt is intrinsically lower risk for the investor. The debt to equity ratio plays a role in the working average cost of capital WACC as well, as the overall interest on financing represents the break-even point that must be obtained to achieve profitability in a given venture.
WACC is essentially the overall average interest an organization owes on the capital it has borrowed for leverage. That means that the weighted average cost of capital is.
A word of caution: Leverage is exponentially more risky the more it is utilized. A useful way to view leverage is the overall existing assets of an organization compared to the amount of money they owe.
If you were to be leveraged at a total of 1. Arguably a reasonable amount. A mistake of this scale on both the lenders and the Lehman Brothers threatened to topple the global economy itself. Financial Leverage Firm Value Implications : This graph illustrates a theoretical firm value maximizing curve when it comes to a debt-to-equity ratio.
Accurately assessing the cash flow uncertainty of the asset is critical to evaluating the risk of structural leverage. By applying an option valuation framework, we can see how structural leverage plays out across the capital structure. The charts show that an increase in asset return drift increases the return across all tranches, while an increase in asset volatility increases the return on the equity tranche, but lowers the return on the senior tranche.
It also shows how the equity tranches are most sensitive to the underlying asset return distribution. Examples include derivatives, synthetics and mark-to-market repos on cash investments.
This is recourse leverage and in the context of a portfolio, there can be a direct claim on all the assets, not just the one being funded. Often, however, this entails making subjective assumptions. Financial leverage is often considered risky given its recourse nature and inherent asset-liability mismatch, which can materialize if a portfolio is forced to sell assets during periods of market dislocations due to a lack of available funding.
However, this risk is often quantifiable, and if used prudently, financial leverage can arguably reduce the overall risk of the portfolio. The difference in funding cost between non-recourse and recourse leverage can, at times, be several hundred basis points.
If the additional borrowing is simply retained as cash in the portfolio, the lower funding cost alone can improve levered return potential by hundreds of basis points. This may enable investors seeking enhanced returns to hold assets with more certain cash flows and potentially a less risky portfolio. Changes in the market environment will shift the relative merits of using structural or financial leverage, whether at the asset or portfolio level, particularly as there are numerous inefficiencies in the funding market.
This is something we believe can be prudently exploited by knowledgeable investors, based on underlying vehicle structure and liquidity provisions. Yet as we described, if you are wrong on the overall economic direction, then the second and third order effects of leverage, could have a significant impact on a portfolio.
Said another way, there is the potential for very high loss in structurally levered positions. For financial leverage there is the opportunity cost of having to sell a non-structurally levered position to meet a margin call. Of course, it should be noted that in volatile markets this could also result in portfolio losses.
When used prudently it is a way to deliver enhanced return potential in a world of low interest rates, but it also entails risks - which in some cases may be significant. Ultimately, and most importantly, an investor needs to understand the cash flow profile and return volatility of the investment being levered, as the impact of leverage is simply a derivative of this distribution.
The pandemic accelerated the secular work-from-home trend, creating winners and losers in office real estate assets. Alternative investments offer opportunities to diversify portfolios in times of market uncertainty.
But among a range of options, investors must first understand the risks and benefits. This article contains hypothetical scenarios. Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight.
If the investor had used all of their cash to acquire the asset, they would have basically maxed out their market exposure. But since they still have cash, they can purchase more investment properties, increasing their exposure even more than if debt were not used. Leverage is also used when trading stocks, where brokers extend investors a margin loan.
These loans do incur interest just like any other interest-bearing loan. However, This is an extremely risky situation. This is particularly true for an investor who is purchasing more than they can afford. The investor will receive a margin call. What does this scenario look like in real estate? Whatever happens to the value of the property, the loan amount must be paid in full. Just as in any capital stack , when the investment turns south, equity goes first. If we compare the above example against an investor who is not over-leveraged, we'll see a drastic difference.
What if an investor has income from their rental property — doesn't that help offset leverage risk? As long as debt is in the picture, there is still risk.
If a property goes vacant, the investor is still on the hook for all of the related monthly expenses. If their business plan underestimates the vacancy rate , the investor may find that they cannot keep up with monthly expenses and debt payments.
While leverage is often talked about because of its ability to amplify positive returns, it cuts both ways, and investors can take significant losses with too much leverage. Learn more about how to incorporate real estate investments into your risk management strategy. Securities offered on this website are offered exclusively through Thornhill Securities, Inc.
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