Financial leverage is a term associated with financing that refers to the use of borrowed funds to acquire investment property. When compared to the value of the property, the amount of leverage increases as the amount of borrowed funds increases, and conversely, decreases when the amount of borrowed funds decreases.
For example, a real estate investor who borrows $80,000 to acquire a rental property valued at $100,000 would be getting a higher financial leverage than an investor who borrowed a lesser amount (say only $70,000) to purchase a rental property valued at $100,000.
Of course higher leverage isn’t necessarily better for the investor than lower leverage, and vice versa. Because leverage has a direct impact on the investor’s yield, the investor must consider how the cost of borrowed funds (i.e., the interest rate) differs from the rate of return on the property that would occur without financing.
In other words, depending on whether the investor might expect to receive a higher or lesser yield when borrowing funds to purchase an investment property compared to paying all cash, the investor is confronted with three types of leverage that could occur during the acquisition of investment real estate.
1) Positive leverage
Positive leverage occurs when borrowed funds are invested at a rate of return that is higher than the cost of these funds to the equity investor. In other words, positive leverage is simply putting money to work to earn more than the money costs to borrow.
The result of positive leverage is an increased yield to the equity investor over the amount that would have occurred without borrowing. The investor benefits both from the investment’s yield on equity and from the difference between the cost of funds and the earnings on those borrowed funds for each dollar borrowed. Therefore, in this case, an investor can be making money on every dollar borrowed.
2) Neutral leverage
Neutral leverage refers to an investment situation where the cost of funds to the investor is exactly equal to the yield of the investment into which they are invested. In this situation, the borrowed funds have no effect on the yield to the equity investor, nor does it change with the amount borrowed for investment.
3) Negative leverage
Negative leverage occurs when borrowed funds are invested at a rate of return that is lower than the cost of those funds to the investor. The result of negative leverage is a decreased yield to the investor over the amount that would have occurred without borrowing. Therefore, in this case, with negative leverage, the investor is losing money (return) on each dollar borrowed.