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5.5 "NO FREE LUNCH"

The combination in Figure 5.5 of the effects of the two figures set out above illustrates the impact of financial leverage on the risk-return ratio. The result is that the trade-off between risk and return is essentially constant.

Within the financial literature, this trade-off is referred to as the "No Free Lunch theorem”,[1] in order to indicate that, absent market imperfections, the high returns generated through financial leverage will be completely offset by the related increase in risk. In other words, the risk premium (understood as the expected return less the no-risk rate divided by volatility) is constant at any level of financial leverage.

In this case too, the increase in volatility and return will be particularly high in cases in which the LTV exceeds 50%.

5.6 THE MECHANICS OF FINANCIAL LEVERAGE

Ample attention has been dedicated above to positive returns as a function of different LTVs; however, there is no guarantee for the decision-making body that recourse to financial leverage will lead to positive results. Were the use of leverage to have a negative effect (resulting in a negative spread between unlevered total return and debt servicing costs), then the impact of leverage on equity return would operate geometrically as is the case for positive effects, that is reducing returns at a rate which is more than proportional to the increase in the LTV.

In Figure 5.5 the slope of the line is dependent on the assumptions made (for example the positive spread between unlevered total return of 9% and debt servicing costs of 7%).

Expected return and volatility against changes in leverage

FIGURE 5.5 Expected return and volatility against changes in leverage

The impact of financial leverage on real estate investment

FIGURE 5.6 The impact of financial leverage on real estate investment

However, as mentioned above, future returns are by definition uncertain and, consequently, the decision to use financial leverage at present could lead to a later result for investors which may be either positive or negative.

Figure 5.6 shows the positive and negative effects of financial leverage. The impact is premised on a LTV of 50% in both cases. If the same spreads (-2% to +2%) between the total return and the debt servicing costs considered in the first example are used, the impact of financial leverage will also be identical.

  • [1] Wolpert and Macready (1997).
 
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