Menu
Home
Log in / Register
 
Home arrow Business & Finance arrow Property finance
< Prev   CONTENTS   Next >

5.7 THE EFFECT OF THE SPREAD

The spread between unlevered total return and debt servicing costs is the only element which determines whether financial leverage will have a positive or negative effect.

Whilst the LTV impinges on the quantity of the leverage effect, the spread is essential in order to decide whether it will be positive or negative, and hence whether its use will be prudent.

Figure 5.7 explains the above. The graph shows variations in unlevered total return (between 5% and 9%), whilst debt servicing costs remain fixed at 7%. The result is a spread ranging from -2% to +2%. When the spread moves from negative into positive territory, two principal consequences may be noted:

• the slope of the line representing the risk-return ratio also changes from negative to positive;

• the starting point for the risk-return ratio increases.

Spread and levered equity return

FIGURE 5.7 Spread and levered equity return

Both consequences indicate the primary importance of understanding and identifying the spread within a real estate investment as correctly as possible.

5.8 A BRIEF SUMMARY OF WHEN TO USE FINANCIAL LEVERAGE

This paragraph is intended to clarify that the effective use of financial leverage depends on the answers to certain key questions.

What is the spread between expected unlevered total return and debt servicing costs?

If the spread is not positive then the leverage will reduce shareholder returns, whilst if it is positive it will increase returns.

Is the spread sufficiently broad in order to offset the greater risks which financial leverage requires the borrower to take on?

Recourse to leverage increases volatility under all circumstances, and hence the spread must compensate the borrower for the increase in the risk profile.

Are there satisfactory alternative investments for equity capital not used in the project?

Since part of the project will be financed through borrowed capital, any amount of equity capital not invested in the project should be allocated to alternative projects with a satisfactory return. An approach of this type should provide for diversification of the real estate portfolio, since investment in multiple assets will have the effect of reducing non-systemic risk.

Are cashflows expected to be sufficiently stable and will they increase sufficiently?

As described above, the comparison between the total return on the investment and debt servicing costs is the sole decisive factor when determining whether recourse to financial leverage will be beneficial or not. In turn, the total return on investment will depend upon constituent elements, such as future growth in costs and earnings and fluctuations in the reference Interest Cap Rate, which are difficult to predict at the time choices are made regarding borrowing options.

Consequently, projections of future cash flows will play a decisive role in borrowing choices relating to the project.

What is the degree of certainty for the assumptions underlying the investment plan?

Since future returns are inherently uncertain and since recourse to financial leverage increases volatility, it is fundamentally important to determine whether the uncertainty associated with the project will have any considerable effects either on return (positive or negative leverage) or the degree of risk inherent in that return. The combination of a reduced spread between total return and debt servicing costs, associated with a high operating risk for the project, may lead to risks which are very different from those envisaged.

The following points provide a summary of the essential elements to be taken into account when using financial leverage:

Recourse to leverage may have a substantial effect on returns. In other words, financial leverage can have either a positive or a negative impact. A definitive judgment on the advisability of leverage can only be made ex post by calculating the returns actually achieved.

It is necessary to carry out a critical analysis of the spread between unlevered total return and the costs for servicing the debt contracted. If the spread is positive, then leverage will operate in favour of the investor. If by contrast the spread is negative, then financial leverage would depress investor returns. Where the LTV increases, the returns on an investment will increase exponentially.

In all cases, financial leverage increases the volatility of the return on the investment. When the effects of leverage on the risk-return ratio are considered together, it is clear that recourse to financial leverage will require an on-going review of returns, according to the no free lunch theorem. This theorem asserts that the benefits expected to accrue through recourse to financial leverage will be offset by an increase in expected volatility.

 
Found a mistake? Please highlight the word and press Shift + Enter  
< Prev   CONTENTS   Next >
 
Subjects
Accounting
Business & Finance
Communication
Computer Science
Economics
Education
Engineering
Environment
Geography
Health
History
Language & Literature
Law
Management
Marketing
Philosophy
Political science
Psychology
Religion
Sociology
Travel