What is Financial Leverage?

[Joe Latson]

Leverage, when used as a noun, refers to a ratio of the amount of debt (loan capital) to the value of the equity (cash or balance sheet equivalent). For example, if an investment, let’s say a property, has $100K of debt and has a total value of $150K (implying $50K of equity value), then the leverage ratio is $100K / $50K or 2:1. You could also say that there is 66.7% leverage ($50K / $150K).

An investment is said to have positive leverage when the interest rate on the debt is lower than the unlevered yield on an investment. This relationship causes the levered yield to be higher.

Sophisticated investors are most concerned with maximizing their risk-adjusted returns. They want to generate the highest possible returns relative to a quantified level of risk. Utilizing leverage is an extremely effective means to increase returns while intentionally dialing up the risk. If the name of the game was ONLY about getting the highest returns without regard for risk, there are plenty of casinos in Las Vegas who would happily take the other side of that trade.

Negative leverage occurs when the interest rate is higher than the unlevered yield, and as a result the levered yield is lower than the unlevered yield – in other words – the leverage is dilutive to returns. What’s happening in situations like this is that the debt investors are being compensated more than the equity investors, despite taking less risk.

Leverage impact on cash flow yields

Let’s look at an example to show the impact of leverage in action. We’ll use the $240K property above, and assume it generates $12K in annual net operating income, resulting in a 5% unlevered yield ($12K ÷ $240K).

The table below illustrates how the levered yield changes based on the interest rates that are less than, equal to, and greater than the unlevered yield. You can see how the leverage magnifies the returns in either direction.

To further emphasize the point, the figures below were adjusted to assume 90% leverage (up from 75%) and the resulting Levered Yields were magnified even further; up from 8% to 14% and down from 2% to -4%.