Leverage effect

The leverage effect in property investment

The leverage effect plays a crucial role in the field of property investment. It describes the possibility of achieving a higher return with a small amount of equity by utilising borrowed capital. In the world of property, particularly in off-market transactions, this effect is especially relevant, as it allows investors to make the best possible use of their financial resources.

What is the leverage effect?

The leverage effect arises from the use of borrowed capital to finance an investment. When purchasing property, this means that investors do not have to raise 100 per cent of the purchase price from their own capital. Instead, they can finance part of the price through bank loans, which gives them the opportunity to acquire more properties and diversify their portfolio.

How does the leverage effect work?

The basic principle behind the leverage effect is simple: by using borrowed capital, investors can increase their return on equity. This happens because the rental income from the properties not only repays the loan taken out but also covers the equity contribution. An example illustrates this:

• An investor buys a property for 1 million euros.
• They invest €200,000 of their own capital and finance the remaining €800,000 through a loan.
• The property generates annual rental income of 80,000 euros.
• After deducting the interest payments on the loan, this results in a significantly higher return on the equity invested.

Advantages of the leverage effect

Using the leverage effect offers numerous advantages:

1. Increased return on equity: The use of borrowed capital increases the return on the equity invested.
2. Portfolio growth: Investors can acquire several properties with the same amount of equity, thereby diversifying their portfolio.
3. Increased liquidity: Less capital tied up allows for more flexible investment decisions.

Risks of leverage

Despite the advantages, leverage is not without risks:

• Interest rate risk: Higher interest rates can increase financing costs and reduce returns.
• Market risk: A fall in property prices can lead to a loss in value and jeopardise the repayment of the loan.
• Liquidity risk: Vacancies can lead to financial difficulties, as running costs must still be met.

Leverage in Off-MarketProperty

The leverage effect is particularly advantageous with off-market properties, as more favourable purchase prices can often be secured here. These off-market transactions enable investors to utilise attractive debt financing to acquire properties below market value and thus benefit from price increases.

Conclusion

The leverage effect is a powerful tool for success in property investment, particularly with off-market opportunities. However, investors should carefully weigh up both the opportunities and the risks and adapt their financing strategies accordingly.

A clear example of the leverage effect

Imagine an investor called Peter who has €100,000 in equity. He wants to buy a flat that costs €500,000. Peter decides to finance 80 per cent of the purchase price with a loan. After the purchase, he lets out the flat for 30,000 euros a year.

Thanks to the leverage effect, the return on investment looks positive for Peter. The rental income slightly exceeds the interest payments on the loan, and as Peter has invested only 20 per cent of his own capital in the property, he achieves a high return on the equity invested. If the flat increases in value, Peter can significantly boost his profit by selling it or refinancing, thereby making the most of the leverage effect.