Question

What condition regarding the property’s return on assets and the interest rate on borrowed capital must be met to achieve positive leverage?

Accepted Answer

Positive leverage is achieved when the property’s return on assets is higher than the interest rate on the borrowed capital. The return on assets, often called the capitalization rate or unleveraged yield, is the percentage return a property generates based on its total value, calculated by dividing the net operating income by the property price. Borrowed capital refers to the debt used to finance the purchase, and the interest rate is the cost of that debt. When the rate of return earned on the total value of the asset exceeds the cost of the interest paid to lenders, the surplus return flows to the equity investor, thereby magnifying the return on their invested capital. Conversely, if the interest rate on the debt is higher than the property&#x27;s return on assets, the investor experiences negative leverage, where the cost of borrowing reduces the overall return on their equity. For example, if a property produces an annual return of 8 percent and the interest rate on the loan used to acquire it is 5 percent, the investor achieves positive leverage because the asset is generating more income than the cost of the debt used to acquire it.

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What condition regarding the property’s return on assets and the interest rate on borrowed capital must be met to achieve positive leverage?