The Power of Leverage
(and the risk of leverage!)
Leverage (the use of debt) increases your return but also increases risk. Why? Let’s explore both.
Increased Return
Return without Leverage
A homebuilder plans to build a home and it costs $1.0 million to build. One year later, it is complete and he is able to sell it for $1.1 million. If he did not borrow any money to finance the cost to build the home, then he effectively used his own equity to build the home. His equity grew by $100,000 or 10% (ignoring taxes).
Return with Leverage
Instead of building one home with the homebuilder’s $1 million, let’s now assume he can build five $1 million homes by using $200,000 of his own money and borrowing $800,000 for each home. In this scenario, the home builder has $1 million of equity (5 x $200,000) and $4 million of debt (5 x $800,000) on five homes which cost $1 million each to build for a total of $5 million.
Let’s assume the cost of debt is 5% and for simplicity, it is an interest-only loan.
Again, the homes can be sold for $1.1 million for a return on the asset of 10%. The homebuilder’s total investment grows from $5.0 million to $5.5 million. Now let’s pay off the debt and interest with proceeds from the sale of all the homes ($5.5 million, ignoring taxes). The debt is $4.0 million and the interest is 5% of $4.0 million or $200,000 for a total of $4.2 million. Once he pays off the loans with interest, what’s left is the homebuilder’s equity of $1.3 million, an additional $300,000
With leverage, he grew his $1.0 million of equity to $1.3 million and thus earned a return on his equity investment of 30%. He now has an additional $300,000 in equity. That is the power of leverage.
Amount of Leverage Determines Return on Equity
The equity return will vary depending on the amount of leverage you use and can be determined using the following formula:
Where Re is the expected return on your equity, Ra is the expected return on the unlevered asset (the houses), D/E is the ratio of debt to equity ($800,000 to $200,000 or 4:1), and Rd is the cost of debt.
If we used equal parts debt and equity where D/E = 1/1, then Re is 15%. Still a greater return than all equity. When D = 0, ie an all-equity investment, then Re = Ra. And conversely, the more debt, the higher the expected return and thus greater risk.
It follows that a higher return is expected when you use leverage because there is increased risk. What is the risk?