Academic journal article Journal of Real Estate Portfolio Management

Leverage: Please Use Responsibly

Academic journal article Journal of Real Estate Portfolio Management

Leverage: Please Use Responsibly

Article excerpt

Executive Summary.

During the recent economic downturn, investors have been confronted with the negative impact of leverage. Consequently, investors now question loan-to-value (LTV) levels in their funds. Until recently, percentages around 50%-65% were common but never based on in-depth research or optimization. This paper examines the benefit of leverage using a simulation model to account for a multitude of scenarios and shows that portfolios with up to 40% LTV are still efficient. More leverage is likely to decrease return expectations. The reasons behind this conclusion are threefold: the disproportionately high cost of distress, asymmetric performance fees, and the impact of incremental interest rates.

(ProQuest: ... denotes formulae omitted.)

Over the last thirty years, liquidity increased substantially and as a result, usage of debt took a serious flight, with a peak in the years 2005-2007. The impact on highly leveraged real estate funds has been well-publicized. Billions of dollars worth of real estate were handed over to banks, as equity diminished. While many investors were very keen on highly leveraged vehicles before the crisis, now many investors seem to be reluctant to take too much, if any, leverage.

Overall, this seems to demonstrate that sentiment has a very strong influence on the amount of leverage and that not many investors have a longterm leverage policy in place. In fact, the topic is rather complex and probably not fully understood. Literature provides some guidance on the use of debt, although there is not yet a clear practical guide on the ideal amount of leverage. Important is the widely-accepted theory of Modigliani and Miller (MM) (1958), which proves that a different financial structure for a company does not result in a different company value, unless leverage provides some tax benefits. In other words, without tax benefits leverage does not add extra value to a real estate portfolio. Boyd, Ziobrowski, Ziobrowski, and Cheng (BZZC) (1998) analyzed the impact of using leverage in a mixed-asset portfolio and their results clearly supported the MM findings. They concluded that for non-taxable investors, leveraging real estate caused a decline in mixed-asset portfolio efficiency. More precisely, for non-taxable investors the allocation towards real estate declined when leverage increased, so their advice to those investors was to avoid leverage. For taxable investors, however, the allocation initially increased, before declining again. This implied the existence of an optimum, which they concluded was somewhere between 20% and 75%. This optimum was theoretically proven by Cannaday and Yang (1996), McDonald (1999), and others. They showed that the optimal loan-to-value (LTV) ratio increases as the marginal tax rate of the investor increases.

Anson and Hudson- Wilson (2003) list six reasons why leverage could or even should be used. They provide a clear overview of all advantages and disadvantages, although some conclusions are debatable. They argue, for instance, that the most productive usage of leverage is the stop-loss quality during a downturn. Of course leverage will limit the absolute loss, but unfortunately the probability that one will lose 100% of their investment also increases. It will therefore only work as a stop-loss if the remaining capital is held in cash, which is rather unlikely for institutional investors. Another interesting conclusion they draw is that diversification benefits of real estate are strengthened when using leverage. While Anson and HudsonWilson do not provide any empirical evidence in support of their conclusion, the opposite was clearly proven in BZZC and Hoorenman and van der Spek (2008). In these studies higher leverage resulted in a lower allocation towards real estate in a mixed-asset portfolio.

Finally, Tyrell and Bostwick (2005) conclude, using a theoretical approach, that there should be an optimal level of leverage. …

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