Leverage: what it adds and what it costs

Leverage is the most misunderstood idea in property. It is not a source of return. It is a multiplier applied to whatever return the asset produces, including a negative one.

The arithmetic

Suppose an asset costs one million and you put in five hundred thousand, borrowing the rest. If the asset rises ten percent it is worth one million one hundred thousand; after repaying the loan you hold six hundred thousand, so your money grew twenty percent. Now run it the other way. A ten percent fall leaves the asset at nine hundred thousand, and after the loan you hold four hundred thousand — a twenty percent loss. Same asset, same event, doubled in both directions.

The costs that example leaves out

Interest is paid whether or not the asset performs, and it is paid before you receive anything. On a variable loan a rate change alters your cost without altering the asset. Amortisation consumes cash that would otherwise be distributed. And a lender's terms can force a sale at the worst possible moment, which is the failure mode that turns a paper loss into a realised one.

Leverage and liquidity are the same conversation

A borrowed position has less room to absorb a bad year. If rent stops and interest does not, the shortfall has to come from somewhere. This is why reserves matter more on a levered asset, and why the size of the reserve deserves as much attention as the size of the loan.

Pooled capital is a different kind of leverage

There is a second sense of the word that involves no debt at all: a group acting together can negotiate terms and reach assets that none of its members could reach alone. That kind of leverage does not amplify losses. The two meanings are worth keeping apart, because marketing tends to blur them.

How to read a levered opportunity

Ask for the loan-to-value, the interest rate and whether it is fixed, the amortisation schedule, the covenants, and what happens at refinancing. Then re-run the downside case with the loan in place. If a modest fall in value wipes out the equity, you have learned something the headline return did not tell you.