Key Takeaways
- Leverage is positive when the unlevered return exceeds the cost of debt, and negative when debt costs more than the property earns.
- The loss multiplier from leverage equals 1/(1-LTV): at 75% LTV, a 1% property decline creates a 4% equity decline.
- During the GFC, approximately $100 billion in U.S. commercial real estate loans became distressed, primarily due to excessive leverage.
- WACC balances the tax benefit of debt (interest deductibility) against the costs of financial distress at high leverage.
- Optimal leverage for real estate is typically 50–65% LTV, beyond which financial distress costs outweigh tax benefits.
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Test Your Knowledge
1.A property earns 7% unlevered return with 6.5% debt cost at 70% LTV (D/E = 2.33). What is the levered equity return?
2.At 80% LTV, what is the equity loss if property value declines 20%?
3.What typically happens to the cost of debt and required equity return as leverage increases?