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Using Financial Leverage in Commercial Real Estate

This paper provides a review of the role of financial leverage and risk analysis in commercial real estate investment. The effect of debt/equity ratio on risks associated with investment in commercial property.

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using financial leverage in purchasing commercial real estate A primary concern in the determination of the optimal capitalstructure for a commercial real estate investment is the effect thatfinancial leverage the debt equity ratio will have on the risk associatedwith the investment in the commercial property Financial leverage withinthe context of commercial real estate investment is the ratio of a fixed-interest debt on the commercial property to b the investor's equity inthe commercial property plus c fixed-interest debt on the commercialproperty Fixed-interest debt

In the context of events, however, this definition of riskremains quite broad. "The Termination of Commercial Mortgage Contracts Through Prepayment and Default: A Proportional Hazard Approach with Competing Risks". Fixed-interest debt refers to long-term debt - that with amaturity longer than one-year. R. Real Estate Issues 25 (Winter 2 ), 26-38.Schneyer, K. Depending on the severity of a cash flow or profitdeterioration, a highly financially leveraged position in a commercialproperty may cause a commercial real estate investor to become illiquid (orat least illiquid in relation to a specific commercial property). There are both advantages and disadvantages to high financial leveragein commercial real estate investing. In one sense, risk is considered to be a measure of uncertainty. Should such a perception becomewidely accepted, (a) the commercial real estate investor will usually berequired to pay a higher rate of interest on any new debt (Ciochetti, Deng,Gao, and Yao 6 2) and (b) the market value of the investor's equity in acommercial property may deteriorate. Cornell Hotel & Restaurant Administration Quarterly 43 (June 2 2), 7-21.Riggs, K. P., Jr., Marling, J. Journal of Portfolio Management 21 (Spring 1995), 92-99.Elgonemy, A. Risk analysis, ina basic context, is a process for evaluating the probability of alternativeoutcomes in relation to a proposed investment (Riggs, Marling, and Harms 3 -31). This concept is valid, and, certainly, risk inwhatever operation must be minimized by investors. Appraisal Journal 62 (July 1994), 353-357. L. While the level of cash flow orprofits on the commercial property may deteriorate, the fixed-interest debtcharges do not. One of the tools available to commercial real estate investors to aidin decision-making related to the appropriate level of financial leveragefor a commercial property, as well as decisions on other issues involvinginvestment in commercial real estate, is risk analysis. Return on investment objectives more often than not are based on areturn on total capital. S., Jr. Inthis broad context, everything that is done by a commercial real estateinvestor involves risk. To earn such a return,however, it is necessary that the earnings rate on the borrowed capitalexceed the commercial real estate investor's pre-borrowing cost of thecapital (Dilmore and Wilson 537). R. using financial leverage in purchasing commercial real estate A primary concern in the determination of the optimal capitalstructure for a commercial real estate investment is the effect thatfinancial leverage (the debt/equity ratio) will have on the risk associatedwith the investment in the commercial property. Real Estate Economics 3 (Winter 2 2), 595-633.Dilmore, G., and Wilson, A. "Diversification Benefits for Investors in Real Estate". A better definition of risk for a commercial realestate investor in relation to financial leverage includes the followingelements: (a) the possibility of an adverse outcome to an event; (b) thepossibility of a real and recognizable loss, as opposed to a failure tomaximize opportunities; and (c) the possibility of a real and recognizableloss, wherein some portion of the risk of such loss may be able to beshifted to another party (when some portion of a risk is shifted to anotherparty, the shifting party bears some proportion of any loss). "The Culture of Risk: Deconstructing Mutual Mistake. Therefore, if two commercial properties withcomparable equity investments earn the same percentage return on totalcapital, the higher financially leveraged property will have greaterearnings than will the lower leveraged firm. Works CitedCiochetti, B. Borrowing funds fromlending institutions, generating funds from investment syndicates, andsecuring seller financing are all effective means for commercial realestate investors to attain financial leverage on a commercial property. A primary advantage, of course, isthat high financial leverage permits a commercial real estate investor, soto speak, to operate on someone else's money. Appraisal Journal 6 (October 1992), 532-548.Hudson-Wilson, S., and Elbaum, B. A., Deng, Y., Gao, B., and Yao, R. This long-term debt may be in the form of(a) a mortgage on the commercial property, (b) a note owed by the purchaserto the seller of the commercial property, or (c) any other financialinstrument against which the purchaser pledged to commercial property ascollateral to obtain funds (Hudson-Wilson and Elbaum 94-95). W. L. "Real Estate Valuation and Finance in the 199 s". The concept of risk isnarrowed somewhat by the definition holding that risk is the possibility ofan adverse outcome to an event. This definition places the concept of riskmore closely in the context of the risks that a commercial real estateinvestor will attempt to avoid in relation to financial leverage (Schneyer429-43 ). "Investment Return and Risk". Commercial real estate investors use financial leverage to optimizetheir potential for returns on their investments. In finance, the process iscalled trading on the equity (Hudson-Wilson and Elbaum 94-95). Risk analysis facilitates(a) the identification of potential events that may become crises, (b) thelikely effects on the investment of such events, and (c) the magnitude ofthe impact on the investment of the effects of such events (Willison 355). H., Jr., and Harms, R. A seconddisadvantage of high financial leverage is that such a position may causebankers and other potential sources of funds to perceive a greater riskassociated with the investor's assets. Thus, the higher the financial leverage ratio, the greater thecommercial property is said to be financially leveraged, and vice versa.Another way of saying the same thing is that the more outside money isbeing used by an investor in commercial real estate for long-term capitalto fund the acquisition and/or retention of the commercial property, thegreater that commercial property is financially leveraged (Elgonemy 9). At noted earlier,financial leverage is based on fixed-interest debt. Fixed-interest debtcarries with it fixed-interest charges. "Property Level Performance Measurement". Risk analysis is an essential element in risk management planning fora proposed commercial real estate investment. Financial leverage (withinthe context of commercial real estate investment) is the ratio of (a) fixed-interest debt on the commercial property to (b) the investor's equity inthe commercial property plus (c) fixed-interest debt on the commercialproperty. Financial leverage may be severely detrimental to a commercial realestate investor in a situation where cash flow or profitability on thecommercial property, for whatever reason, deteriorates. American Business Law Journal 34 (Spring 1997), 429-453.Willison, D. "Debt-Financing Alternatives Refinancing and Restructuring in the Lodging Industry".

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