Property Leverage

A

Remember that, in real estate, the use of debt financing to purchase a piece of property will affect its risk-return parameters.

The correct answer to the question is A. Positive leverage.

Positive leverage refers to a situation where the return on a property exceeds its debt cost, leading to an increase in the investor's overall return. In other words, it is a condition where the use of borrowed funds (debt financing) in a real estate investment results in a higher rate of return than what could have been achieved through an all-cash investment.

When an investor purchases a property using debt, such as a mortgage or a loan, they are leveraging their investment by using other people's money. The investor's own equity investment is typically a fraction of the total property value, while the remaining amount is financed through debt. As a result, the investor's return is based on the entire property value, not just their own equity.

Positive leverage can enhance the investor's return in two ways:

1. Amplified Income: By using borrowed funds, the investor can acquire a larger property or invest in multiple properties, which can generate higher rental income or cash flow. The rental income received from tenants contributes to covering the property's operating expenses, debt payments, and generating a positive cash flow. The excess of the property's return over the debt cost contributes to the investor's increased return.

2. Leveraged Appreciation: When the property value increases over time, the investor benefits from the appreciation on the total property value, not just their own equity. This is known as leveraged appreciation. The investor's initial equity investment acts as a down payment, and any increase in property value is proportionally magnified due to the leverage provided by the borrowed funds.

It is important to note that while positive leverage can enhance returns when the property performs well, it also amplifies losses when the property's return is lower than its debt cost. In such cases, the investor may experience negative leverage, also known as unfavorable leverage, which is the opposite of positive leverage. However, in the given question, the focus is on the scenario where the property's return is in excess of its debt cost, leading to an increased return for the investor, hence the answer is positive leverage (option A).