Effects of Financial Leverage

B

Remember that, in real estate, the use of debt financing to purchase a piece of property will affect its risk-return parameters. In this case, leverage has a negative effect.

Based on the given information, we are provided with two scenarios:

1. Return on Investor's Equity with 80% Financing = -75%
2. Return on Investor's Equity with 0% Financing = -15%

To analyze the effect of financing on the investor's equity return, we need to compare the return on equity (ROE) under different financing conditions.

ROE is calculated as the net income divided by the average shareholders' equity. It represents the return generated by the company for its shareholders.

In the first scenario, with 80% financing, the investor's equity return is -75%. This means that the investor's equity has experienced a significant loss, exceeding the amount of capital invested. A negative ROE suggests that the net income generated by the investment is insufficient to cover the cost of financing.

In the second scenario, with 0% financing (indicating that the investment is fully equity-financed), the investor's equity return is -15%. Although still negative, the return is less severe compared to the first scenario.

Comparing the two scenarios, we observe that the return on equity worsens when the investment is financed with 80% debt (in the first scenario) compared to when it is fully equity-financed (in the second scenario). This indicates that the financing structure has a negative impact on the investor's equity return.

Based on this analysis, we can conclude that the investor is experiencing the effects of negative leverage. Negative leverage refers to a situation where the use of debt financing results in a lower return on equity than if the investment were fully equity-financed. In other words, the presence of debt magnifies the losses and reduces the investor's equity return.

Therefore, the correct answer is B. negative leverage.