The leverage effect describes, for example, the increase in the return on equity through borrowing. In the case of leveraged property purchase, there is currently the opportunity to achieve an enormous increase in the return on equity with the leverage effect. With a normal return of 3 % on real estate, a 90 % increase in the total return can be achieved many times over if the purchase of real estate is financed by a 90 % interest on the debt capital of 1 %. If you have the opportunity to agree on 100% or even more debt financing by offering collateral that corresponds in value, for example, to 10% of the acquisition cost, then the leverage effect is actually enormous, because the return on equity grows immeasurably if there is no equity. In addition, interest rates also help to reduce taxes because they are tax deductible.

Anyone who invests capital wants to generate a return. The more return you get, the better. And the more capital you spend to get the return, the higher the return. So the next logical conclusion is that in addition to the available equity, one should possibly also use debt to increase the return. Clearly, debt financing causes costs that have to be deducted from the return in order to determine the actual extent of the return. However, if the costs remain low in relation to the return, then it is worth taking out a loan. However, if you want to know to what extent the actual return is incurred, you have to put the after deduction of all expenses in the ratio to the invested equity. Thus, the return on equity is an important reference point with which the so-called leverage effect in economics is linked. The leverage effect is, in a sense, an instrument for increasing the economic efficiency of equity capital.

Now that we have already made some considerations about the leverage effect, we should also add a general explanation of the term.

Similar to leverage in physics, the leverage effect in economics generally describes all processes in which relatively small adjustments to variables lead to significant changes in the final result. There is the leverage effect in very different areas. Be it in the capital structure of companies, the optimization of costs or completely different economic contexts, the leverage effect meets us at every turn. As an example from everyday life, you can look at the use of lock offers, where you buy three items for the price of two. With the leverage effect, you can determine much more than just the return on equity, you can optimize it.

You have to know how to use the leverage effect advantageously. To demonstrate this, we present a calculation example as part of a fictitious real estate purchase. Here we want to look at what return you can expect if you buy real estate on the one hand with equity and on the other hand with a loan-based debt capital share.

So let’s say we plan to invest in real estate. This sounds quite good, because currently you can expect a solid return of 3%. However, we only have EUR 500,000 at our disposal. Nevertheless, we succeed in acquiring a property that yields the hoped-for return of 3%. The annual return is therefore EUR 15,000. And since the return is completely based on the acquisition by equity, the return on equity is also 3 % in this case. In other words, equity yields a 3% return.

Let’s now assume that in our search for a real estate property, we find a property that also brings 3% in return, but costs EUR 5,000,000. Of course, we only have equity capital that is 10% of the acquisition cost. But the capital market is currently characterized by particularly low interest rates. So before we look for a property that matches our own equity for a long time, we could also take out a loan that contributes the remaining 90% of the acquisition costs. Because with an equity compartment of 10 %, it should probably be much easier to obtain such a loan. An interest rate of 1 % should also be realistic.

Said, done. The return is now EUR 150,000. Of this, we deduct the interest of EUR 45,000 in this case. Consequently, EUR 105,000 remains as a return. Despite the interest on the loan, this is significantly more than the return we would achieve if we had bought a property only with our own equity. In terms of equity, the situation is even more positive. Because here we expect a ratio of EUR 105,000 to EUR 500,000. This results in a fantastic return on equity of 21 %. And if you compare the yield amounts, namely EUR 15,000 to EUR 105,000, then you see an increase with a factor of more than 7. The leverage effect is clearly visible.

An alternative scenario: if we want to limit the acquisition costs for the property to EUR 500,000, but only want to spend a tenth of the equity, then we come to the following calculation example. The loan is therefore EUR 450,000. The interest rate should continue to be 1% on this. Of course, the return should also be 3%, so that we can again expect revenue of EUR 15,000. This time, however, we deduct the interest of 4,500, leaving a yield of EUR 10,500. Let us now calculate again how high our return on equity is in this case: 100 x EUR 10.500 / EUR 50,000 = 21%.

And here, too, you can see that adjusting a variable, namely the leverage ratio, triggers a leverage effect. So instead of only generating a return of 3%, debt financing brings us a seven-fold higher return on equity.

But what we can also see from the examples is that the return on equity also depends on the actual amount of the loan. Thus, the share of equity capital is also decisive. If you manage to raise the financing completely without equity, then the leverage effect is of course even greater. Because if the return on equity tends towards infinity in the absence of equity, this is of course an expression of an immeasurably large leverage effect.

But how can you set up financing only on the basis of external capital? In the past, when interest rates on loans were well above today’s level, credit institutions expected an equity participation of at least 50 % when financing the purchase of a property. But with falling interest rates, the willingness to grant loans increased more risk-taking. Even today, a certain share of equity is still a good basis for an agreement when negotiating a loan to buy a property. But if you can offer other collateral instead of providing equity, then even a 100% debt financing is within reach. Therefore, an optimal leverage effect through a fully leveraged purchase of a property is nowadays quite realistic.

If we consider the leverage effect in connection with the purchase of real estate for return, then we should also briefly address the tax specifics here. Because the interest you pay on the loan is tax relevant, because you can deduct it from the taxable amount. So while you would have to tax EUR 5,000 on a taxable return of, for example, EUR 15,000 after deduction of a basic allowance of about EUR 10,000, with a deduction of EUR 4,500 in interest for a taxation only an amount of EUR 500 remains. Admittedly, with higher returns, the tax advantage is significantly lower, but it is still noticeable. Therefore, the leverage effect of buying real estate for returns should always be considered in combination with the tax deductibility of interest on the debt.