Effect of leverage on returns in real estate investments
This page explains how leverage affects returns over a multi-year holding period. The worked examples show two contrasting cases:
- where the property return equals the cost of debt
- where the property return is higher than the cost of debt
The numbers make clear when leverage helps and when it merely increases risk without improving returns.
Common assumptions used in both examples
To isolate the effect of leverage, both examples use the same base property.
Property assumptions
- Purchase price: £200,000
- Holding period: 5 years
- Net rental income (before financing): £10,000 per year
- Sale price after 5 years: £200,000 (no capital gain)
Financing assumptions
- Loan-to-value (LTV): 60%
- Loan amount: £120,000
- Equity invested: £80,000
- Interest-only loan
- Interest paid annually
Property return before leverage
Over 5 years, the property produces:
| Component | Amount (£) |
|---|---|
| Total rental income (5 × £10,000) | 50,000 |
| Capital gain | 0 |
| Total property return | 50,000 |
Unleveraged return:
- £50,000 ÷ £200,000 = 25% total
- Equivalent to 5% per year
This 5% is the underlying return generated by the property itself.
Example 1: property return equals cost of debt
In this example, the interest rate on debt is 5%, equal to the property return.
Financing cost over 5 years
| Item | Amount (£) |
|---|---|
| Annual interest (5% × £120,000) | 6,000 |
| Total interest over 5 years | 30,000 |
Cash flows to equity
| Component | Amount (£) |
|---|---|
| Rental income | 50,000 |
| Interest paid | (30,000) |
| Net cash flow to equity | 20,000 |
Equity position on sale
| Item | Amount (£) |
|---|---|
| Sale price | 200,000 |
| Loan repayment | (120,000) |
| Equity on sale | 80,000 |
| Initial equity | (80,000) |
| Capital gain / (loss) | 0 |
Total return to equity
| Component | Amount (£) |
|---|---|
| Net cash flow | 20,000 |
| Capital gain | 0 |
| Total profit | 20,000 |
Return on equity
- £20,000 ÷ £80,000 = 25% total
- Equivalent to 5% per year
What this shows
When the property return equals the cost of debt:
- leverage does not increase returns
- equity return matches the unleveraged return
- risk increases without additional reward
Leverage is neutral in return terms but not in risk terms.
Example 2: property return higher than cost of debt
Now assume the property return remains 5%, but the interest rate on debt falls to 3%.
Financing cost over 5 years
| Item | Amount (£) |
|---|---|
| Annual interest (3% × £120,000) | 3,600 |
| Total interest over 5 years | 18,000 |
Cash flows to equity
| Component | Amount (£) |
|---|---|
| Rental income | 50,000 |
| Interest paid | (18,000) |
| Net cash flow to equity | 32,000 |
Equity position on sale
Unchanged from the previous example.
| Item | Amount (£) |
|---|---|
| Equity on sale | 80,000 |
| Initial equity | (80,000) |
| Capital gain / (loss) | 0 |
Total return to equity
| Component | Amount (£) |
|---|---|
| Net cash flow | 32,000 |
| Capital gain | 0 |
| Total profit | 32,000 |
Return on equity
- £32,000 ÷ £80,000 = 40% total
- Equivalent to 8% per year
What this shows
When the property return is higher than the cost of debt:
- leverage increases return on equity
- the spread between property return and interest rate accrues to the investor
- lower equity magnifies the benefit
This is positive leverage.
Side-by-side comparison
| Case | Cost of debt | Equity return (total) | Equity return (annual) |
|---|---|---|---|
| Unleveraged | – | 25% | 5% |
| Leveraged (debt = return) | 5% | 25% | 5% |
| Leveraged (debt < return) | 3% | 40% | 8% |
Practical implications
These examples show that leverage only improves returns when:
- the property return exceeds the cost of debt by a clear margin
- that margin is stable over time
If the spread disappears due to rising interest rates or falling income, leverage quickly becomes a drag on returns.
Key point to remember
Leverage is not a strategy by itself.
It is a multiplier. When the return on the property exceeds the cost of debt, it works in your favour. When it does not, leverage adds risk without improving outcomes.