Leverage, risk and capital structure: insights from Modigliani–Miller
This page explains how leverage affects risk using the intuition behind the Modigliani–Miller (M&M) propositions. The focus is on what debt really does to risk, and why leverage does not create value on its own, even though it changes returns.
The examples apply these ideas to real estate in a practical, non-theoretical way.
The core M&M insight, stated plainly
Modigliani–Miller’s central insight can be summarised simply:
Debt does not make an investment safer or more valuable.
It only changes who bears the risk and how concentrated that risk is.
When you add leverage to a property:
- the property’s underlying risk does not disappear
- part of the cash flow is promised to lenders
- the remaining risk is pushed onto equity holders
Equity becomes riskier precisely because debt exists.
Capital structure does not change the property
M&M starts from a clean idea:
- the building produces cash flows
- financing does not change the building
- financing only changes how those cash flows are split
Whether a property is financed with:
- 100% equity, or
- 60% debt and 40% equity
…the total risk of the property stays the same.
What changes is how that risk is allocated.
Example 1: same property, different capital structures
Consider a property with uncertain cash flows.
Property assumptions
- Property value: £200,000
- Net rental income (before financing):
- good year: £14,000
- weak year: £6,000
- Holding period: ongoing
Case A: unleveraged (all equity)
| Item | Good year (£) | Weak year (£) |
|---|---|---|
| Rental income | 14,000 | 6,000 |
| Interest | 0 | 0 |
| Cash flow to equity | 14,000 | 6,000 |
Risk profile
- cash flow is volatile but always positive
- no default risk
- equity absorbs all variability gradually
Case B: leveraged capital structure
Financing
- Debt: £120,000
- Interest rate: 5%
- Annual interest: £6,000
- Equity: £80,000
| Item | Good year (£) | Weak year (£) |
|---|---|---|
| Rental income | 14,000 | 6,000 |
| Interest | (6,000) | (6,000) |
| Cash flow to equity | 8,000 | 0 |
Risk profile
- lenders receive stable cash flows
- equity absorbs all volatility
- downside risk is compressed into equity
This is exactly what M&M predicts: debt makes equity riskier.
M&M Proposition II: why equity becomes riskier with debt
M&M’s second proposition explains that as leverage increases:
- equity holders demand higher returns
- not because the property improved
- but because equity is now a residual claim
Debt holders are paid first. Equity gets what is left.
This is not a market inefficiency. It is a mechanical consequence of leverage.
Example 2: price risk and equity volatility
Now look at price movements instead of cash flow.
Assumptions
- Initial property value: £200,000
- Sale after 5 years
- Debt (if any): £120,000
Unleveraged outcome
| Sale price (£) | Equity value (£) | Equity gain / loss |
|---|---|---|
| 220,000 | 220,000 | +10% |
| 200,000 | 200,000 | 0% |
| 180,000 | 180,000 | –10% |
Equity moves one-for-one with property value.
Leveraged outcome
| Sale price (£) | Equity value (£) | Equity gain / loss |
|---|---|---|
| 220,000 | 100,000 | +25% |
| 200,000 | 80,000 | 0% |
| 180,000 | 60,000 | –25% |
The property risk is unchanged, but equity volatility is much higher.
This is M&M in action: leverage amplifies equity risk, not property risk.
Why leverage can look attractive (but is not free)
Leverage often appears attractive because:
- equity returns increase in good outcomes
- less capital is required upfront
But M&M shows this comes at a cost:
- higher probability of poor outcomes
- higher volatility of equity value
- higher chance of forced sale or distress
There is no free lunch. Higher expected equity returns are compensation for higher risk.
What M&M does not say (important in real estate)
In the real world, M&M assumptions are not perfect. Real estate has:
- taxes
- transaction costs
- refinancing risk
- illiquidity
These frictions can make moderate leverage sensible.
However, they do not invalidate the core insight:
Debt does not remove risk.
It redistributes and concentrates it.
Practical implications for real estate investors
M&M leads to several disciplined conclusions:
- leverage should not be justified by higher returns alone
- equity risk must be analysed explicitly
- stable assets tolerate leverage better than volatile ones
- if an investment only works with leverage, it is likely fragile
Key point to remember
Modigliani–Miller shows that capital structure is about risk allocation, not value creation.
Leverage does not make a property safer or better. It makes equity riskier, by design. If you understand that trade-off clearly, leverage becomes a deliberate choice rather than an illusion of higher returns.