Financial Risk in Property Investments
The financial risk in property investing stems from the use of borrowed funds.
The use of borrowed funds may enhance the return on the equity capital that is used to acquire the property, in which case it is referred to as positive leverage, or it can have a negative effect on such a return, in which case it is referred to as negative leverage.
According to Greer and Farrell (1993) the use of borrowed funds enhances the return of an investment when the cost of these funds, that is the interest rate on the loan, is lower than the yield on the property that is acquired. The financial risk and the negative leverage of course stems in case that the yield on the property falls below the cost of borrowed capital.
The financial risk in the case of a property investment then is the prospect that the property will not produce enough net operating income to cover the required periodic mortgage payment, as well as that upon the resale of the property the price that will be achieved will not be sufficient to repay the remaining loan balance.
Financial risk may entail very serious losses on the part of the investor as the property may end up in foreclosure due to default in which case the investor will lose both the equity capital that was invested in the property and the property itself. Furthermore, in some countries, the investor may have further liability for any outstanding amount of the loan that is not recovered from the sale of the property depending on the provisions of the loan contract.
A useful means of evaluating the financial risk of the property is to calculate the required occupancy rate, under a pessimistic rent scenario, for breaking even (that is the level of net operating income required to cover the periodic mortgage payments) for different loan amounts. This way the investor can assess the risk in terms of required minimum performance of the property for the different loan amounts