How Affect Break Even Leverage in Property
Break Even Leverage (BEL) is defined by Pyhrr, Cooper, Wofford, Kapplin and Lapides (PCWKL hereafter)1 as the leverage at which the use of borrowed funds does not affect the investor’s return on equity, measured in a one-period framework as opposed to a multi-period discounted cash flow framework.
According to the PCWKL definition, BEL occurs when the return on total capital invested (ROI) for acquiring a particular property is equal to the mortgage constant (MC), which actually expresses the constant periodic payment that is required to repay a loan by the end of its term as a percentage of the total loan amount. Notice that the mortgage constant has nothing to do with the amount of the loan but only with the interest rate and the term of the loan.
Based on the above the condition for the break even leverage to take place is that:
Return on Investment = Mortgage Constant
The return on investment (ROI) can be calculated as:
ROI = Net Operating Income/Total Capital Invested
The mortgage constant (MC) can be calculated as:
MC = MR / [1-(1/(1+MR)n]
where MR is the mortage rate.
According to PCWKL when the return on investment is greater than the mortgage constant then borrowing magnifies the Return on Equity (ROE) of the property investments with ROE, defined again within a single-period and before-tax framework. Within this context ROE can be calculated as:
ROE = Before-Tax Cash Flow/ Equity Investment
This article discusses the concept and measurement of the break even leverage within the context of a multi-period and discounted cash-flow analysis framework.