In principle the leverage effect can work to the advantage as well as to the disadvantage of investors. Applied to real estate investments, however, the term usually serves to describe a positive effect for investors: When purchasing a property, the term leverage effect is usually used when a loan makes it possible to finance a property, the value of which will rise significantly in the near future, with a comparatively low equity share.
How high the percentage return on equity can turn out to be depends on two factors – the available debt capital and the increase in the value of the property. The more pronounced these two factors are, the greater the leverage effect of the debt capital. For example, if a buyer invests equity of 1,000,000 euros to purchase a luxury apartment that increases in value by 50,000 euros in subsequent years, this means a return of only 5 percent. However, if the same buyer acquires the same luxury property with the help of a loan of 800,000 euros, the calculation changes drastically: Thanks to the leverage effect in real estate financing, there is now an increase in value of 50,000 euros for 200,000 euros of equity – which means an impressive 25 percent return.
The leverage effect is particularly pronounced when we look at real estate transactions in the luxury segment, as exquisitely appointed properties – especially luxury apartments and city villas in sought-after urban locations – can be relied on to appreciate in value in the face of enormous demand and low supply. This is the reason why credit institutions also consider luxury properties to be particularly stable investments and often grant extensive loans for the purchase of these residential units to interested parties with the corresponding financial means.
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Breuer, Wolfgang/Breuer, Claudia: Leverage-Effekt. In: Gabler Wirtschaftslexikon. The version of the article cited here was last revised on 15.02.2018 at 15:02.