Leverage in real estate investments: an optimization approach

Real estate investments are frequently leveraged. Leverage is an important tool for any real estate investor whose target return exceeds the expected return on core, unleveraged assets, since it can increase potential returns – although at the cost of increasing risk. It therefore competes with other means of raising risk and returns – in particular, buying riskier underlying investments – as a method of improving the performance of a portfolio. From a theoretical perspective, leverage should be preferred so long as the marginal increase in expected return per unit of extra risk from leverage exceeds that obtained from buying riskier assets. Since there are diminishing returns to leverage – primarily because costs rise as borrowing levels rise relative to value – this trade-off will become less attractive as leverage rises, leading to an equilibrium optimal level of leverage. If all investors face the same opportunity set, then, from a theoretical perspective, all investors should leverage core investments up to this level so long as their return target is at least as high as the returns generated at this equilibrium point – a conclusion that is out of line with current practice. Unfortunately, it is very difficult to measure this equilibrium point, since, while it is relatively straightforward to compute the increase in risks and returns deriving from leverage, rather little is known about the risk/return trade-off in real estate space. Copyright © 2008 John Wiley & Sons, Ltd.