What Is Leverage Risk?

What Is Leverage Risk?

Posted by on Sep 14, 2021

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Leverage allows investors to increase their exposure to a market, whether real estate, stocks, or commodities. If managed well, leverage can work in an investor’s favor. But some investors take on too much leverage. When the market goes against them, it amplifies the negative impact. In some extreme cases, an investor can be wiped out just from using too much leverage. Let’s see how leverage works and the risk it presents.

What Is Leverage?

Leverage is the use of debt or credit to acquire an asset without paying the full price. Some definitions define leverage as the use of debt to purchase more than you can afford. That isn’t always true. An investor may have enough cash to purchase an asset but chooses to supplement the purchase with debt rather than reduce/drain their cash reserves.

Leverage is commonly used in real estate. Taking out a mortgage/loan to purchase an investment property means using leverage. Leverage allows an investor to gain more exposure to the real estate market. 

If we analyze that last statement, it applies to those with little cash and a lot of cash. An investor who has little cash can’t gain much exposure (if any) to the market. Leverage allows them to gain exposure.

An investor who has enough cash to acquire an asset but chooses to use a mixture of debt and cash will have remaining cash left over. If the investor had used all of their cash to acquire the asset, they would have basically maxed out their market exposure. But since they still have cash, they can purchase more investment properties, increasing their exposure even more than if debt were not used.

Leverage is also used when trading stocks, where brokers extend investors a margin loan. For example, an investor wants to buy 100 shares of a $100 stock. That’s a total value of $10,000. The stock’s margin requirement is 30%. This means the investor’s equity in the position must not fall below 30% or $3,000 in this case. 

The investor puts in $5,000, and the remaining $5,000 becomes available as a margin loan. These loans do incur interest just like any other interest-bearing loan.

An investor with a $5,000 account can basically double their buying power and holdings by using leverage. However, This is an extremely risky situation.

Why Is Leverage Risky?

Leverage extends an investor’s exposure to a market and can also put them into a risky situation. This is particularly true for an investor who is purchasing more than they can afford. 

Going back to our $5,000 account that has $10,000 in buying power, what happens if the investor purchases $10,000 in stock and the value of their holdings move against them by 15%? That’s equal to an unrealized loss of $1,500, putting the total value of the position at $8,500. 

The $5,000 margin loan remains, leaving $3,500 (of the original $5,000) as investor equity. At this point, the investor has lost 30% of their equity in this position. Suppose the position drops by another $500, investor equity will hit $3,000 or 30%, the margin requirement. The investor will receive a margin call. They’ll have to sell some of the position to increase equity or deposit cash into their account.

What does this scenario look like in real estate? As an example, an investor purchases a $500,000 property with an 80% loan to value. That’s a $400,000 loan and $100,000 in cash (or perhaps funds provided by investors). If the house's value goes down by 5%, the home will be worth $475,000. 

Although the home value dropped by 5%, the investor’s investment (i.e., equity) drops by 25% (25,000 / 100,000). You didn’t think that was coming out of the bank’s loan amount, did you? Whatever happens to the value of the property, the loan amount must be paid in full. Just as in any capital stack, when the investment turns south, equity goes first.

If we compare the above example against an investor who is not over-leveraged, we'll see a drastic difference. Instead of only 20% down, the investor puts 80% into the property and takes out a 20% loan. The property drops by 5%. The investor’s return is -6.25% (25,000/400,000) vs. -25% in the previous example. 

What if an investor has income from their rental property — doesn't that help offset leverage risk? As long as debt is in the picture, there is still risk. If a property goes vacant, the investor is still on the hook for all of the related monthly expenses. If their business plan underestimates the vacancy rate, the investor may find that they cannot keep up with monthly expenses and debt payments.

While leverage is often talked about because of its ability to amplify positive returns, it cuts both ways, and investors can take significant losses with too much leverage.

 

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.

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