Financial Leverage & Real Estate

A primary concern in the determination of the optimal capital structure for a commercial real estate investment is the effect that financial leverage (the debt/equity ratio) will have on the risk associated with the investment in the commercial property. Financial leverage (within the context of commercial real estate investment) is the ratio of (a) fixed-interest debt on the commercial property to (b) the investor's equity in the commercial property plus (c) fixed-interest debt on the commercial property. Fixed-interest debt refers to long-term debt that with a maturity longer than one-year. This long-term debt may be in the form of (a) a mortgage on the commercial property, (b) a note owed by the purchaser to the seller of the commercial property, or (c) any other financial instrument against which the purchaser pledged to commercial property as collateral to obtain funds (Hudson-Wilson and Elbaum 94-95).

Thus, the higher the financial leverage ratio, the greater the commercial property is said to be financially leveraged, and vice versa. Another way of saying the same thing is that the more outside money is being used by an investor in commercial real estate for long-term capital to fund the acquisition and/or retention of the commercial property, the greater that commercial property is financially leveraged (Elgonemy 9).

Return on investment objectives more often than not are based on a return on total ca