React: Debt always enhances the returns on equity because the borrowing rate is lower than the...

React: Debt always enhances the returns on equity because the borrowing rate is lower than the cash yield and properties go up in value.

Expert Solution

The theory that Debt always enhances the return on equity is valid only when the expected returns are greater than the cost of debt. Hence, when your cost of debt is lower than the expected return, a positive financial leverage is set to exist. So the higher the positive financial leverage is, the higher benefit you would achieve on return on equity

Also, Debt has the following advantages which enables a company to boost its return on equity
1. Allow you to put in a lower upfront equity, thereby enabling you to acquire or build a property even with lower available equity
2. Debt provides a tax shield on the interest portion of the borrowing, thereby increasing the available cash flow
3. Increases your return on equity when a positive financial leverage exists

Cash Yield: Generally cash yield is calculated as the ratio of free cash flow from the property divided by the equity investment.

Cash Yield = ((Gross Rent received + Other income) - (Operating expenses + Annual Repayment along with Interest))/Total equity invested

So, the returns on cash yield depends on the annual rent received and also the borrowing cost. A high borrowing cost would mean the annual free cash flow would be lower, and hence a lower cash yield

So, it is not always true that the cash yield is always greater than the borrowing cost. Also appreciation is property value depends on many factors including location, inflation, economic growth, interest rates and demographics. Hence we just cannot predict the appreciation in property prices. But generally given time, property prices appreciate but we cannot just measure the appreciation accurately

So the statement that borrowing rate is lower than cash yield and property prices go up in value, is not entirely true. It might be true in some cases, but can't be accepted universally.

So the basic thing is, Debt always enhances the returns on equity if the cost of debt is lower than the expected returns/return on equity

jeff jeffy answered 4 months ago

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