Property investment: gearing and the equity rate of return

DOIhttps://doi.org/10.1108/JPIF-02-2019-0011
Pages323-328
Publication Date10 April 2019
AuthorNick French
SubjectProperty management & built environment,Real estate & property,Property valuation & finance
Property investment: gearing
and the equity rate of return
Nick French
Real Estate Valuation Theurgy, Frilsham, UK
Abstract
Purpose The purpose of this paper is to comment upon the relatively straightforward but often
misunderstood role of gearing (or leverage) on the potential equity return of a property investment.
Design/methodology/approach This education briefing is an explanation of the upside and downside
risk of borrowing (at different levels) to successful investment.
Findings The use of gearing can greatly enhance equity returns but at an increased risk.
Practical implications The process of borrowing at a bank rate below the return rate on an investment
project can increase the equity return of the project as long as all incomes and discount rate remain at
appropriate levels.
Originality/value This is a review of existing models.
Keywords Leverage, Bank debt, Equity rate of return, Gearing, Investment risk, Project rate of return
Paper type Technical paper
Risk comes from not knowing what you are doing (Warren Buffet, 1993[1]).
Introduction
All investments attempt to have positive returns. The greater the risk accepted by the
investor, the higher the expected return. However, it is only with hindsight and a knowledge
of the cash flow received over time, that an investor can say that positive returns
were achieved:
Investment is the giving up on a capital sum now, in exchange for benefits to be received in the
future, such as an income flow and/or capital gain (Enever, 2009).
This briefing looks relationship between equity returns and project returns and the impact,
good and bad, on each when the investor uses debt to purchase an investment. It is a very
straightforward relationship (albeit it can be dressed up as complex financial vehicles). Debt
increases the amount of money that an investor can invest and, as long as that debt is
serviced and returned, it can increase the return on the investors own equity. It is a
technique used extensively in property development and investment and is referred to as
gearingor leverage[2]. The use of debt increases the RoE as long as the debt rate is lower
than the project return and cash flows are received as expected. In other words for every£1
invested, the unit return is higher with a balanced debt portfolio than the return if there was
no borrowing. The term comes from the physical world as gearson (say) a bike increases
the wheel revolution relative to the pedal revolution.
Oddly, for such a simple concept, it is one of the least understood by students. For that
reason, the example below is deliberately simple to illustrate the impact of gearing on a very
simple real estate investment.
Return on equity (RoE)
In finance, equity is the term given to an investors own money whereas debt is the term for
money borrowed. In all investment types, the RoE is a measure of the net return on an
investment relative to the equity invested. If there is no debt involved, then the RoE is the
same as the project return.
Journal of Property Investment &
Finance
Vol. 37 No. 3, 2019
pp. 323-328
© Emerald PublishingLimited
1463-578X
DOI 10.1108/JPIF-02-2019-0011
Received 4 February 2019
Accepted 4 February 2019
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1463-578X.htm
323
Property
investment

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