Optimal Leverage Strategy: Capital Structure in Real Estate Investments
J. OF REAL ESTATE FINANCE AND ECONOMICS, Vol. 13 No. 2
Posted: 25 Apr 1997
This paper examines the optimal leverage strategy for real estate investors who are investing in income-producing properties. Within a discounted cash flow context, the investment objective for the equity investor is to maximize the contribution to net present value of using mortgage financing. Utilizing more debt decreases the required equity investment and increases the size of the tax shelter. On the other hand, as the loan-to-value ratio increases, the interest rate charged by the lender increases, which indicates a higher cost of debt. This paper goes beyond the simple conventional wisdom that debt financing should be used when financial leverage is positive by developing an equation that allows one to determine the optimal level of debt financing to use when positive leverage is possible. The optimal loan-to-value ratio is found to be a function of the investor's characteristics. Several hypotheses about the relationships between such an optimal loan-to-value ratio and the investor's characteristics are derived.
JEL Classification: R19
Suggested Citation: Suggested Citation