Optimal Leverage Strategy: Capital Structure in Real Estate Investments

J. OF REAL ESTATE FINANCE AND ECONOMICS, Vol. 13 No. 2

Posted: 25 Apr 1997

See all articles by Roger E. Cannaday

Roger E. Cannaday

University of Illinois at Urbana-Champaign - Department of Finance

Tyler T. Yang

Federal Home Loan Mortgage Corporation (FHLMC) - Portfolio Management

Abstract

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

Cannaday, Roger E. and Yang, Tyler T., Optimal Leverage Strategy: Capital Structure in Real Estate Investments. J. OF REAL ESTATE FINANCE AND ECONOMICS, Vol. 13 No. 2. Available at SSRN: https://ssrn.com/abstract=9255

Roger E. Cannaday (Contact Author)

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
1206 South Sixth Street
Urbana, IL 61820
United States
217-333-2278 (Phone)
217-244-9867 (Fax)

Tyler T. Yang

Federal Home Loan Mortgage Corporation (FHLMC) - Portfolio Management ( email )

McLean, VA 22101
United States

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