The Principal Reasons to Use Debt

Use debt to increase returns, hedge risk, and increase diversification

To manage risk, use debt with low-risk investments and during the market downside

Here we consider the principal reasons to use debt as an asset management tool.

1. Increase the total return of individual assets

This is the most straightforward reason, straight out of basic real estate texts. Nevertheless, you need to meet two important conditions to produce the desired result. First, you need a positive spread between the cash-on-cash yield of the property and the mortgage constant. Second, you need the mortgage balance to be below the property value. During the down portion of the real estate cycle, the spread may disappear as cash flows fall or property values drop. Either case effectively reduces the total return of the leveraged portfolio (or worse, decreases one's wealth).

2. Hedge the downside risk of an investment

Use debt to hedge the downside risk of an investment. The use of the default option allows investors to use leverage as a stop loss, or hedging device. To illustrate: An investor holding an unleveraged asset at the top of the cycle has three options:

Hold the asset without adding debt, even though there is more downside risk than upside potential.
Sell the asset and harvest any increase in value since acquisition.
Place debt on the asset and partially harvest the value increase.

If investors choose to place debt on the asset, they gain a valuable option to default if the asset value falls below the mortgage balance. Note that there are serious consequences for defaulting, which you must consider before using this strategy.

The exercise of the "put" option hedges the loss. In addition, placement of debt to achieve a "partial sale" is much less costly than an outright sale. Upon recovery, the investor can participate in the recovery without having to rebuy the asset, avoiding search and acquisition costs. The use of debt in this fashion can be an excellent way to deliver superior returns to a market timing strategy.

3. Enhance the diversification role of real estate

Add debt to individual assets to enhance the diversification role of real estate in the portfolio. Here you use debt to "short-out" the debt-like behavior of real estate and more closely capture the equity-like behavior of real estate. Leverage improves the correlation relationships between real estate and stocks and bonds (it makes the correlations more negative—a good thing). The behavior of real estate becomes more exposed to the real estate cycle as you add leverage. This strategy is especially valuable for those who own real estate for its diversification benefits.

Managing risk

For all of these reasons, there is no question that adding debt makes the remaining flows to individual assets riskier (more volatile). But there is a very big "however"—you can add debt to a low-risk investment and boost the volatility to the same level as a different average-risk investment. Given positive leverage, increased return is the reward. This strategy can be used in the portfolio: add debt to the low-risk assets in a way that the risk of the portfolio does not rise above the desired level.

Also, debt applied at the bottom of the cycle (assuming one can time the cycle) is much less risky than debt applied at the top of the cycle. The existence of a well-developed short-term debt market allows one to use this product to enter and exit the debt markets efficiently and cost effectively to manage individual asset and portfolio risk.

The information here is adapted from Susan Hudson-Wilson, "Leverage in a Private Equity Real Estate Portfolio." Chapter 8 in Susan Hudson-Wilson (ed.), Modern Real Estate Portfolio Management (New Hope, PA: Frank Fabozzi Associates, 2000).