Can and did Camera #2 - What is Leverage? - Indian Real Estate for Dummies

On a hot summer afternoon in Pune, India, refreshing sugarcane juice comes in a plastic glass thanks to this lever!

What is a Lever?

The word comes from the French lever, "to raise". A lever amplifies an input force to provide a greater output force, which is said to provide leverage. The ratio of the output force to the input force is the ideal mechanical advantage of the lever. Is that still stressing you? The image below should help.

What is Leverage then, in finance and real estate?

In finance, leverage is a general term for any technique to multiply gains and losses. Most often it involves buying more of an asset by using borrowed funds, with the belief that the income from the asset will be more than the payout for the cost of borrowing. Almost always this involves the risk that borrowing costs will be larger than the income from the asset causing a reduction in profits.

Really stupid examples to understand Leverage in Real Estate?

Okay, you can try and read through these;

1. Buy Rs. 1 lac worth of land with money out of pocket. Assets are INR 100,000 (INR 100,000 of land), there are no liabilities, and assets minus liabilities equals owners' equity. Accounting leverage is 1 to 1. The notional amount is INR 100,000 (INR 100,000 of land), there are no liabilities, and there is Rs. 1 lac of equity, so notional leverage is 1 to 1.

2. Borrow Rs. 1 lac (difficult, so lets keep it imaginary) and buy Rs. 2 lacs worth of land. Assets are INR 200,000, liabilities are INR 100,000 so accounting leverage is 2 to 1. The notional amount is Rs. 2 lacs and equity is Rs. 1 lac, so notional leverage is 2 to 1. The volatility of the position is twice the volatility of an unlevered position in the same assets, so economic leverage is 2 to 1.

How much leverage is cool?

If you are the guy with 1 lac in your pocket and someone agrees to give you another 10 lacs, it is not going to hurt you. So theoretically, your leverage could be anything. For example, in the Pune sugarcane machine, if that wooden lever the dude is pushing in circles around the cart was 1 kilometre long, you could probably crush anything between the rollers!

"Give me a place to stand and with a lever I will move the whole world." - Archimedes. So your problem is exactly the same. When you make a lever that large, you also need to a place to stand and move it.

So, can things get over leveraged?

Oh yes. In business and real estate, things went that way and caused a lot of mayhem in the recent past. With a huge amount of leverage and no place to stand and operate the lever, over leveraging can be a bit like this;