How Financing Changes Investment Returns: A Worked Example

The same property, bought two ways, producing two different returns and two different risk profiles.

Financing changes an investment's return in both directions, and the effect is larger than most investors expect. This example runs the same property through three structures to show how the return and the risk move together.

The situation

An investor is assessing a property at SAR 1,000,000 producing net rental income of SAR 55,000 per year, and comparing three funding structures.

Assumptions (illustrative)

• Property price: SAR 1,000,000.
• Net rental income after operating costs: SAR 55,000 per year.
• Structure A: fully funded from capital.
• Structure B: 50 per cent financed, assumed cost 5 per cent per year.
• Structure C: 75 per cent financed, assumed cost 5 per cent per year.
• Assumed property value change scenarios: plus 5 per cent, flat, and minus 5 per cent in a year.
• All figures are illustrative assumptions used to demonstrate the method.

Step 1: Structure A returns

SAR 55,000 on SAR 1,000,000 of capital equals 5.5 per cent, before any value change.

Simple and resilient. The entire return comes from income, and there is no obligation to service.

Step 2: Structure B returns

Financing cost SAR 25,000, leaving SAR 30,000 on SAR 500,000 of equity, equal to 6 per cent.

The return on your own capital improves because the property yields more than the financing costs.

Step 3: Structure C returns

Financing cost SAR 37,500, leaving SAR 17,500 on SAR 250,000 of equity, equal to 7 per cent.

Higher again, and the cash margin has fallen from SAR 55,000 to SAR 17,500, which is the part investors notice too late.

Step 4: Adding a 5 per cent value increase

A SAR 50,000 gain adds 5 per cent to Structure A, 10 per cent to Structure B and 20 per cent to Structure C on equity.

This is why financing is attractive in rising markets. The gain is measured against a smaller equity base.

Step 5: Adding a 5 per cent value decrease

A SAR 50,000 loss removes 5 per cent from Structure A, 10 per cent from Structure B and 20 per cent from Structure C.

The amplification works identically in reverse, which is the part that is understated when leverage is discussed.

Step 6: Adding three months of vacancy

Losing SAR 13,750 of income leaves Structure A at SAR 41,250, Structure B at SAR 16,250 and Structure C at SAR 3,750.

Under Structure C, an ordinary vacancy nearly eliminates the year's return. Under Structure A it remains comfortable.

What changes the answer

• If the financing cost exceeded the property yield, financing would reduce returns rather than improve them.
• Rate increases compress the financed structures directly and leave Structure A unaffected.
• Longer vacancy turns the highly financed structure negative while the unfinanced one remains positive.
• Transaction costs reduce all three and matter more when equity is thin.

What the numbers tell you

• Financing improves returns only while the property yields more than the finance costs.
• The same leverage amplifies losses exactly as it amplifies gains.
• Assess the structure against vacancy, since that is what tests it in practice.
• Choose the structure you could hold through a difficult year, not the one that performs best in a good one.

Limits of this example

Every figure above is an illustrative assumption used to show the method, not a quote, valuation or market rate. Costs, rates, fees and regulations change and must be confirmed with the relevant authority, lender or supplier before you commit.

If you are weighing a financing decision, Domira can review the offers, model the total cost and stress test the obligation with you before you sign anything.