Leverage in a Bad Year: A Worked Example of What Debt Does to Risk

A side-by-side calculation of the same Saudi building bought with and without debt, showing what leverage adds in a normal year and removes in a poor one.

Leverage raises the return on your own capital while income holds and reduces it faster than the income falls when it does not. The arithmetic is simple and the consequence is not intuitive, because the same asset can look modestly better with debt in a normal year and dramatically worse in a weak one. This illustrative comparison runs both cases on one building.

The situation

An investor is assessing a let building priced at SAR 10,000,000 and is deciding whether to buy it outright or with a facility covering 60 per cent of the price. They want to see what debt does in the base case, in a year of lower income, and to the value of their equity if market pricing softens at the same time.

Assumptions (illustrative)

• Purchase price SAR 10,000,000, with acquisition costs assumed at SAR 700,000.
• Net operating income assumed at SAR 750,000 in a normal year.
• Case A: no debt, so equity committed is SAR 10,700,000.
• Case B: debt of SAR 6,000,000, so equity committed is SAR 4,700,000.
• Assumed all-in cost of debt of 6.5 per cent on an interest-only basis, giving annual service of SAR 390,000.
• A weak year is modelled as net operating income 25 per cent lower, at SAR 562,500.

Step 1: Cash return in a normal year without debt

SAR 750,000 divided by SAR 10,700,000 equals about 7.0 per cent.

This is the asset return before any financing decision. It describes the building and nothing else, which is why it is the right starting point for comparing one property against another.

Step 2: Cash return in a normal year with debt

SAR 750,000 less SAR 390,000 of debt service equals SAR 360,000. Divided by SAR 4,700,000 of equity, that is about 7.7 per cent.

Leverage improves the return by about seven tenths of a percentage point, because the asset earns more than the debt costs. That modest improvement is the entire benefit being purchased, and it is worth comparing against what is being risked for it.

Step 3: The same two cases in a weak year

Without debt, SAR 562,500 divided by SAR 10,700,000 equals about 5.3 per cent. With debt, SAR 562,500 less SAR 390,000 equals SAR 172,500, divided by SAR 4,700,000 equals about 3.7 per cent.

A 25 per cent fall in income reduces the ungeared return by about a quarter, from 7.0 to 5.3 per cent. It reduces the geared return by more than half, from 7.7 to 3.7 per cent. The asymmetry is the whole point: debt service does not fall when income does.

Step 4: Cover ratio and the break point

Base cover is SAR 750,000 divided by SAR 390,000, which is about 1.92 times. In the weak year it is SAR 562,500 divided by SAR 390,000, about 1.44 times. Cover reaches 1.00 when income falls to SAR 390,000, a decline of 48 per cent.

The break point is the number to compare against the building's own history. If income has previously fallen by close to half, the facility is sized against an event that has already happened once.

Step 5: A deeper fall

At income of SAR 412,500, a 45 per cent decline, cash to equity is SAR 22,500, a return of about 0.5 per cent, and cover is about 1.06 times.

Between a 25 and a 45 per cent income fall, the geared position moves from reduced to effectively zero while the ungeared position still returns about 3.9 per cent. The last stretch of decline is carried entirely by the equity.

Step 6: What happens to the value of the equity

If weak income of SAR 562,500 is capitalised at 9 per cent rather than the 7.5 per cent implied at purchase, value becomes SAR 6,250,000. Deducting the SAR 6,000,000 of debt leaves equity value of SAR 250,000 against SAR 4,700,000 committed. Without debt, the equity is worth the full SAR 6,250,000 against SAR 10,700,000 committed.

This is the effect people do not model. A fall in income combined with a widening of market pricing does not reduce geared equity proportionally; it can remove most of it, while the ungeared position simply holds a less valuable building.

What changes the answer

• Debt at SAR 7,000,000 raises service to about SAR 455,000, lifting the base geared return to about 8.0 per cent and reducing weak-year cash to SAR 107,500.
• An all-in cost of debt of 8 per cent rather than 6.5 per cent raises service to SAR 480,000 and reduces the base geared return to about 5.7 per cent, below the ungeared figure.
• An amortising facility rather than interest-only raises the cash requirement each year and lowers the break point at which cover fails.
• A capital expenditure item of SAR 300,000 in the weak year consumes more than the entire geared cash return and most of the ungeared one.
• If income recovers within one year, the geared position recovers fully; the risk is a sustained fall rather than a single weak year.

What the numbers tell you

• Leverage improves the base case modestly and worsens the downside sharply, so judge it on the downside rather than on the base.
• The break point at which cover fails is the single most useful output, and it should be compared with the asset's own history.
• Fixed debt service against variable income is the whole mechanism; nothing about leverage is complicated beyond that.
• Income decline and a widening of market pricing usually arrive together, and together they can remove geared equity entirely.
• Report the ungeared return alongside the geared one, because only the first describes the building you are buying.

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.

Domira builds the numbers on a Saudi property with you before you commit: rent and cost evidence, condition and capital expenditure, the appraisal and the sensitivities that decide whether the deal survives a bad year. The investment decision stays yours, and so does the advice of your licensed tax and legal advisers.