Leverage

Leverage means buying an asset partly with borrowed money. It magnifies returns in both directions. Whether leverage helps a rental investor depends on how the cap rate compares with the cost of the loan, measured as the mortgage constant.

Leverage is positive when the cap rate exceeds the mortgage constant, because each borrowed dollar earns more than it costs. It is negative when the cap rate is lower. The example property at 5.78% against an 8.19% constant has negative leverage, and its cash flow turns negative with a 75% loan.

Investors in low cap rate markets often accept negative leverage and count on appreciation or rent growth. That can work, but it is a bet on the future rather than on current income. The cash on cash return shows the effect directly.