Leverage: The End of an Era: How the Market Got Here and Where it Will Go Next
Throughout much of the past bull market, it was the use of historically excessive leverage in a historically low interest rate environment that drove up prices to all-time highs and drove cap rates to all-time lows. As we’ve noticed this past year, during which losses for our heavily leveraged financial institutions have reached unheard of levels and continue to mount, leverage cuts both ways. When the bubble bursts, the same system that facilitated extraordinary heights yields depressing lows.
The following is a deconstruction of a hypothetical transaction that I believe gives insight into the dynamics of our recent bull market. Let’s say there were two investors competing to acquire an asset that produced $6.50 per year in net income, for which the broker price talk was $100, or a 6.50 percent cap rate. The first, Mr. Conservative, was prepared to invest $20 of equity and borrow the remaining $80 at a rate of 5.5 percent, paying $4.40 per year in debt–service payments