the relationship between inflation and real estate prices.

CFA Level III
#1

hi guys,

when the schewser notes talk about the relationship between inflation and real estate prices.

it says:

Deflation also reduces the value of real assets financed with debt. In the case of real estate, if the property is levered with debt, declines in the property’s value lead to steeper declines in the equity position.

i thought the decline in the property’s value and the decline in the equity position would be of the SAME percentage. why is it STEEPR decline in the equity position?

Please help guys. Appreciate your help!

Thanks!

#2

If you pay cash for a $1,000,000 plot of land and its value declines $200,000, you have lost 20% of your equity.

If you borrow $800,000 and pay the remaining $200,000 in cash for a $1,000,000 plot ot land and its value declines $200,000, you have lost 100% of your equity.

#3

As S2000 pointed out :

Leverage cuts both ways. If returns on the investment exceed the interest paid on debt , you get magnified returns on the same equity position , but losses or below interest returns do not preclude debt payments , which have to come out of equity , so you magnify losses