Optimal Leverage in Real Estate Investment with Mezzanine Lending GCP-07-02

John F. McDonald
Professor Emeritus of Economics and Director, Center for Urban Real Estate at the University of Illinois at Chicago

The paper presents a theoretical analysis of the optimal leverage for the purpose of investing in real estate under the condition that borrowing in excess of a standard amount such as 70 to 80 percent of the purchase price must be accomplished through a mezzanine loan with a high rate of interest.  The conditions under which a mezzanine loan is used are derived.  It is shown that a larger mezzanine loan is used the greater is the required expected after-tax rate of return to equity.  Investors who choose greater risk require a higher expected after-tax return to equity and therefore borrow more and purchase more real estate with a given equity investment.

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