Maarten van der Spek: The underestimated risk of real estate financing

September 16, 2025

_{This column was originally written in Dutch. This is an English translation.}

By Maarten van der Spek, Spek Advisory & Adjunct Professor Real Estate TIAS Business School

Real estate financing can increase returns, but the risks involved, such as negative market scenarios and the impact of rising interest rates, are often underestimated in real estate investments. As a result, the leverage effect does not always work out as expected.

Leverage, or the use of debt to increase the return on equity, is a favourite tool among property investors. The promise is attractive: borrowed money allows you to build a larger portfolio and potentially increase returns. However, in practice, this leverage often fails to have the desired effect. Two factors are regularly underestimated: the impact of negative market scenarios and the role of incremental interest.

Let's start with the first point. Excessive leverage significantly increases the volatility of property investments. For example, if you finance 50% of the purchase price, the volatility of your own investment is roughly doubled. This means that a decline in property value or rental income has a much greater impact on the return on equity. In declining markets, this can lead to significant losses, sometimes even forced sales, because refinancing is difficult or extremely expensive. In the long term, the negative financial impact of such situations often far exceeds the extra return realised in favourable times.

The second, equally crucial risk is the incremental interest rate. What does this mean? Suppose you take out a loan for 50% of the value of an office building at an interest rate of 4.0%. If you increase this loan to 60% of the value, the average all-in interest rate will normally be higher, say 4.45%. This seemingly limited increase for the entire loan masks the fact that the additional amount borrowed is financed at a much higher interest rate, in this example 6.7%. This higher interest rate on the additional portion – the incremental interest rate – significantly reduces the return. Especially if the return on the property is around or below 6.7%, this increase can negate the positive leverage effect.

The combination of these effects – disproportionate impact in negative scenarios and rising interest charges at higher financing levels – means that too much leverage often does not lead to better results in the longer term. Research among institutional investors[1] and listed property funds[2] has also confirmed this: on average, excessive leverage actually leads to lower returns. Nevertheless, some market players remain optimistic about borrowing, with levels sometimes reaching 70% or even 80%.

In the short term, leverage can have a very positive effect. To benefit from this, an investor must be able to time it right. This is almost impossible, especially for long-term investors. Professional investors would therefore be wise not to focus solely on the maximum loan amount or the average interest rate, but to pay close attention to the incremental effect per tranche of debt and the associated risk.

The message is crystal clear: leverage is a powerful but risky instrument. Maximising it without understanding the implications will sooner or later lead to disappointment – and often painful losses. A disciplined, long-term approach with a focus on risk management is essential for sustainable success in real estate investments.

[1] See, for example, Alcock, Jamie, et al. ‘The role of financial leverage in the performance of private equity real estate funds.’ The Journal of Portfolio Management 39.5 (2013): 99-110

[2] See ‘Capital Structure in the REIT Sector’, Feb 2025, Green Street