Understanding the Risk
Debt can enhance returns in real estate investing, but it comes with its own set of risks. Higher levels of debt can lead to higher financial risk due to the obligation to make interest payments and repay the principal amount. If these obligations are not met, it can lead to financial distress and potentially bankruptcy.
The Role of WACC
WACC can be an effective tool to understand this risk. A lower WACC indicates a lower cost of capital and, therefore, a less risky investment, all else being equal. It signifies that the firm or investment project is efficiently using its mix of debt and equity financing.
If a private real estate investment project's expected rate of return is higher than the WACC, it indicates that the project is expected to create value and that the returns compensate for the risk level. Conversely, if the project's expected return is lower than the WACC, it implies the project is not generating sufficient returns for the level of risk, which may deter investors.