**Illustration with Two Funds**

Suppose there are two funds, each making loans at 75% of cost which works out to 60% of after-repair value. Each fund has 50 loans of $1 million each. One (unlevered) fund has $50 million of investor capital and no bank debt. The other (levered) fund has $40 million of investor capital and $10 million of bank debt.

Both funds hold loans on property whose gross value upon sale is $83 million ($50/.6). Assuming that the market is flat, increasing gradually or decreasing gradually, the levered fund will have higher returns than the unlevered fund. Assuming that loans earn a 9% yield and the bank debt costs 5%, there would be a spread of 4% on the $10 million of bank leverage, adding $400,000/yr of income. This extra income is spread across $40 million of investor capital, equating to an increase in return of 1% per year over an unlevered fund, all other things being equal.

**Stress Testing Both Funds**

But suppose that the real estate market drops dramatically so that every loan goes into foreclosure and each fund only recovers $45 million total, of the $50 million invested in loans. This equates to a market drop of more than 40%.

In the unlevered fund, each investor would lose 10% of his or her investment (a loss of $5 million/$50 million). In the levered fund, the loss would be $5 million/$40 million = 12.5% of principal. In other words, the bank leverage helps returns in normal times but it exacerbates losses in the unlikely event of a steep decline in the market that is large enough to wipe out the substantial margin of safety in this strategy.

Note that the bank leverage is not changing the size of the margin of safety itself--both funds make loans with the same 75% LTV/60% loan-to-after repair value of the homes. It just changes what happens if this 40% margin of safety is breached.