How cost of equity capital can be a risk factor for the PE Real Estate investment?
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Real Estate is a highly leveraged industry wherein plenty of projects are operating and most of the projects likewise houses, buildings, etc are built by taking loan against some collateral. Due to hefty borrowing and leveraged industry, Investors tend to be cautious due to borrowing and with interest rates fluctuations at the same time. Real Estate Industry is a cyclical industry. Not all the RE businesses are profitable. Financial leverage is the use of debt to buy assets or build revenue generating models. A huge interest cost is going every quarter, month..or whatever the case is. Therefore it becomes a significant measure to check before investing in RE busines. Cost of debt is used in WACC calculations for valuation analysis, it is lower than equity (since debt holders are always paid out before equity holders; hence, it’s lower risk). Leverage, however, will increase the volatility of a company’s earnings and cash flow, thereby increasing its cost of debt which in turn will also increase a company’s cost of equity (since investors will also become cautious due to high borrowings of the business and skeptical about the potential ROI on their investment and will demand a high risk premium)
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