Practice Question 10.5 is "Suggest reasons why an investment in the XYZ property company might produce a higher rate of return than an investment in the ABC property unit trust." One of the answers is that "XYZ benefits from gearing when property prices are rising." But wouldn't ABC benefit from higher unit prices when property prices are rising as well?
Hi - the point about having gearing is that it exaggerates price movements. So the share price of a geared property company would benefit more from a property price rise than the equivalent unit price in the property unit trust. As a fairly extreme example, if the property company has 50% gearing (ie 50% equity, 50% debt funding) then a 10% increase in the value of properties owned would translate to a 20% increase in the value of the equity holding and hence, broadly speaking, the share price. (If assets held are 100, 50 of this belongs to shareholders with the other 50 needed to repay the debt. A 10% increase in the value of the assets to 110 would now be shared 60 to shareholders and still 50 to repay the (fixed) debt, so the shareholders' share (the 'net asset value') has increased by 20% from 50 to 60.) Hence the high level of gearing in this example has doubled the impact of the property price rise. Simplistically, the unit price in the UT would have increased by 10% but the share price in the property co would have increased by 20% (or thereabouts). Of course it works the other way too: gearing means that the property company would suffer more under property value falls.
