The real estate sector comprises different groups of companies that own, develop, and operate properties, such as residential land, buildings, industrial property, and offices. Since real estate companies usually buy out the entire property, such transactions require large upfront investments, which are often funded with a large quantity of debt.
One metric that investors pay attention to is the degree of leverage the real estate company has, which is measured by the debt-to-equity (D/E) ratio.
Key Takeaways
- The debt-to-equity (D/E) ratio is an important metric used to determine the degree of a company's debt and financial leverage.
- Since real estate investment can carry high debt levels, the sector is subject to interest rate risk.
- D/E ratios for companies in the real estate sector, including REITs, tend to range from 1.0 to over 8.0:1.
D/E Ratios in the Real Estate Sector
The D/E ratio for real estate companies ranges from less than 1.0 to more than 8.0. A ratio of 1.0 indicates an equal amount of debt to equity; less than 1.0 means more equity than debt; more than 1.0 means more debt than equity.
Real estate companies represent one of the most attractive investment options due to their stable revenue streams and high dividend yields. Many real estate companies are incorporated as REITsto take advantage of their special tax status. A company with REIT incorporation is allowed to deduct its dividends from taxable income.
Real estate companies are usually highly leveraged due to large buyout transactions. A higher D/E ratio indicates a higher default risk for the real estate company.
The D/E ratiowill differ for every company depending on how they are capitally structured and which type of real estate they invest in.
How to Evaluate the D/E Ratio
The D/E ratio is a metric used to determine the degree of a company's financial leverage. The formula to calculate this ratio divides a company's total liabilities by the amount of equity provided by stockholders. This metric reveals the respective amounts of debt and equity a company utilizes to finance its operations.
When a company's D/E ratio is high, it suggests the company has taken an aggressive growth financing approach with its debt. One issue with this approach is additional interest expenses can often cause volatility in earnings reports. If earnings generated are greater than the cost of interest, shareholders benefit. However, if the cost ofdebt financingoutweighs the return generated by the additional capital, the financial load could be too heavy for the company to bear.
Why D/E Ratios Vary
D/E ratios should be considered in comparison to similar companies within the same industry. One of the major reasons why D/E ratios vary is theindustry's capital-intensive nature. Capital-intensive industries, such asoil and gasrefining or telecommunications, require significant financial resources and large amounts of money to produce goods or services.
For example, the telecommunications industry has to make substantial investments in infrastructure, installing thousands of miles of cables to provide customers with service. Beyond that initialcapital expenditure, necessary maintenance, upgrades, and expansion of service areas require additional major capital expenditures. Industries such as telecommunications or utilities require a company to make a sizeable financial commitment before delivering its first good or service and generating revenue.
Another reason why D/E ratios vary is based on whether the business's nature means it can manage a high level of debt. For example, utility companies bring in a stable amount of income; demand for their services remains relatively constant regardless of overalleconomic conditions.
Also, most public utilities operate as virtual monopolies in the regions where they do business, so they do not have to worry about being cut out of the marketplace by a competitor. Such companies can carry larger amounts of debt with less genuine risk exposure than a business with revenues that are more subject to fluctuation in accordance with the economy's overall health.
Do REITs Have High Leverage?
In some cases, REITs use lots of debt to finance their holdings. Some trusts have low amounts of leverage. It depends on how it is financially structured and funded and what type of real estate the trust invests in.
How Much Leverage Is in REITs?
The amount of leverage REITs use ranges from less than zero to as much as they can carry. Simon Property Group had over $29 billion in liabilities at the end of its 2023 second quarter. Annaly Capital Management had more than $77 billion in liabilities for the same period.
What Is a Good Leverage Ratio for REITs?
Leverage ratios vary for REITs based on the types of real estate they invest in and how they are structured. A good ratio is one created by a balanced structure of income, interest, risk, and return. Whether a ratio is good or not will be determined by the success of each company.
The Bottom Line
Leverage allows real estate investors to purchase real estate they otherwise could not afford. Many real estate companies use it to create investment portfolios. Too much debt financing can cause problems for these companies, so they have to maintain a ratio of debt financing to equity financing that allows them to control the risks involved.
Each real estate investment company will have a leverage ratio it believes it can maintain. Investors should compare similar companies to each other to determine if a company is using too much leverage. To fully assess a real estate investment company, investors should use as many financial metrics as possible to get a broad view rather than narrowing it to only debt-to-equity.
