You guys don't believe that Modigliani-Miller bullshit, do you?
I felt the need at the time to defend M&M, even though REITS--especially leveraged REITS--were earning terrific rates of return at the time. In the end, it just took a year or two for M&M to bite those who thought leverage was a free lunch.
But leverage can be a risk management tool, because it allows owners to diversify across more than one property. Consider an investor who has enough equity to buy one building with cash, or two buildings with a 50 percent LTV loan. Suppose real estate earns an 8 percent return, and mortgage rates are 6 percent (this is hypothetical). Also suppose that each property has a standard deviation of 5 percent on returns, and the correlation of the returns is .5. An unlevered portfolio with both properties would have a standard deviation of a little under 4 percent (the magic of diversification).
But the fifty percent LTV loans necessary to obtain both property doubles the volatility of equity returns, to a little under 8 percent. On the other hand, because of positive leverage, the six percent loans help push up return on equity to ten percent. So in exchange for a 3 percentage point increase in risk, one gets a two percentage point increase in returns [we should subtract some risk-free rate from returns in this analysis, but I am not certain what the correct risk free rate is right now. The fed funds rate is close to zero]. One also avoids a total loss should one building burn down.