Wednesday, September 02, 2009

Fun with real estate leverage and diversification

A few years ago, I had a REIT CEO speak to one of my classes. He is a very smart guy, with an MIT degree. He opened his talk with the following rhetorical question:

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.


Anonymous said...

Yet the growth in REIT dividends has historically tended to lag inflation. On top of this, REIT dividends were halved during the recent credit crises. Lots of debt for speculative purposes can lead to sub par returns.

Super low interest rates initially lead to higher asset prices. However,subsequent returns are inevitably sub par, since the assets are then priced too high to deliver a reasonable return.

Its sort of an economy wide Ponzi scheme. Subsidized low rates enrich the first people in the leveraged asset price rise, and then subsequent players lose out.

Uncle Billy, Mental Widget said...

" and then subsequent players lose out."

Not if they were using someone else's money.

Anonymous said...

We owe it to someone else's achievements in health and thus feel joy, depending on the success of others as if their achievements, and this is the Buddha mind. Always hold the interests of all sentient beings of the heart, we can not leave the joy forever.

csissoko said...

I don't think your argument addresses M&M.

"Consider an investor who has enough equity to buy one building with cash ..."
Doesn't the investor have the choice of getting a partner (i.e. equity investor) rather than leveraging his returns? In this case the investor gets the advantage of reducing the volatility of equity returns with no additional cost (except for those associated with managing the partnership).

Calling debt a "risk management tool" in a context where issuing equity is also possible seems very questionable to me.

Anonymous said...

"Also suppose that each property has a standard deviation of 5 percent on returns, and the correlation of the returns is .5"

This is the problem: using historical data to predict the future, and thus being overwhelmed by a "black swan."

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