Effects of leverage in Real Estate and measuring it against stocks.

Real estate is just one of the many asset classes an investor can choose from. How does someone make that decision? How do they compare the different asset classes? In this post I'm going to briefly compare the returns of two real estate options with and without leverage and the S&P 500.

One of the advantages of purchasing real estate is cheap financing. Right now you could get a 30 year fixed rate mortgage between 3.5-4%. If you decide to purchase real estate without leverage you're neglecting one of the major advantages of real estate.

Below are two real estate investment options. On the left we have cash purchase of a condo and on the right we have a 4 unit multifamily property with 25% down. Both are using the same $50k cash outflow.

Even though both investments are using the same amount of cash you can see the effects of leverage when you look at the return on equity (ROE). In the all cash purchase example ROE is 6.7% and in the leveraged multifamily the ROE is 11.9%. Clearly using leverage to purchase real estate offers advantages over purchasing with cash. Some of the numbers are different in the comparison, for example Operating Expenses and the depreciation. Typically the Operating Expenses are lower on multifamily properties. Deprecation is based on the how the city accesses the value of the property, part of the value is assigned to the land and to the building, and you can only depreciate the building. The percentage listed is the building or improvement portion of the value.

By using ROE, I can compare real estate to investing in stocks, specifically S&P 500 ETF trading under SPY. For those who aren't familiar you can learn more HERE. I picked the S&P 500 index because it is incredibly diversified and a cheap option to investing in stocks. On SPDR's website they show that the ROE for SPY is currently 24.13%. As seen in the example above leverage effects the ROE. Online and I found a Leverage Ratio of 3.68 or 27% for the S&P 500. This leverage is inherently baked into the index through the individual companies themselves, no additional leverage is required.

The purpose of this exercise was to evaluate if a cash deal is worth investing in. Going through the process I have decided that investing in real estate without leverage is not for me.

Aside from the returns it's worth considering the risks associated with real estate such as, lack of diversification, liquidity, and the frictional costs of selling. There is no doubt that investing in SPY offers significantly more diversification, liquidity and lower frictional costs. Because of this you should be rewarded more for investing in real estate. Before investing in anything look at the numbers and make sure you're being compensated for this risk!

Notes

1. Return on equity isn't typically used for evaluating real estate. The common ratios are gross rent multiple or capitalization rate, which are both using pretax numbers and removing the effects of leverage.