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 quite 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.
- 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 be around 3.5:1.
D/E Ratios in the Real Estate Sector
The D/E ratio for companies in the real estate sector on average is approximately 352% (or 3.5:1). Real estate investment trusts (REITs) come in a little higher at around 366%, while real estate management companies have an average D/E at a lower 164%.
Real estate companies represent one of the most attractive investment options due to their stable revenue stream and high dividend yields. Many real estate companies are incorporated as REITs to 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 average D/E ratio among S&P 500 companies is approximately 1.5:1.
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 of debt financing outweighs 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 the capital-intensive nature of the industry. Capital-intensive industries, such as oil and gas refining or telecommunications, require significant financial resources and large amounts of money to produce goods or services.
For example, the telecommunications industry has to make very substantial investments in infrastructure, installing thousands of miles of cables to provide customers with service. Beyond that initial capital 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 large financial commitment prior to delivering its first good or service and generating any revenue.
Another reason why D/E ratios vary is based upon whether the nature of the business means that 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 overall economic 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 accord with the overall health of the economy.