A debt-to-equity ratio is a simple way to evaluate how much ownership leverage an investor has in a property. This can help you determine how little (or how much) risk you’ll be taking as an investor.
In this article, we’re going to break down the debt-to-equity ratio formula, help you determine if you have a “good” debt-to-equity ratio, and explain what high and low debt-to-equity ratios mean for your real estate investment portfolio.
Debt vs. Equity in Real Estate Defined
Debt is the amount owed on an asset, while equity is the amount owned.
For example, if you have a property worth $1,000,000 with a mortgage balance of $600,000, your debt is $600,000 and your equity is $400,000.
Debt-to-Equity Ratio Defined
The debt-to-equity ratio measures the amount of debt as compared to the amount of equity on a given asset or portfolio.
How Debt-to-Equity in Real Estate Is Calculated
To calculate your real estate debt-to-equity ratio, divide the total amount of debt by the total amount of equity.
For example, if you have $600,000 in debt and $400,000 in equity on a million-dollar property, you would divide 600,000 by 400,000, which gives you 1.5. This makes your debt-to-equity ratio 1.5:1, which means that for every dollar you have in equity, you have $1.50 in debt.
Implications of High and Low Ratios
The higher the debt-to-equity ratio is, the more risk the investment carries. This is because the investor owes substantially more on the investment than they own. While real estate is a low-risk investment generally, having a single asset saddled with too much debt can make the prospect riskier than the average investment. Additionally, carrying too much debt can lead to higher interest expenses, which is something to consider, particularly when interest rates are high.
On the other hand, a low ratio could mean that the investor isn’t leveraging enough debt to generate desirable returns.
Finding a good debt-to-equity ratio is about balancing your desired returns with your risk tolerance.
The Average Debt-to-Equity Ratio in Real Estate
For real estate investment companies, including real estate investment trusts (REITs), the average debt-to-equity ratio tends to be around 3.5:1. This means that for every dollar owned in shareholders' equity, the company carries $3.50 in debt.
What Constitutes a 'Good' Debt-to-Equity Ratio in Real Estate
While the average debt-to-equity ratio for real estate companies sits around 3.5:1, many private real estate investors are more comfortable with a ratio closer to 2.33:1. At 2.33:1, an asset would be 30% owned and 70% financed.
So, if you were planning to buy a million-dollar property, and you wanted to enter the investment at the 2.33:1 ratio, you would put $300,000 down and take out a mortgage loan for $700,000.
Having said that, different investment vehicles may warrant different debt-to-equity ratios.
You can use the debt-to-equity ratio to help adjust the risk level of different property types. In asset classes that are inherently riskier (like hotels, for example), you could carry a lower debt-to-equity ratio to reduce the risk profile of the investment. And in lower-risk real estate investments (like multi-family rental properties, for example), you could leverage a higher debt-to-equity ratio to generate higher returns.
Using Debt-to-Equity Ratios When Making Investment Decisions
When evaluating real estate investments, you can use the debt-to-equity ratio to help determine how much risk the investment carries. You can also manipulate the risk level by increasing or decreasing the ratio as outlined in the previous section.
Furthermore, the debt-to-equity ratio is just one indicator of the financial health of an investment. Investors should also consider metrics like Return on Investment (ROI) and International Rate of Return (IRR) when making investment decisions.