Why real estate values decline with leverage: a Modigliani–Miller example

Abstract

This article shows that, because real estate investors borrow at an interest rate that is greater than the rate at which they can lend, the reservation value of real estate investments declines with the amount borrowed. The proof is a modified version of the home-made leverage examples introduced by Modigliani and Miller (1958). Market value is established as the reservation value of the marginal investor.

Notes

¹On the day this is being written (24 November 2010) the Wall Street Journal (2010) reports that insurance companies are lending at interest rates of 4.75–5.5% on commercial real estate and that 5-year certificates of deposit are yielding as much as 2.5% (with a national average of 1.5%). Yields on corporate bonds vary with the rating and maturity. It is possible to find a long-term investment-grade corporate bond with a yield that rivals the interest rate on commercial real estate loans. For example, the New York Times (2010) reports that JPMorgan Chase 2020 bonds (rated Aa3 by Moody's) yield 4.2–4.4% and Goldman Sachs 2020 bonds (rated A1 by Moody's) yield 4.8%. Junk bonds have higher yields. However, recall that Real Estate Investment Trusts (REITs) are restricted to investing in real estate.