The unique thing about the financial markets is leverage. As a shareholder you have incredible power to make use of leverage that is not part of your personal balance sheet. You stand to lose nothing more than your investment capital in the worst case scenario.
You could go so far to say that as an investor in a public company you have unlimited upside and limited downside. The most you can make is not constricted by any upper bound, and you cannot lose more than your original investment.
Real Estate vs. REITs
This is a great example of how easily risk can be shifted in our personal balance sheets. To invest in real estate on an individual level requires using your income, assets, and personal balance sheet to make a deal. The banks care about your data – you’re the risk. And your balance sheet is the collateral.
Real estate investment trusts (REITs), however, allow you access to the same kind of leverage (borrowing inexpensively to purchase higher-yielding investments) without risk to your personal balance sheet.
You might find 15% cash on cash returns on your own real estate investments made by yourself. But you can find similar 15% cash on cash returns in leveraged REITs. The biggest difference is which balance sheet you’re playing with – your personal and individual balance sheet, or a trust’s balance sheet in which your liability is limited.
These are not completely equal investments, of course. One might say that the cash on cash return in individual properties on your own balance sheet gives greater opportunity for profits in appreciation. This is very true. To some extent, though, REITs have their own advantage in that you can compound faster and with less rigidity. Shares in a REIT can be purchased every time you have enough to purchase a single share. You’ll never get into real estate on your own balance sheet with $40; you have to wait to have enough cash on hand to make a much larger transaction.
Also, a trust can access much more leverage at an interest rate much lower than an individual, adding another advantage. Further, you can compound indefinitely in a REIT whereas few banks will let you add inexpensively financed and highly-leveraged individual real estate purchases to your portfolio forever.
Leverage in Public Companies
Investors in public companies can also access internal leverage. For example, suppose your choices are limited to two oil companies. One operates with a perfectly clean balance sheet with zero debt. Another operates with substantial debt, and only a small amount of equity.
You could always juice up your portfolio with creative financing to purchase the unlevered oil company to make it as attractive as the leveraged company. You might use your home as a source of investment capital – many people have done the same. (Few people make a conscious decision to use home equity as a source of leverage, but at any point you forego a mortgage prepayment and deploy capital elsewhere, you are using home equity as a source of leverage.)
Alternatively, might leverage with the best margin rate at a sub 2% rate.
Once again we expose ourselves to different risks. Using our personal balance sheet to invest with home equity risks our own personal finances. Using brokerage margin creates market risk – if the price of the company falls precipitously, your position is stopped out. At 2:1, a 50% drop in share prices means you get a margin call. Your position is closed at a total loss.
On the other hand, internal leverage used by any given firm does not have the same effect. The leverage is held on the company’s balance sheet. And you have no real risk of loss in the event of a temporary decline in share prices. Only a complete and total bankruptcy could wipe out your entire investment.
Somewhat Theoretical, Yet Entirely Applicable
The whole idea of segmenting different investments by balance sheet is somewhat theoretical, but it is entirely applicable to how we think about different opportunities. As your job as an investor is to be a capital allocator, you have to make a decision about how you allocate capital, and also where that capital comes from.
All things considered, I find it a better choice to let the risk ride on a balance sheet that does not directly flow into mine. A REIT’s balance sheet can blow up without any effect other than the loss of investment capital. An individual real estate purchase can blow up, resulting in the loss of investment capital plus a massive stain on my personal balance finances and credit report, limiting my ability to leverage in the future.
The purchase of individual stocks with personal leverage again brings new risks. Purchasing an already levered company gives the same upside, with limited downside risk.
I would say that all things being equal, playing on someone else’s balance sheet is always preferable to playing with my own.