What Is a Good Debt-to-Equity Ratio? 3 Things You Need to Know

May 13, 2022
May 13, 2022 disrupt

What Is a Good Debt-to-Equity Ratio? 3 Things You Need to Know5 min read

There are several metrics prospective investors use to evaluate a company’s overall health. Like the debt-to-equity ratio, these metrics individually don’t tell the whole story of a company’s financials. Still, when combined, they can give a good idea of the performance relative to other investment opportunities. However, to use these metrics to effectively evaluate a commercial real estate opportunity, you need to know what ranges show the company is performing well and which ones indicate problems. Since this post focuses on the debt-to-equity ratio, we will answer the question, “what is a good debt-to-equity ratio,” and provide three key things to remember when looking at this metric for real estate transactions.

What Is a Good Debt-to-Equity Ratio?

Before getting into some things to keep in mind when looking at a company’s debt-to-equity ratio, it’s first essential to know how to calculate this metric and a good value for this ratio.

The debt-to-equity ratio is straightforward to calculate. All you need to do is take the company’s total liabilities and divide that amount by its shareholder’s equity. So, as a quick example, if a company has $1 million in equity and owes $2 million to creditors, that represents a debt-to-equity ratio of 2.0 ($2 million owed / $1 million equity = 2.0).

As you might imagine, this metric is heavily industry-dependent. Some industries might require more debt overall as part of their business model, thus having a higher ratio. The casino industry, for example, is often highly leveraged. Other sectors might operate on minimal debt.

When this ratio is high, it indicates a company is fuelling its growth with debt. When this ratio is too low, management may be very cautious and may not smartly use debt to fuel growth.

In general, though, you’ll want to see companies with a ratio below 2.0. Some people like to see ratios between 1.0 and 1.5, while others like to see numbers below 1.0. In many respects, a good debt-to-equity ratio is personal. If you’re risk-averse, you’d want to see lower debt (perhaps below 1.0), but higher ratios are acceptable if you’re more comfortable with risk.

With that in mind, here are three things you should know about this metric – especially for commercial real estate transactions!

1. A Good Ratio Is Different for Real Estate

If you’re evaluating a real estate deal, particularly a commercial one, you’ll want to know many metrics, including the debt-to-equity ratio. A commercial real estate deal laden with debt may run into cash flow issues. Conversely, a real estate transaction with minimal debt may suggest a too cautious or conservative approach.

Recall that the debt-to-equity ratio is a company’s total liabilities divided by the total shareholder’s equity. 

So, with that in mind, let’s review an example syndication that wants to buy a $5 million apartment complex. To finance the transaction, the general partners put up $100,000 and receive investments totaling $900,000. They then take out a $4.5 million loan, put $500k as a down payment (10%), and keep $500k in reserves for renovations.

In this case, the total debt is $4.5 million. The equity is $1 million. Therefore, the debt-to-equity ratio is $4.5 million / $1 million = 4.5.

However, isn’t above 2.0 generally considered problematic?

In many contexts, yes, it is. But this debt is backed by an asset, which, unfortunately, this ratio doesn’t consider. Indeed, it will be nearly impossible for most real estate transactions to get a debt-to-equity number below 2.0. Think about a standard house purchase: 20% down gives a debt-to-equity ratio of 4.0 (80% loan / 20% down payment = 4.0).

So, within commercial real estate, a ratio of 4.0 would be perfectly fine (the syndication has raised 20% of the purchase price). However, if you see a debt-to-equity ratio of 9.0 or higher, the syndication has raised 10% or less of the purchase price, which doesn’t provide much room for error!

2. With Time, the Ratio Should Decrease

For most real estate transactions, the ratio will start high (e.g., 4.0 or more), but it should decrease. As tenants pay their rents, the syndication should pay off some of its mortgage and reduce its overall debt obligations.

As such, a well-run syndication should have a ratio that trends downwards with time. If a syndication has a ratio that grows, that’s usually a sign that the rents aren’t able to meet the financial obligations of the venture. Maybe they can pay the mortgage but can’t pay all the overhead. Or, perhaps the renovations have created a significant bill, but the rents haven’t caught up to paying those off. 

No matter the reason, the general partners of a syndication should have a good answer for a debt-to-equity ratio that grows. There are times when it needs to grow, but the more this metric trends down, usually the better the health of the overall endeavor.

3. A Better Question Might Be: Why Is the Debt-to-Equity Ratio What It Is?

When asking the question, “what is a good debt-to-equity ratio?” perhaps the better question is, “why is the debt-to-equity ratio what it is?” In other words, why is the metric low or high, and what does that tell you about the financial state of the business? You might find that the ratio is high, but the company used that money to finance growth smartly. You might also find that the company is not prudent with its funds.

As you look into syndications and evaluate them, you will quickly develop a feel for which syndications have enough capital and reserves to survive and which are under-funded.

What Is a Good Debt-to-Equity Ratio? It Depends!

As should be self-evident, a company’s debt-to-equity ratio is insufficient to evaluate a business. There are many reasons why a high debt-to-equity ratio could be good (e.g., a mortgage that is backed by a tangible asset). There are equally many reasons why the debt-to-equity ratio could be problematic (e.g., the company has taken numerous loans to expand but is struggling to pay them off. 

Therefore, the next time you’re evaluating a real estate transaction, or even an investment in a public company, look at the debt-to-equity ratio and see what the number is trying to tell you! There is an excellent chance you can learn something about the company’s financial health by diving into this metric and fully understanding why it is the number it is!

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