Why real estate is attractive with mortgage leverage!


#1

Recently, I came across a theory called “M&M Theory”.

The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is an influential element of economic theory; it forms the basis for modern thinking on capital structure. The basic theorem states that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. Since the value of the firm depends neither on its dividend policy nor its decision to raise capital by issuing stock or selling debt, the Modigliani–Miller theorem is often called the capital structure irrelevance principle.

The key Modigliani-Miller theorem was developed in a world without taxes. However, if we move to a world where there are taxes, when the interest on debt is tax deductible, and ignoring other frictions, the value of the company increases in proportion to the amount of debt used. And the source of additional value is due to the amount of taxes saved by issuing debt instead of equity.

Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions.

Source:


#2

WB uses no interest debt called insurance premium :wink: so he didn’t get the benefit of tax deductible interest.


#3

https://www.bloomberg.com/opinion/articles/2019-01-03/is-warren-buffett-sending-a-signal-about-the-bond-market

Warren Buffett is wading into the bond market with a new deal, leaving traders wondering whether the Oracle of Omaha is making a prediction about the direction of interest rates.

Berkshire Hathaway Finance Corp. 1 is issuing 30-year fixed-rate bonds to refinance $950 million of floating-rate senior notes that mature at the end of next week. The decision to switch from floating to fixed could be viewed as a bet on where interest rates are headed. Or, at the very least, it could indicate that the company sees the steep decline in long-term yields over the past two months as a market-timing opportunity that’s too good to pass up.

Berkshire, with the third-highest credit rating from both Moody’s Investors Service and S&P Global Ratings, is expected to price the debt on Thursday with a spread of 150 to 155 basis points above benchmark Treasuries. The 30-year U.S. yield fell to 2.91 percent on Thursday, the lowest since January 2018. The recent bond rally equates to millions of dollars of savings a year for Berkshire, if its plan all along was to convert from floating to fixed rate.


#4

Here are the details for real estate. Simple formula, not taking advantage of tax benefit.

Rate of Return (Leveraged) = Rate of return (Full cash) + (Debt/Equity) ( Rate of return (Full cash )-Cost of debt)

Assumption: Home is bought for $1M with 20% down payment at 4.5% fixed mortgage, assuming rent (even if we live as primary) is $3000 (expenses $1000) and appreciation of 5% YOY.

ROR-Rent = ((3000 - 1000) * 12 )*100/1000000 = 2.4% for full cash paid home (unleveraged)

Total ROR (unleveraged) = 5% + 2.4% = 7.4%

ROR(Leveraged) = 7.4 + (800000/200000) ( 7.4 - 4.5) = 7.4 + 4 * 2.9 = 19%