Leveraging Real Estate? Know This Before It Cuts You Deep
Leveraging Real Estate is one of the most touted ways of making money from real estate. Borrowing money is cheap and many investors are successfully expanding their already big portfolios using leveraging. And if this is what you are also doing, there is something important for you to know.
Leveraging real estate is a double-edged sword that can cut even the smartest of investors deep. As good as the leveraging is, the successful investors often occur to overleveraging and end up losing their money.
What is Overleveraged in Real Estate?
Overleveraged in real estate is a situation when the business is under too much debt that it disrupts its ability to provide for the expenses. Your debt payments are so high that your present business income is not able to sustain the loop.
Imagine you buy a $400,000 rental property by paying $80,000 out of your pocket and leveraging the remaining $320,000 with bank financing. Your business can afford to pay a $1900 monthly mortgage at the moment.
But after some time, the conditions of your business change for some reason, and your business isn’t able to afford the monthly mortgage payment. This is the position where you will be overleveraged. After which the bank forecloses on your property and sells it for $350,000.
The $350,000 will go towards your remaining mortgage balance, say it is $300,000. You left with $50,000 and you have invested $80,000 from your pocket. You have a net loss of $30,000.
How Do You Occur to Overleveraged Real Estate?
Investment is a risk and a reward transaction. You invest in hopes of getting a reward by assuming some risk. An Overleveraged business gets too clingy for the reward that it completely ignores or underestimates the risks.
Common Reasons Why Investors Occur to Overleveraged Real Estate
Using leverage in real estate doesn`t harm. Rather an investor who can use it wisely can benefit from it greatly. But the issue why investors occur to overleveraging is they get too optimistic and fail to understand how much leverage they can actually afford or their business can sustain.
1. Paying High For a Property
When you pay more for a property than what it’s actually worth, you are setting yourself up for overleveraging. You are buying a property at a higher price. But will it be able to keep up with the trends of the market? Will you get enough rent to pay that higher monthly mortgage? What if the market retraces back and you have to sell your property?
Say, you bought a property for $435,000 in a bull run when property prices are rocketing high. You paid $87,000 cash and leveraged $348,000 in the form of a mortgage. Though the actual property worth was only $400,000. After a year the market dips and there are a lot of inventories on sale. Your property price also plummeted to $336,000; a decline of 12.4%.
Now, suppose you are forced to sell at this stage. Your remaining mortgage balance after a year, say, is $340,000. Your property was sold for $336,000. An equity loss of $87000 plus an additional $4000 to pay more to the bank.
Mind you this isn’t an imaginary supposition. It happened in the past during the 2008 housing crash. Prices of real estate dipped by 12.4% in the fourth quarter of 2008 .
2. Falling For Low Down Payment Trap
With low money-down loans, it becomes easy for real estate investors to buy a property with just a fraction of money. If you have fallen for this too, there are chances that you have occurred to bad leveraging.
When you have very little skin in your business, you have a very high mortgage payment to pay every month. Imagine you have put only 3.5% in down payment compared to someone who has made a 20% down payment.
On a $400,000 property, you will have a 17% bigger EMI compared to who has put 20% down. Sure you paid low and can get very high cash on cash returns compared to the other investor. But what if things do not go as planned and you experience an unexpected event in your business?
Will you be able to pay these larger monthly mortgage payments then? And when you aren’t able to pay, your good leveraging will turn into an over-leveraged portfolio. Also, don`t forget to take into account the high mortgage closing costs with low down payment loans.
3. Not Leveraging Abruptly
If you are an investor who borrows money but tries to repay the loan as early as possible, this is about you. You are at risk of overleveraging because you aren`t leveraging the real estate purchase abruptly.
Let me explain this by asking you this. What do you think is a better mortgage term between 15 years vs 30 years? Though it depends on various factors. But in general, when you have a 30 yr mortgage term vs a 15-year term, you will have a small mortgage payment every month with a 30 yr term.
Those in the hurry of repaying the mortgage as early as possible will certainly go for a 15 yr term without realizing the cons of it. Your rental business can afford a bigger monthly payment today. But what if a sudden unfavorable situation arises? Will you be able to afford the bigger payment? Would you be okay with negative cash flow?
If not, leverage the right amount for the appropriate duration. Don`t you think it will be better to save the cash flow with a lower monthly payment? And then utilize it wisely to either make pre-payments or buy more assets?
4. Not Understanding Cash Flow
Your rental property must put some decent enough cash in your pocket every month after paying for the mortgage and the expenses. Imagine you have put $80,000 cash from your pocket to buy a property and get only $300 cash flow every month because of high expenses.
Do you think it is a good return even though you have a positive cash flow? Your money is earning only a 4.5% return that too when it is 100% occupied. Imagine what if a vacancy happens or any unexpected repair comes up? Will you be able to keep up with the mortgage payments in these cases? I don’t think you have a lot in your cash reserves with a $300 cash flow.
Cash Flow Analysis is the backbone of successful investing. Not doing a thorough analysis, you can certainly end up with an overleveraged portfolio. Cash Flow analysis is not rocket science and an investor can easily learn to do it right.
5. Counting only Appreciation
It is the mistake that most real estate investors commonly make once in their lifetime. When you bet appreciation, you are too absorbed with the reward that you are ignoring the risk.
Imagine from the above example if the investor still chooses to invest in a property where he is only getting $300 cash flow or a 4.5% return. Because he thinks he can still benefit from appreciation. On average the real estate prices appreciate by 3%-3.8% every year. So, his combined rate of return will be about 8% which is considered a decent enough return in real estate. However, this is a problem. He doesn’t have enough cash flow and counting appreciation to be in his favor.
Such an investment strategy is sure to fail. It will surely cause the investor to feel the burden of overleveraging in the long run. Appreciation does favor an investor but it is not as linear as investors assume it to be. The prices do appreciate in a long span but not necessarily in 2, 3, or 5 years.
6. Negligent Cash-out Refinancing
By leveraging real estate, you can slowly build equity in your property. And then pull this equity by doing a cash-out refinance. When you do a cash-out refinance, you further leverage your equity by putting your property as collateral. Your current mortgage balance increases.
Smart investors use this money to acquire more assets. But imagine what if the next asset underperforms and you aren’t able to pay for the increased mortgage? This is a classic case where investors occur to overleveraging. Some people even spend this equity to buy unwanted luxuries. You can imagine where such a person will end up finally.
7. Leveraging too much
The idea of owning real estate with little to no money is highly alluring in itself that every so-called investor wants their hands on it. Little do they know whether they are actually in the position to leverage real estate or not.
If you take into account, more than 14% of individuals in the US have student loans. Over 62% carry home loans and about half of the population carry credit card debt. When you already have so much debt and are looking to take on more debt, you are sure to end up overleveraging yourself. A smart strategy would be to pay off your loans first or increase your take-home income.
How Much Should You Leverage In Real Estate?
In real estate, you should have a balanced approach towards investing when using leverage. An optimal leveraging is taking calculated risks, staying reasonable with returns, and don`t be averse to risks completely. Not leveraging optimally or overleveraging can cause financial hardships.
An optimal leveraging would be having enough wiggle room that borrowing doesn`t become a stress to you even during unfavorable situations. But how can you determine this? How can you know the maximum amount of leverage you can afford?
The answer to optimal leveraging is the Debt To Income Ratio (DTI). Leveraging according to DTI helps you understand whether you have enough income to borrow the debt. Banks recommend that your DTI ratio should be below 36% which is considered a safe wiggle room. Leveraging more when your DTI is already above 36%, you can end up overleveraging yourself.
Tip: It is recommended that you keep enough cash reserves when you are leveraging real estate. Nothing is permanent and unfavorable situations in your business can arise anytime. And if you have enough money in reserve, then you can stay afloat a little longer.
How To Know If You Are Over Leveraged Already?
You can lose your business and its assets down the line if you have leveraged more than what you can afford. When you over-leverage real estate purchases, you don’t feel the burden right away. But it will certainly affect you in the near future. You may be running a risk of over-leveraging if
- Making barely enough income to pay for the debt.
- Multiple loans
- DTI more than 36%
- Not Enough Cash Reserves
- Pulling Out Equity from Your Property Quite Often
- Own Multiple Rental Properties
Furthermore, there is a case of occurring negative cash flow sometimes in your rental business. It is a situation when you are burning more cash than your business is generating. If you have occurred to negative cash flow, this necessarily doesn`t mean you are overleveraged. A negative cash flow can be due to a temporary condition. But if there is nothing that you can do to change the negative cash flow, you are overleveraged.
Do the above cases match with your case? If yes, it is recommended that you analyze your situation and understand that you are not running for overleveraging.
A good way to do this is by running a stress test on your rental business. A stress test will determine whether your business can stay afloat even if you occur in unfavorable situations. Evaluate your rental business with a quick stress test by
- Increasing the Vacancy Rate by 2X
- Jumping the Current Mortgage Rate by 25 bps.
- Double the amount of the Rental Delinquencies
- Decrease the value of Real Estate by 20%
- Account a Large Repair
When you pull all these conditions and your business can still be capable enough to pay for the debt. You are likely not overleveraged.
What To Do If You Are Over Leveraged Already?
Overleveraging can be stressful. But don`t worry there are few ways by which you can get your portfolio out of the claws of overleveraging.
Refinancing is the most common way people use to get out of overleveraging. Doing a refinance on your mortgage allows you to shop for better interest rates, or increase the loan term. This allows you a reduced monthly payment and gives you some extra wiggle room to stay afloat. The only thing to look out for is the fees to be paid for Refinancing. Account for the fees and check whether refinancing is actually viable for you or not.
2. Onboarding a Partner
Your next recourse would be to partner with someone who can bring some equity into your business. You can sell some stake of your business to this partner and can use the equity to lessen your burden of overleveraging. Though the partner must see a solid potential in your business to invest his equity.
3. Sell Your Property
The ultimate option is to cut ties with this non-performing property and use the proceeds to unleveraged yourself. After all, there is no good to keep feeding the business from your pocket for the rest of your life when you see no other way of bringing it back on track.
4. Rent To Own Contract
Selling the overleveraged property is sometimes not a very sensible option as you are at risk of losing a lot of your money. But if you can do a Rent to own contract with someone, you can turn around your overleveraged portfolio.
When you do a rent-to-own contract on your property, you receive earnest money. It can be anything from 1%-5% of the agreed purchase price of the property. You can use this money to prepay some part of your mortgage which causes your monthly mortgage payment to go down.
With Rent to own, you eventually have to cut ties with your property. But it will save you from large losses and can give you that much required time. Leverage this time to make things better for you.
The Bottom Line
I hope that now you will use leverage in real estate more diligently. With this article, I really want to pinpoint the fact that you should analyze all the risks before committing to an investment. And when leveraging is involved you should really be very careful as losing your equity is no good. Always remember the number one rule of investing as Warren Buffet also advocates is to never ever lose your money.
“Leveraging Real Estate gives you an edge.” Sharp enough to cut deep if you aren’t careful.
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