Leveraging Real Estate? Know This Before It Cuts You Deep

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 [1].  

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?

Read:  Deciding Between a 15 Yr Vs 30 Yr Mortgage

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. 

Read: How to do Rental Cash Flow Analysis like a Pro?   

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.  

Read: Cash-Out Refinance Vs HELOC to Pull Out Equity   

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.[2] Over 62% carry home loans and about half of the population carry credit card debt[3][4]. 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.