Good plan? Over-leveraged?

17 Replies

I have a plan that I'm throwing around.   I currently own one rental property that is paid off.  Cash flowing around 500 a month.  I have a primary residence, house is worth 135k and I owe 65k.  My current income is around 80k, and I'm able to save around 30k a year.

I was thinking about max-ing out my ROTH IRA, but after fees I will average around 5% over time. If I do real estate buy-and-hold it may be more like 10%.

I am able to afford to buy one rental per year, putting around 30% down on each property. I can cash flow about 50% of the PITI on properties, with these numbers. Long story short, I will be financing 70% on these properties.

If I buy one rental per year, for say, 10 years, will I be overleveraged? It sounds like a good long-term plan on paper. But in reality, I have no idea. I will be using a property manager on these properties (and still cash flowing 50% or more of PITI).

Well, depends on your comfort with debt. So long as you have enough cash flow cushion to absorb downturns and vacancies, in theory you could have 100% leverage on everything and be fine. Obviously, the more outstanding debt, the less cash flow (though your return is probably higher with leverage). So there's no good answer. If you have a whole lot of cash reserves, with that few houses you are probably in good shape either way. If you have 500 bucks to your name after buying everything, you are probably in bad shape either way. 

Don't box yourself in. You need to pivot with the market. If it works now, go with it. Do what you can to look for market indicators and think about potential scenarios/moves you can make if x,y,z were to happen. Essentially, come up with multiple exit plans if necessary. 

You might decide that you want to try an apartment building in which case it might be more than a year before you can afford that down payment. 

Lending changes with time. You might consider getting a HELOC. There are so many different ways to approach investing. Leverage can be scary, but that's why you find people to pay your mortgage and do what you can to increase rents. If you want to, you can refinance your loans on your properties and look at your LTV change over time.

Be free, not boxed in.

First, you are assuming you will be able to get 10 loans...in addition to your current one on your primary.  Not likely.

Joe, a conventional lender won't give 10 loans if the properties are cash flowing well (over 50% of PITI)? Over the course of 10 years?

Depending on the value of your paid off property your return is probably nothing or negative on the property itself. Return on your cash probably very low. Opportunity value of cash/equity being minimum 10% deduct $866/100K of equity off of your rental income as return on your equity. What remains, after all other expenses, is the actual cash flow on your property. 

You need to pull the equity if you wish to increase your true cash flow on the rental property.

To increase cash flow you need to leverage. Provided your cash flow remains positive and you have adequate reserve funds there is little risk from having leverage. If you set up a HELOC on your home you can use that as a revolving reserve fund.

I don't feel comfortable doing a HELOC. I want my PITI to remain below 50% of my rent income. With a HELOC I would certainly be over that amount.

Well, maybe you're right. If I HELOC-ed the paid off property, I could expand my return on another property. Good point. Hmm.

No, you wouldn't be over-leveraged. Each property would have an LTV less than or equal to 70%. You'd need to be smart about maintaining adequate liquidity though. As long as you have liquidity, no, you're definitely not over leveraged.

How much liquidity though?  How can one figure out what is appropriate?

Originally posted by @Byran Parson :

How much liquidity though?  How can one figure out what is appropriate?

I consider appropriate liquidity to being able to absorb at least one year of a unit being vacant. So if you had a house with a $500 PITI payment, $6000 should be accessible at a minimum (actually it should be more, as you need some utilities and maintenance). Keep in mind that doesn't necessarily have to be all cash lying around, just something where you can readily access cash - borrowing from your own retirement fund; cash in the bank; etc. Point being that under unusual circumstances you can readily avoid losing the property. As you gather more properties you can start spreading this risk among all your properties, such that it there would be virtually zero percent of all properties needing 100% support in that time.

Leveraged people generally get in trouble because they either own properties that will not cash flow with leverage, which requires constant infusions of outside funds, or they have no liquidity and cannot absorb any hiccups in the system.  

People have pretty loose definitions of cash flow, curious how you're getting 500 after a paid off property. Could that be sold and invested in a better performing property to kick start future investments?

Our market rents for a SFH in our rural town is 800 a month. So after taxes, insurance, I'm probably clearing 500 or slightly more.

Originally posted by @Byran Parson :

I don't feel comfortable doing a HELOC. I want my PITI to remain below 50% of my rent income. With a HELOC I would certainly be over that amount.

You keep mentioning "PITI to remain below 50% of my income", but, what about: PITI plus its other expenses? 

If paying for it with a HELOC takes you over the edge, then I reckon you're too close to the edge to begin with.

70% LTV should not usually be considered over-leveraging, but it would would be better if that represented 100% OPM!

ie. With the "BRRRR strategy", by buying RIGHT, from day one, you get to keep buying with Other People's Money!

Buy, Rehab, Rent, Refinance, Repeat! The Refinance part gets you ALL your deposit back - if you bought RIGHT! Cheers...

In my opinion you don't have to worry about being over-leveraged in this scenario.  With the relatively high rate of savings you're capable of and the slow rate of acquisition, you will have ample time and flexibility to react to unforeseen circumstances as some others have said.

Something I haven't heard mentioned yet in the thread is that properties with conventional financing automatically tend to de-leverage over time.  Over such a long time-frame you would have to periodically refinance additional equity from amortization/appreciation and aggressively reinvest it to stay at a high leverage ratio.  Rents will increase over time but the cost of your debt will remain fixed unless you refinance resulting in more cash flow if you need it.

B&H real estate doesn't generally move so quick that you can't gradually re-position yourself as necessary.  Assuming you keep a decent buffer in cash equivalents your plan of slowly buying one rental unit a year with 20% - 30% of your own personal capital down won't bring you anywhere near the levels where I'd start worrying about excessive leverage.

Originally posted by @Byran Parson :

Our market rents for a SFH in our rural town is 800 a month. So after taxes, insurance, I'm probably clearing 500 or slightly more.

 Bryan. Two things here. First off it scares me when somebody says "probably??" When referring to cash flow. You don't know for sure??  Secondly  it's difficult if not impossible to determine cash flow using one month as an example. In your example a new $500 hot water heater would reduce your CF to 0 for one month and $250 for 2 months. It's more accurate to figure CF over several years. Clearing X amount in one month is hardleyv an indicator of cash flow. RR

Just a thought:   

1st - you make your money going in, not going out.  (you collect it as you exit)  So First off Buy Right.

2nd- The only thing for sure is that circumstances will change, It appears that you have life by the horns and you have a great amount of cash to put in to real estate.  What I am saying is that you may pick up more than one in some years and some years you may have to hold on. 

3rd- If you are buying  great deals, with 70% loans you should not get in trouble.  Even without appreciation, the balances will be slowly inching downward, which raises your equity.  

If you keep your property properly maintained, keep some reserves for CapEx you should be fine. Since you are not needing the cash flow for living, I would bank it for the next purchase and for unforeseen expense.

I notice a lot of individuals on here use a 90-95% occupancy on their deal sheets.  I have over 90% occupancy, probably closer to the 95% but when I am purchasing, I use an 80% occupancy.  It builds cushion into my deal, (just a thought as you examine your next purchase.)

Great question that we all should consider as we scale up. My answer would be...it depends. Do you have a detailed contingency plan for a market downturn for each and every one of your properties? Thinking more along the lines of "when" the market takes a downturn as opposed to "if" it takes a downturn. If you do not have a detailed contingency plan then I would say yes, you are overleveraged. For starters, I would include at a minimum 7 items in my expenses allocation for each property. Mortgage, Insurance, Prop Mgmt, Prop Taxes, Repairs, Vacancy, and Cap Ex. I personally don't fudge my numbers here, I actually set aside 5-10% of the incoming rent for repairs, vacancy, and Cap Ex. In addition, I set aside $7K as a "starter" fund for each property. The money that I don't use month-to-month (vacancy, repairs, Cap Ex) feeds that starter fund. Finally, I keep 6 months of "operating costs" in a liquid account for each property. Maybe I am being overly cautious but my strategy is to create cash flow income while also preparing for a potential market correction. Hope this helps you assess whether or not you are overleveraged.

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