How Much Debt is Too Much Debt?

Question

I've been real estate investing for about ten years. I've had as many as five mortgages, but never went over $1M in debt.  Question for those who own many rental properties, how much debt is too much debt?  Is it common for investors to have over $1M in real estate mortgages? I look forward to the feedback.

Steve Vaughan · Answer

A lot of it for me is ratios of debt to value and whether it's residential or commercial debt.  Like @Brent Coombs points out, $1M of debt on a $5M portfolio is low.  $1M of debt on a $800k portfolio (like so many BKs in the GRC) is ludicrous.

Same for location.  $1M in San Jose is much much different than $1M in Detroit.

As many point out, it's a personal decision.  Sylvia B has 10 rentals, but carries no debt.  @Julie Kern and @Perry Ivy and I are more debt-averse. It represents risk.  Some of us would rather have 30 paid for than 200 leveraged. Same CF, less work.  @Russell Brazil has well over a couple million and is hoping to double it in this 3% long-term rate environment. He's also in an expensive market.  My math brain agrees, but my risk meter does not.

I am aggressively accelerating my commercial apt building loans.  Got tired of the annual reporting requirements and adjustable & callable terms. Those are also what I have inside LLCs, so I feel my equity is more protected.   I am more comfortable with higher LTVs on little houses I own personally.  I will pay those off in large chunks before I get them out of my name. The older ones in the 6% range, especially.

A lot on here will say to borrow every dime you can.  All folks I've mentioned are seasoned with actual assets and experience.  Don't give too much credence to the broke with only an opinion @Joseph Duenas!

Rich Baer · Answer

Simple. When you can't sleep it is too much.

Bill Gulley · Answer

Well, actually, it's not all that simple, but Rich Baer hit on an important aspect, if your mind can't wrap around your financial situation it's probably out of control.

In finance and accounting we look at a "Quick Ratio" (also known as the Acid Test) this shows the ability of a company to meet obligations, but this only looks at current assets or liquid assets and current liabilities, real estate is not a liquid asset.

So we move to other ratios like "Current Ratio" and "Cash Ratio" these to help to illustrate the ability of a company to cover current debts.

As to mortgages or long term debt, coverage is difficult to predict due to uncertainty over longer periods, but by looking at the current coverage and cash available we can see what funds remain for these other obligations.

Most everyone is familiar with the debt to income ratio we suffer through at a loan application, say 24/36, meaning that you should not pay more than 24% of your income to current liabilities, revolving accounts and car loans, the 36% includes the 24% to establish your ability to cover the mortgage, total debts should not exceed 36% in this instance. So, that really means you should only have 12% of your income available for longer term debt if, if, your other debts are maxed out. But, keeping those other debts low, we can use the additional amounts toward the longer term debt, so if your current debt obligation is only 10% of your income, you can use 26% of your income to cover the mortgage.

That's not news for most of you. But it goes deeper, larger debt loads on non liquid assets requires analysis of cash, use of cash, inventory turn over or how fast we turn over deals or tenants, how quickly we collect revenues, tax liabilities, seasonal changes in those areas of business and real estate that are subject to seasonality (vacation rentals, apartments near colleges or seasonal employment, think motels or restaurants or gas stations and C-stores).  What must be identified is the debt coverage ratio at its leanest times during revenue streams and the ability to move through those lean times.

The debt coverage ratio as to loans vary by industry and operations, debt coverage for a flipper might be 125%. the borrowers earning assets would be 125% of the loan debt, this is low and might be acceptable as the period of time to carry the debt is assumed to be short lived, ultimately the property is sold and the obligation is paid off. A landlord may walk in to a lender that requires 175% or even 200%, this debt is expected to be long term and will heavily rely on the property and performance by management.

When an investor believes that debt won't matter as it's paid by tenants, or just as long as you can make the payment, they can be on the road to failure. Doesn't matter what kind of business you're in, a company or operation that no longer has the ability to grow and finance operations will be on the way down.

I'm not sure if it was worth writing all this, but it's slow this morning :)

All of this is part of what we bean counters call debt management, debt is not as simplistic in business as it is in personal finance with good or bad debt. An important aspect here is the timing of debt maturing, balloon payments or renewing option payments or meeting purchasing goals.

By manipulating the timing of obligations we can reduce the financial impact to our operations and take some steps used in asset management, but in reverse. Maturity distribution is staggering the holding time of maturing assets, like bonds, to meet the timing requirements of other obligations. When you deal in millions, every dollar should be at work until just before it is needed and not sit idle. As we take on additional debt you need to ensure that any balloon obligation or even the renewal date of that debt is not closely aligned with other obligations. You don't want to have different loans coming due where you must go ask for renewals or new loans in much larger amounts to consolidate debt, it can be easier for a lender to say no.

Lastly, yes, lastly, another aspect of debt held by mortals is debt concentration, mentioned this a few times lately about that infinite financing with BRRRR, it's not infinite, not with conventional financing.

You can reread the above, pick out more detail, but all of this plays on loan concentrations, too much money loaned to one borrower or another side for lenders, too much concentration in the types of loans made. Might prolong some of these issues by having a lead lender that actually has affiliate lenders to take a piece of a large loan reducing risks for all the lenders, but the lone home investor, well, you'll hit a wall.

That's what we basically look at in larger loans, investors need to be aware of the big picture and keep an eye on their accumulation of debt, you have to to succeed. :)

Ken Teng · Answer

In my opinion, you should get as many good debts as you can manage. Two keywords here:

1, Good: The debt is working for you, generating money instead of consuming your money;

2, Manageable: You should have an idea of what you are doing and can keep track of things all the time. In case bad things happen, you need to have an exit strategy.

All the rich become rich through leveraging, no exception (well, except inheritance).

Chris Mason · Answer

As long as your tenants are paying for it, not you, who cares?

Antoine Martel · Answer

That all depends. If you have a 10M portfolio with 1M in debt then that is nothing. It all depends on the values of the properties that you own.

You just don't want to over leverage a property.

Joseph Duenas · Answer

Wow! Great responses!  @Bill Gulley and Steve Vaughan, thank you for your expert advise here. The input here has shaped my decision on how to move forward.

Thomas S. · Answer

There is no such thing as too much good debt.

Brent Coombs · Answer

If the properties are worth $5M, then ONLY borrowing $1M is WASTING too much equity! Cheers...

How Much Debt is Too Much Debt?

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