When are you too over levaged?

25 Replies

Ground work:

Purchases: 

2015 SFH1 purchased 3/2 118k rents for 1100

2016 SFH2 purchased 3/2 122 rents for 1100

2017 (10/28/2017) closed on first multifamily (4plex) for 268k 12k in repairs expected rent per unit is 800 but looks closer to 900.  2/1 

Used 40k from refinance from SFH1 to use towards part of the Down payment for the multi family. 

SFH1 debt is 129k worth 172k 

Mortgage is 700 now

Rents for 1100

SFH2 debt is 96k and worth 160-170

Mortgage is 638

Rents for 1100

MF1 debt is 201k with 300k

Mortgage 1500

Rents for 3200-3600

My question: 

I currently own my own training company it is just me. 

At what point do you start paying off debt or stop buying properties.. like how many mortgages do you feel is easy to handle feel you won't over leverage. 

That is a personal preference based on where you are in your investment strategy and how much time you have to devote to the business.  I would say that many RE Investors follow the following cycle (NOT ALL INVESTORS!):

Acquisition Phase- Here will be a highly leveraged position as you put mortgages on every property.  You may even do a cash out refi on some to get down payment money for another.  You constantly look for deals and buy right.

Plateau Phase- Here is where you decide that you had enough with expansion and just want to run your business.  No new purchases or you may only buy something if it is a Grand Slam of a deal. You may even focus on debt pay down here.

Winding down phase- Maybe you want to retire and want to be finished with RE.  You let someone take care of it for you or you just sell it all and roll it into something else.

Sometimes an investor gets stuck in one phase for a long time, sometimes they go up and down each one.  It is largely a personal decision.  How big do you want your portfolio?  What are your goals? How much income you want from it?  Do you have enough RESERVES for each new property added to your portfolio?

Good luck.

Personally I plan on getting to 6-8 properties and then start paying down balances. Once I get to 10, I’ll probably spend a year or two and pay down a lot.

After that I’ll enter a higher growth mode of acquiring larger multifamily on my own and partnerships.

Everyone is different and I think this would work well for me. To put it in perspective I should be at 10 units in 4 years (when I’m 27) and from there could easily be at 30 plus units by 35, which would generate a lot of income.

Hope this helps.

50% Loan to REAL value

30% REAL EQUITY

20% REAL working capital

@Dean H. I like these rule of thumbs 

@David S.  wow what a great write up! Love it I think I can't decide on acquiring phase or platue phase. 

@Caleb Heimsoth great work man! I'm currently 31 and started buying property at 27-28 and have 6 doors now, 3 properties. 

@Dean H. Would it be possible for you to drill down on those numbers, say an example, for us less experience.

As long as the property cash flows then I don't think there is any such thing as "too leveraged."  We have 16 units and will continue to add to the portfolio as long as each acquisition meets our criteria and cash flows.  My experience has been that once you have a track record and bring good deals, banks are more than happy to loan you all the money you want.  Just make sure you keep discipline on your deals and the numbers work.

@Brandyn Duff

You're only over-leveraged if you're under-reserved.  That's why people with access to adequate cash reserves can weather storms, people who don't fold.

@Brandyn Duff  good advice already given by @Brie Schmidt , @David S. , @Dean H.

Asking how many mortgages is the wrong question. You could have one mortgage and be over-leveraged or 100 and not be over-leveraged. 

First question: If you had to sell all your properties to cash buyers that could close in less than one month, how much cash would you have at the end of the month? Make sure you use the cash value, not inflated market value. Take out closing and selling costs for net cash.

Second question: If half your properties went vacant, how many months could you carry expenses (mortgage, taxes, insurance, utilities)?

Third question: If all your properties went vacant, how many months could you carry expenses (mortgage, taxes, insurance, utilities)?

There is no right answer. My questions are just designed to make you think about your liquidity or lack there of depending.

Keep in mind that risk partially depends on your age. If you are 25 and lose everything, you have lots of time to recover. If you are 65 and lose everything, you are in trouble. 

If it all went to hell and was the worst case scenario you could come up with could you make it past that and service your debt?

Now, what if it was actually worse, would you still be able to?

Once you answer no to these you are over leveraged. 

As @Justin Fox stated, the real risk is cash reserves. Cash reserve needs change with the number of units you have. Someone with 20 units should have a larger cash reserve than someone with 1. But the funny thing is someone with 200 units probably needs less reserves than someone with 20 units IMO. 

I attached a little doodle I just to illustrate this. Assuming every unit averages to the same long term cash flow. With 1 unit it's binary; you either have expenses or you don't. With 20 you can have a lot of issues all at once. With 200 the odds of it deviating from the average by a lot are very unlikely. When you have a ton of units, you reach some economies of scale as expenses are concerned and your monthly cash flow remains much more stable. It doesn't fluctuate as much off of the long term average. 

Think of every property as a dice you roll every month. 3.5 is the average roll possible... 1, 2, & 3 are varying amounts of lower than average cash flow. 4, 5, & 6 are higher than average cash flow.  (the difference is 1 can be VERY negative when capex, or unit turnover happens)

   -  With 1 property it's pretty explanatory. 

   -  With 20 rolls of the dice, every once in a while you may roll 1's & 2's on 17 of the die. This could send you extremely negative for a while. Other times you'll roll a lot of 5's & 6's and be much higher than average cash flow.... 

   -  With 200 rolls of the dice, you won't deviate too far from the 3.5 average.  

BTW: that was a quick doodle to illustrate a point. I'm sure it's not fully accurate, but the concept of standard deviation holds true. 

@Austin Fruechting - nailed it.  and I love the doodle.

I have 30 properties / 90 + units and have been doing this for 6 years.  If I look at it on a single property basis, I would have a panic attack.  I had a duplex with long term tenants for a few years, then one lost his job, both moved out at the same time without paying and the units were trashed.  It took us a few months and a few thousand dollars to get it fixed up and rented out again.  So if that was my only unit, I would have been paying the mortgage out of my own pocket.  But with a portfolio, that one major downturn was a tiny blip in the grand scheme of things and barely registered on my radar in terms of performance and profitability.  

Brie Schmidt, Real Estate Agent in Illinois (#471.018287) and Wisconsin (#57846-90)
Originally posted by @Brie Schmidt :

@Austin Fruechting - nailed it.  and I love the doodle.

I have 30 properties / 90 + units and have been doing this for 6 years.  If I look at it on a single property basis, I would have a panic attack.  I had a duplex with long term tenants for a few years, then one lost his job, both moved out at the same time without paying and the units were trashed.  It took us a few months and a few thousand dollars to get it fixed up and rented out again.  So if that was my only unit, I would have been paying the mortgage out of my own pocket.  But with a portfolio, that one major downturn was a tiny blip in the grand scheme of things and barely registered on my radar in terms of performance and profitability.  

Exactly! When I was in the earlier stages I had a time when I was rolling all 1's and 2's for a period of time. I had an additional $35k in big ticket items beyond the average happen in a few months. Now with 156 units it stays very steady and doesn't have those wild fluctuations overall. Individual units will still have the big fluctuations, but the monthly stays pretty close to the average. 

Glad you liked the doodle! lol

Originally posted by @Justin Fox :

@Brandyn Duff

At least 6 months of PITI. One year if possible.

Justin, so I'm just starting out.  

I own an 1800 sq. ft. 3x2 rental outright and get 950 a month for it.  It's paid off.


I just bought another 3x1 1100 square foot.  My payment on it is going to be 358.93.


So are you saying I should have

358.93 x 6 = $2153.58 

in reserve for the 3x1?

What about for a house you own outright?  

So maybe use the 50% rule?

so 950 * 50% = 475 * 6 = $2850?


I'm pretty conservative and want to have plenty of cash for emergencies or for when times go bad / turn tough.

Thoughts?

I could totally double that too and put it in a "don't break glass unless emergency" fund lol.

@Austin Fruechting @Brie Schmidt

Great info! I'm at the 6 unit part and feel more comfortable but I still have my own job which is my security blanket.. 

My cash flow is positive on all properties and my cash reserves are empty currently since I just bought a 4 unit..

I guess my next steps are building a cash reserve, then start building a fund for purchases... 

Not using all my reserves for a purchase. 

@Shane Sams

I would include your tax/insurance monthly premium/cost in that 6 month reserve (in addition to the mortgage payment) for the leveraged property.

For the second one, I would just have at least 6 months of the taxes and insurance because there is no mortgage.

With three rentals in the DC area, all cashflow properties, I also question whether I'm too leveraged. In the DC market, properties tend to be high so finding properties for under 200k is a challenge unless you want to go to the D class neighborhoods. As such, the carrying cost can be high.  To a degree, I agree with some of the comments that the more cashflow properties you have, the less of an issue that becomes. I suspect you will have to come up with your own rule by looking at your carrying cost, the average turnover period in your market, the average cost to prepare your rentals after a tenant moves out, and how many of your units you believe could become vacant at the same time. 

Originally posted by @Justin Fox :

@Shane Sams

I would include your tax/insurance monthly premium/cost in that 6 month reserve (in addition to the mortgage payment) for the leveraged property.

For the second one, I would just have at least 6 months of the taxes and insurance because there is no mortgage.

 Good stuff on that.  Makes sense.  The goal is emergency fund to survive a downturn or no renter.  So just make sure you can pay the taxes and insurance and worst case fix stuff later.  Am I thinking right?

Originally posted by @Brandyn Duff :

@Austin Fruechting @Brie Schmidt

Great info! I'm at the 6 unit part and feel more comfortable but I still have my own job which is my security blanket.. 

My cash flow is positive on all properties and my cash reserves are empty currently since I just bought a 4 unit..

I guess my next steps are building a cash reserve, then start building a fund for purchases... 

Not using all my reserves for a purchase. 

 I would also look at getting a line of credit somewhere which can act as part of your cash buffer/additional buffer. I ran very cash lean as I was acquiring, but only because I had the safety net of ~$50k in LOCs. 

Originally posted by @Shane Sams :
Originally posted by @Justin Fox:

@Shane Sams

I would include your tax/insurance monthly premium/cost in that 6 month reserve (in addition to the mortgage payment) for the leveraged property.

For the second one, I would just have at least 6 months of the taxes and insurance because there is no mortgage.

 Good stuff on that.  Makes sense.  The goal is emergency fund to survive a downturn or no renter.  So just make sure you can pay the taxes and insurance and worst case fix stuff later.  Am I thinking right?

Carrying costs are certainly something to consider, but probably the smaller portion of what you need reserves for. If your tenant moves out and it needs all new flooring, repainted, and other updates how much does that cost? You need at least that plus the carrying costs for the time it takes to do the work and hold until you get a new tenant in. What if the HVAC goes out around that time too? Or any number of other things. 

Just using a certain amount of months of carrying costs doesn't make for a great calculation of a cash reserve (just as you shouldn't plug in a % of rent for repairs/capex). What if it's a property you got at a steal so your mortgage is low? Or paid off? Say your monthly carry costs are $500 or less. Is 12 months of that ($6k) a good reserve? Of course not! That HVAC is going to cost you $4-5k wether your carrying costs are $500 or $1500. If you have other repairs and vacancy there your "12 months of reserves" doesn't get the work done and you're sunk.  

Let's say a long term tenant moves out. It sits vacant for 3 months to complete work and get a new tenant. Carry costs $500 a month x 12 = $6k reserve. New flooring; $3000.. paint whole house; $2000.. HVAC: $5000.. Miscellaneous repairs; $1000.. small bathroom update; $1000.. TOTAL WORK: $12,000.. carry costs; $1500.. Total: $13,500.... your 12 months of carry costs don't even cover half of it.

The carrying costs is only one part of the equation for your cash reserve needs. 

Based on numbers, as many have pointed out, as long as you know how to properly manage your business you can never be over leveraged as long as you have positive cash flow through a sufficient # of doors. The more doors the higher your leverage tolerance. 

I prefer 100% leverage but that is due to my strong investment income and reserve capability with lines of credit etc. I have excess income, I am no longer growing real estate investments, and believe the worst investment decision is to park cash in real estate. I continually pull out equity and  invest outside real estate. My risk is very low overall. 

Originally posted by @Austin Fruechting :
Originally posted by @Shane Sams:
Originally posted by @Justin Fox:

@Shane Sams

I would include your tax/insurance monthly premium/cost in that 6 month reserve (in addition to the mortgage payment) for the leveraged property.

For the second one, I would just have at least 6 months of the taxes and insurance because there is no mortgage.

 Good stuff on that.  Makes sense.  The goal is emergency fund to survive a downturn or no renter.  So just make sure you can pay the taxes and insurance and worst case fix stuff later.  Am I thinking right?

Carrying costs are certainly something to consider, but probably the smaller portion of what you need reserves for. If your tenant moves out and it needs all new flooring, repainted, and other updates how much does that cost? You need at least that plus the carrying costs for the time it takes to do the work and hold until you get a new tenant in. What if the HVAC goes out around that time too? Or any number of other things. 

Just using a certain amount of months of carrying costs doesn't make for a great calculation of a cash reserve (just as you shouldn't plug in a % of rent for repairs/capex). What if it's a property you got at a steal so your mortgage is low? Or paid off? Say your monthly carry costs are $500 or less. Is 12 months of that ($6k) a good reserve? Of course not! That HVAC is going to cost you $4-5k wether your carrying costs are $500 or $1500. If you have other repairs and vacancy there your "12 months of reserves" doesn't get the work done and you're sunk.  

Let's say a long term tenant moves out. It sits vacant for 3 months to complete work and get a new tenant. Carry costs $500 a month x 12 = $6k reserve. New flooring; $3000.. paint whole house; $2000.. HVAC: $5000.. Miscellaneous repairs; $1000.. small bathroom update; $1000.. TOTAL WORK: $12,000.. carry costs; $1500.. Total: $13,500.... your 12 months of carry costs don't even cover half of it.

The carrying costs is only one part of the equation for your cash reserve needs. 

 I like the worst case scenario there haha. 

I may just drop 10K / rental in an account.  Keep that cash out.  

Buy a house, put 10k in an account...

Buy 10 = 100k in reserves.  Problem solved.

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