Over leverage a bad thing?

Question

Quick question.  I often hear people warn of being overleveraged if the economy has a correction.  I would think that if the housing market dropped by 50%, you are protected in the form of having your tenants pay your mortgage, even if it is underwater.  If it takes 5 to 10 years to recover, you should cash flow throughout the downturn if you are managing your money for the property properly.  With that being said, I could completely be wrong with the way I am thinking here.  Thanks in advance for responses!!!

Jaysen Medhurst · Answer

Being over-leveraged presents a number of challenges, @James Baker. How they actually manifest themselves depends on the nature of the downturn. One of the biggest issues is the lack of flexibility. P&I are fixed (at least for the loan term) so if there are any bumps in the road, you're stuck. You could delay repairs, self-manage, or cut the lawn yourself, but that mortgage lender has their hand out every month, no matter what.

As you eluded to, a drop in housing prices, isn't really a major issue for a landlord in the short term. You may lose equity and not see CG or have to hold a property longer than you want. But as long as rents stay steady, you should be fine.

One huge risk of being over-leveraged is when you have a mortgage with a term shorter than the amortization period (most all commercial mortgages). Let's say you have a 10-year term with a 30-year amortization. Over that time (assuming 20% down) you should have ~34% equity of the original price. But what if prices have actually dropped 20% since you purchased? You're not going to have enough equity to refi without kicking in some cash--maybe a lot of cash. Worse yet, what happens if credit markets are frozen and you can't get another mortgage at all? And neither can anyone else, so you can't even find a buyer.

Of course, it depends on the nature of the recession. I think it's a huge mistake to use the last financial crisis as the template for what future recessions are going to look like. Last time values fell and credit froze, but in most places rents actually bumped up due to greater demand from displaced homeowners or those who would have bought, but couldn't get financing. Depending on what sets off the next downturn, we may see rents fall...or not. Additionally, the effects won't be felt uniformly across markets. A major issue in Grand Rapids may not even register in Seattle.