Is it better to be over-leveraged or under-leveraged?
Chicago, IL · Member since 2014 · 24 posts · 17 votes
Is it better to be over-leveraged or under-leveraged?
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Lender · Lenexa, KS · Member since 2013 · 119 posts · 80 votes
11yWilla -
I have two perspectives on leverage.
1. Just like the stock market, leverage is good (and wise) when prices are rising. It's like buying stocks on margin. Once you are satisfied with the increase in stock price, you sell, pay off the margin, and take your profits. When stock prices are falling, leverage is bad. Now you purchased on margin, anticipating higher prices, and the opposite occured. Now you are losing money. And leverage only magnifies the losses (just as it magnifies the gains when prices are rising). the key is to know when to get in, and when to get out.
@Franklin Romine made a key point - what is your strategy? Based on what I can gleen from your posts, sounds like you are a buy-and-hold investor. Assuming this is true, then the declsion to use leverage changes. You are not so much concerned about how the pricing of homes fluctuates. You are more concerned about the cost of the funding, and (hopefully) the rate is fixed. If the rate is not fixed, now its starting to get dicey. Nobody thought interest rates in 1980 would hit 18%+. But they did. Any rates that were indexed went through the roof. Nobody thought what happened in 2007 would happen. But it did. The crash of 1980 hurt both fix-and-flip investors as well as buy-and-hold investors. The 2007 crash primarily hurt the fix-and-flip investors. Buy-and-hold investors actually saw interest rates drop over time, although getting loans on new acquisitions was pretty much impossible. And when the markets crash like they did on 1980 and 2007, rental demand GOES UP. Rental rates remain stable or increase. However, rent volatility increases as well. Renters lose jobs. Their savings and income gets stretched. So kind of a double edged sword.
2. I have been on the capital side of the business for 21 years now, and have seen a lot. My philosophy is that in general, the fix and flip market is fully matured. There is lots of competition for deals. Supply is thin. Prices are higher. And the most forboding indicator - its taking longer to complete the flips. That is a absolute sure-fire sign that its time to reduce risk. Not everywhere, not with everyone. But in general, its reality. I think Atlanta is one of the bright spots. I am sure there are a few other great markets as well. But most are fully matured. Therefore, those who leverage in the current fix-and-flip market are taking greater risk. The lenders too.
On the buy-and-hold side, leverage is OK (I emphasize OK) as long as you have low, fixed rates, your property is a mid-rental rate property in a highly desireable area, and you are not so overleveraged that it will be tough to cash flow with some hiccups in the economy. And most of all, you still maintain very high cash reserves to help you weather any storm.
I saw a lot of investors crash in 2007. Just about anybody who was leveraged suffered. That is why today I err on the side of caution. As Warren Greenspan stated, irrational exuberance is a bad thing.
29 Replies
- Bedford, NH · Member since 2012 · 2k+ posts · 1k+ votes11y
How can over-leverage possibly be a good thing? You mean max leverage, maybe?
- Chicago, IL · Member since 2014 · 24 posts · 17 votes11y
Originally posted by @Richard C.:
How can over-leverage possibly be a good thing? You mean max leverage, maybe?
Yeah, I guess max leverage would be the word. Over- and under-leveraging are both bad by definition. I just wanna see what people would be more comfortable with if they had to choose one.
- Rental Property Investor · Henderson, NV · Member since 2013 · 96 posts · 33 votes11yBased on the way you asked your question, I think your goal in using leverage is to reduce your risk since you said you don't want to put your hard earned money into an investment that may lose money so I'll answer from that perspective. Unless you're leveraging your investments with non-recourse loans (lender can only go after collateral and not you personally), then you're not reducing your risk by using leverage. For example, let's say you buy a place for 100k, put 20k down and borrow the rest. If the property value drops to 50k, you're still on the hook for the 30k. And even if you do have a non-recourse loan, there will be ramifications to walking away from the property like a black mark on your credit. If you are able to get a non-recourse investor loan and not in your personal name, then the leverage may help reduce some risk if things go really bad. I don't think this type of financing would be easy to obtain though.
- Chicago, IL · Member since 2014 · 24 posts · 17 votes11y
@Paul Thanks for figuring out my question. I don't really know how to ask questions sometimes when I'm just thinking. I see what you mean about me still being on the hook anyways and I'm not actually reducing any risk by maximizing leverage.
I think it's just a psychological thing, about wanting my sweet cash in my hands. I guess the smart way to look at it would be to make my decisions based on interest rates, and if I can make a higher return off my cash than I'm paying on the mortgage then I'd keep the mortgage(s).
- Chicago, IL · Member since 2014 · 24 posts · 17 votes11y
@Paul C. Thanks for figuring out my question. I don't really know how to ask questions sometimes when I'm just thinking, so I like to try to phrase it like a discussion starter I guess. I see what you mean about me still being on the hook anyways and I'm not actually reducing any risk by maximizing leverage.
I think it's just a psychological thing, about wanting my sweet cash in my hands. I suppose the smart way to look at it would be to make my decisions based on interest rates, and if I can make a higher return off my cash than I'm paying on the mortgage then I'd keep the mortgage(s).
- Investor · Arlington, VA · Member since 2012 · 1k+ posts · 491 votes11y
Being overleveraged would suggest you are underwater on your loans (e.g., you owe more than you have in equity). To me, this is the worst position you can be in.
Being fully leveraged when suggest that you have reached the limit of your borrowing capacity based on bank borrowing requirements. This to me would be the optimal sitaution given you have the reserves to cover any hiccups in your plan (e.g., capital expenses, long term vacancies, etc.).
Being underleverage suggests that you are leaving money on the table that could be working for you to grow your empire. I shoot to be fully leveraged with a reserve contingency that can be filled by equity (e.g., HELOC), business reserves generated by VMTIM accounting, and my emergency fund.
At the end of the day, it's personal preference...as long as you are able to sleep at night. Just my $0.02.
- Visalia-Fresno, CA · Member since 2009 · 1k+ posts · 863 votes11y
Your leverage position would depend on your strategy with the asset. Are you buying to hold?, is it turnkey?, are you rehabbing? fix and flip?
Leveraging should be calculate based on your cashflow, return on investment, comfort level, personal resources, other income, etc.
If your leveraging an asset by refinancing out equity... where is the new equity going? are you buying more assets or smoking it?
Me personally I like equity almost as much as I like cash flow. You don't want to complete a personal financial statement and have little equity.
Frank - Herndon, VA · Member since 2014 · 1k+ posts · 324 votes11y
Assuming your interest costs are low, generally a more liquid position is better. Assuming you had a theoretical 500K portfolio it would generally be better to have 25K in equity and 100K in reserves vs. 100K in equity and 25K in reserves.
The liquidity isn't free. Even at 4% you would be paying 3000/year for the extra 75K in leverage.
Besides the interest costs there are a couple of other risks of a large pile of cash and low equity. The first is having the discipline to keep the cash in the business. The second is making a bad deal because you have "free" money. A deal with a low return can look deceptively good if you remove the interest costs.
- Scottsdale, AZ · Member since 2014 · 659 posts · 536 votes11y
Based on the intent of your question, there are times for both. It would vary depending on the state and direction of the market. Also with where you are in your career.
- SFR Investor · Dallas, TX · Member since 2011 · 604 posts · 243 votes11y
When people discuss being over leveraged, often they are talking about days of the past, when you could put $0 down or close to it, on investment properties.
Today you will normally have at least 20% equity (note I didn't say 20% cash, if you buy right you can use some of the built in equity as part of the 20%) before you make the first payment.
Can property fall more than 20%, absolutely, but if your buying in the right property, the chances of that happening are very slim, and even if it did happen, as long as the property cash flows (I'm a buy and hold guy), you should still have positive cash flow to get through the dip in the market.
Everyone has their own comfort level with leverage,,if you won't sleep at night unless you own a property outright, then don't buy until you can pay cash. For most of us leverage is a very useful tool, and I can sleep at night with a 80% mortgage on a property without any trouble.
- Rental Property Investor · Henderson, NV · Member since 2013 · 96 posts · 33 votes11y
Originally posted by @Account Closed:
I think it's just a psychological thing, about wanting my sweet cash in my hands. I guess the smart way to look at it would be to make my decisions based on interest rates, and if I can make a higher return off my cash than I'm paying on the mortgage then I'd keep the mortgage(s).
You hit the nail on the head. Once you figure out the risk side of the equation and what you're comfortable with, then you want to maximize your return by investing in assets that return more than your cost of debt.
Also keep in mind that money is fungible. I tend to look at all my debt and investments together. For example, you may find that the cost of borrowing against a stock portfolio is cheaper than borrowing against rental property, but you may use the proceeds to invest in property.
- Lender · Lenexa, KS · Member since 2013 · 119 posts · 80 votes11y
Willa -
I have two perspectives on leverage.
1. Just like the stock market, leverage is good (and wise) when prices are rising. It's like buying stocks on margin. Once you are satisfied with the increase in stock price, you sell, pay off the margin, and take your profits. When stock prices are falling, leverage is bad. Now you purchased on margin, anticipating higher prices, and the opposite occured. Now you are losing money. And leverage only magnifies the losses (just as it magnifies the gains when prices are rising). the key is to know when to get in, and when to get out.
@Franklin Romine made a key point - what is your strategy? Based on what I can gleen from your posts, sounds like you are a buy-and-hold investor. Assuming this is true, then the declsion to use leverage changes. You are not so much concerned about how the pricing of homes fluctuates. You are more concerned about the cost of the funding, and (hopefully) the rate is fixed. If the rate is not fixed, now its starting to get dicey. Nobody thought interest rates in 1980 would hit 18%+. But they did. Any rates that were indexed went through the roof. Nobody thought what happened in 2007 would happen. But it did. The crash of 1980 hurt both fix-and-flip investors as well as buy-and-hold investors. The 2007 crash primarily hurt the fix-and-flip investors. Buy-and-hold investors actually saw interest rates drop over time, although getting loans on new acquisitions was pretty much impossible. And when the markets crash like they did on 1980 and 2007, rental demand GOES UP. Rental rates remain stable or increase. However, rent volatility increases as well. Renters lose jobs. Their savings and income gets stretched. So kind of a double edged sword.
2. I have been on the capital side of the business for 21 years now, and have seen a lot. My philosophy is that in general, the fix and flip market is fully matured. There is lots of competition for deals. Supply is thin. Prices are higher. And the most forboding indicator - its taking longer to complete the flips. That is a absolute sure-fire sign that its time to reduce risk. Not everywhere, not with everyone. But in general, its reality. I think Atlanta is one of the bright spots. I am sure there are a few other great markets as well. But most are fully matured. Therefore, those who leverage in the current fix-and-flip market are taking greater risk. The lenders too.
On the buy-and-hold side, leverage is OK (I emphasize OK) as long as you have low, fixed rates, your property is a mid-rental rate property in a highly desireable area, and you are not so overleveraged that it will be tough to cash flow with some hiccups in the economy. And most of all, you still maintain very high cash reserves to help you weather any storm.
I saw a lot of investors crash in 2007. Just about anybody who was leveraged suffered. That is why today I err on the side of caution. As Warren Greenspan stated, irrational exuberance is a bad thing.
- Investor · Burbank, CA · Member since 2014 · 21 posts · 7 votes11yDan Brewer I too agree that the "fix & flip" period is over. At least in Southern California. Thank you everyone for the great insights to investing. Lots to think about.
- 11yPeter MckernanBusiness MemberResidential Real Estate Agent · Irvine, CA · Member since 2013 · 2k+ posts · 1k+ votes
Isn't a HELOC a loan with a variable rate? I ask because I have read information that says that, and if a person were going to use that and have the loan out while the interest rates are rising, it would make it tougher for them to pay it back with that increasing rate? That could cause a financial strain with an investor that has a more fixed income and is not prepared for the interest rate to jump up?
I have heard that there are some HYBRID HELOCS with a fixed rate.
Peter
The McKernan Group4.957 Reviews - 11yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
I generally agree with you except a few markets that the rental market absolutely tanked with the property values.. and that was PHX area and Vegas... Mid west not so much because so many homes were already rentals and it was mainly landlords that fail there and not because of value issue because of tenant vandalism and bad debt issues along with lack of reserves..
case in point... Linda Gerchik and I were doing investment seminars in the Bay Area circa 2004 selling investment properties to SF Bay ARea clients.. I was selling Portland she was selling 4 plexs in PHX... She sold the heck out of those I sold a bunch of my inventory.. BA buyers were paying 300 to 350 for PHX 30 year old 4 plex.s when the crash happened those things went vacant big time and the value plummeted to under 100k and many were sold for no kidding 50 to 60k for the whole 4 plex.. I had many clients that bought my stuff and her stuff that lost the properties because they were vacant they had high debt on them and could not afford them.. WE had some foreclosure here in ORegon but nothing like what happened there and Vegas.. Many multi family in Vegas went under because of mass vacancies.... It has happened in Texas over the years as well. I worked for a syndicator in SF in the 80's that lost 2 big Dallas apartments because they had mass vacancies it can happen... But in other parts of the country rents remained stable and home owner lost homes and had to rent. no question about that.
- Rental Property Investor · Douglas County, MO · Member since 2014 · 1k+ posts · 1k+ votes11y
Originally posted by @Jay Hinrichs:
I had many clients that bought my stuff and her stuff that lost the properties because they were vacant they had high debt on them and could not afford them..That is one of the main reasons that Hubby and I are not leveraged at all. We own our home on 80 acres, a small commercial property, and 7 (soon to be 8) single family rentals. In the unlikely event that all of our rentals were vacant at the same time we could afford to carry them for quite a while because taxes and insurance combined average less than $100/month/house and we have no mortgage to pay.
But where we are in life and in our investment strategy is not where others are, so what we do would not work for them. That's the key to answering this thread's question, I think. Each person needs to evaluate their own strategy and decide what is best for them regardless of what others do or think.
- Investor · Arlington, VA · Member since 2012 · 1k+ posts · 491 votes11y
You are correct, a HELOC is variable, but I believe it has a limit on the amount it can rise. So, you should be able to anticipate a worst case scenario and purchase appropriately.
Many of the smarter investors will buy a property that is less than 70% ARV (minus repairs) using the HELOC, make the repairs to bring the property up to code, and then refinance into a conventional, fixed loan with the ability to pay of the HELOC. The HELOC is generally better than using a hard money lender because the fees and interest rate are almost always consideraly lower.
Or, you can use the cash flow (after accounting for ALL expenses) to pay off the HELOC faster than the original terms.
It comes down to how comfortable you are being leveraged. I've read that many millionaire studies have shown that they will have no more than 60% equity in their property. They always ensure that the other 40% is working for them, usually in more real estate or in the stock market.
Good luck!
- Investor · East Lansing, MI · Member since 2014 · 82 posts · 43 votes11y
@Frankie Woods What is VMTIM accounting?
- Investor · Arlington, VA · Member since 2012 · 1k+ posts · 491 votes11y
Vacancy, maintenance, taxes, insurance, and property management. I got the reference from another BP member, but it is an excellent way to remember the critical expenses. But don't forget about capital expenses! If you account for these, you've probably covered about 90-95% of all expenses that will occur.
- Investor · Thermopolis, WY · Member since 2012 · 4k+ posts · 4k+ votes11y
Leverage is usually just a multiplier of your portfolio performance. With high leverage in a good times you make a lot more money, in bad times you lose a lot more money. The higher the leverage usually the greater chance that a bad run of events will break you. With lower leverage you can often sell or finance yourself back to a safer condition.
If you have 10 houses worth one million and are leveraged 50% your $500K of equity may have a return of $24K per year assuming $200 cash flow per door. If you have 100 houses with $500K total equity and make $200 per door per month you cash flow $240K per year. No contest who makes the most money. The problem comes when you have a 30% vacancy rate in everything. The guy with $50K equity can sell 2 or 3 houses and easily pull through even at 30% vacancy. The guy with 100 houses will probably lose everything. The cost of selling a house is more than his equity interest. While this is an exaggeration the principal holds true. In our real estate company when the debt tipped over to more than 50% equity it felt pretty good, when we bought out a partner and went the other way it was kind of scary.
- Real Estate Consultant · Brookfield, WI · Member since 2014 · 873 posts · 350 votes11y
Safely first, you really can't go wrong if you are under-leveraged but i guess it depends on what your goals are.
- 11yRobert AdamsBusiness MemberReal Estate Broker · Henderson, NV · Member since 2009 · 1k+ posts · 373 votes
my VERY brief answer is "different strokes for different folks and both can be beneficial and/or costly"....I am going to come back to this thread when I have more time to read all these lengthy replies as this is a great topic and I would like to add my 2 cents in more detail.
The Adams Team at Rothwell Gornt Companies4.971 Reviews - Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes11y
I would rather miss out on a little extra gain being under-leveraged (under-maximized) than have my head taken off by being over-leveraged like many were just a few years back. Like they say in the stock-market biz: "shorts can get rich, longs can get rich, but hogs always get slaughtered." Greed will eat your lunch.
- Mechanicsburg, PA · Member since 2013 · 3k+ posts · 2k+ votes11y
@Account Closed
To answer your question depends on you.
How much risk adverse are you?
Will having millions in debt cause sleepless nights?
Are you just starting out or winding down?
How much cash do you have?
Do you have other sources of income?
Do you have partner/spouse with steady income or financial stability?
When I was staring out I didn't have nay money and the first 11 properties that I bought were all essentially 100% financed. I talked about that in BP Podcast #82
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