Is it better to be over-leveraged or under-leveraged?
Chicago, IL · Member since 2014 · 24 posts · 17 votes
Hypothetically, would you be more comfortable being over-leveraged or under-leveraged in your investments? And what's your reasoning?
I'm thinking the most optimal position would be to have a lot of leverage, but with enough cash reserves so I can choose to bail myself out in case of emergency. I don't think I'd want to shovel my hard earned money into equity that may or may not lose value.
All thoughts and opinions are welcome! I'm just brainstorming over here.
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.
Thanks for the discussion everyone this is all very good input. I'm thinking it's just one of those things that needs to be continually adjusted based on your comfort level, market conditions, goals etc. at any given point in time.
Since my boyfriend and I both have decent income, we're planning on buying our first property distressed for all cash. Then creating value by rehabbing it and renting the units out. I think this will give us a solid footing to build our investing career off of. My question for this thread came when I was thinking how much we should cash out afterwards to roll into other investments, but I think the answer to that question will be more clear when the time comes. I don't want to get greedy with max leveraging but I don't want my money not working for me either.
I really appreciate all the perspectives and guidance.
different strokes! For me, I buy cash only for buy and holds in 50k houses in TX. When the market crashes, the priices will drop and I will just buy more in cash. Love investing in cash.
Hypothetically, would you be more comfortable being over-leveraged or under-leveraged in your investments? And what's your reasoning?
I'm thinking the most optimal position would be to have a lot of leverage, but with enough cash reserves so I can choose to bail myself out in case of emergency. I don't think I'd want to shovel my hard earned money into equity that may or may not lose value.
All thoughts and opinions are welcome! I'm just brainstorming over here.
From my basic understanding of accounting and finance you need to determine what your cost of debt is in the leverage you are trying to do. Factor in your opportunity costs of that debt and you will have the actual cost of your debt. Now if you are using this as a % down, calculate the cash-on-cash return and see if its worth the risk. If you are using it to purchase out right determine your cap rate and see if its worth the risk.
Using either method will allow you to analyze to potential cash flows from leveraging your property. If the cost of debt is $200 for $40,000 in leverage and you use that to purchase a property that cash flows $1,000 out the door then that would seem a good deal. It's when the cost of debt begins to exceed the potential returns that leveraging becomes less and less desirable. My idea on the subject is never leverage more than you can afford to pay for out of pocket and still put food on the table and a roof over your head. There are times of plenty and times of famine but planning for famine will always ensure you will have times of plenty.