When does overleverage get you in trouble?

General Real Estate Investing
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When does overleverage get you in trouble?

Benjamin Sussman
Investor · San Diego · Member since 2020 · 92 posts · 60 votes

I’ve heard that people lose everything when they’re overleveraged.

When would you say people lose their shirt in RE investing, when debt to equity ratios are to high or when their debt to cash reserve ratios are too high? Or is it a mix of both, or something else?

Just wondering if owning 10 properties with 5% equity in all of them is a dangerous thing or if that sort of portfolio structure is fine as long as the investor has sufficient cash reserves?

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Allan Smith
Contractor · Nashville, TN · Member since 2014 · 1k+ posts · 1k+ votes
5y

I've done a lot of research on historical successes and failures and over Leverage is a very common denominator. I have come to the conclusion that anyone who went bankrupt or even lost a considerable amount of their net worth did not have enough cash reserves to service their debts.

there are many ways that people run out of cash  so each time that is different, but ultimately it's the first few Dominos that start to fall because  they could not pay their creditors.  Yes, a bank may call a loan due  but that is more rare if you have fixed terms . 

I will even go as far as to state that  your Equity position or loan-to-value position on your rental property does not matter.  If you are  Leverage leveraged to 105%, where you owe more than the property is worth, most people would say that is over-leveraged. However, the argument I would make is that that does not matter as long as you have cash on the side. Who cares if it's underwater? As long as you can keep making payments and keep the property kept up to have tenants pay you, in a way you are still not over leveraged.

almost every story I've heard of someone losing their shirt from over-over Leverage involved a hunger for growth that got them off balance. They did not have cash to dig themselves out, their cash was invested in multiple things to help them grow faster.

most recently I read the bubble in the sun book about the Florida land speculation boom in the 1920s. The four richest men in in the state died poor because they could not stop themselves from buying more and more land to develop even while the boom was crashing around them. They could not stop spending money. They would have large developments underway that they had put all their cash in and would need more cash from other investors to finish the development but since the economy had crashed nobody wanted to invest, and their development became worth pennies on what they had put into it because it wasn't finished. They had spent all their cash so they stopped making payments, the bank comes calling, and pretty soon all their assets come Crashing Down.

it's good to grow fast but your growth rate should gradually slow down over time to make you sure you keep what you earned. These guys would invest every penny back into the machine but never actually stop and slow down to make a profit.

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  • Patti RobertsonBusiness Member
    Property Manager · Virginia Beach, VA · Member since 2016 · 2k+ posts · 2k+ votes
    5y

    If you have enough cash reserves you should be able to buy your way out of any scenario, but who wants to be in a low equity position, ever?  Not me!

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    9Reply
  • Jill F.
    Investor · Akron, OH · Member since 2016 · 2k+ posts · 4k+ votes
    5y
    When prices drop so that you are underwater on your loans and then you can't make your payments (presumably because tenants don't pay or because you can't keep/or get the property to a rentable condition) or if your lender makes an equity call and you can't come up with any money so the lender calls the loan and you can't pay or sell without a loss (rare).
    3Reply
  • Theresa HarrisPro Member
    Member since 2019 · 15k+ posts · 11k+ votes
    5y

    You need to have enough cash reserves so that if you are hit with a couple of vacancies at the same time, turnover costs and an unexpected repair, you are fine.  You won't be able to have multiple properties with only 5% equity as banks require 20% down for rentals.

    1Reply
  • Kenneth GarrettPro Member
    Investor · Florida Panhandle/Illinois · Member since 2016 · 4k+ posts · 3k+ votes
    5y

    @Benjamin Sussman

    Over leverage is always dangerous.  It puts you in a position where your exit strategy of selling will always be at a loss.  I shoot for no greater then 75% when buying.  I try to keep all of my properties at 60% or less.  Let’s be realistic when you are starting out, your probably at 75%-80% unless you bought a personal residence and converted it over to a rental at 3.5% down then you might be at 95%.  As long as you have cash to support any emergencies then you probably are ok, but who wants keep that much cash on hand that’s not doing anything.

    2Reply
  • Alex Kreeger
    Member since 2019 · 63 posts · 60 votes
    5y

    @Benjamin Sussman when the market corrects.

    1Reply
  • Ben Lapane
    Rental Property Investor · Houston, TX · Member since 2017 · 29 posts · 25 votes
    5y

    @Benjamin Sussman

    For real estate, it is when your exposure is so high that if a few renters stop paying you can’t afford to cover your expenses.

    Example:

    Let’s say you have W2 income of 5k / month (net)

    Your expenses are 4K a month so you have our 1k left in your pocket every month.

    You have some capital on the side. Let’s say you got 40k.

    With that 40k you are able to purchase 2 single family rentals. Your note on the two rentals is $1600 / month.

    Let’s say you get a tenant in both of them and the rent covers that note/insurance/taxes etc.

    But let’s also say 5 months from when your tenant signs the lease they up and leave on you. Now all of the sudden you gotta pay from your pocket that note. Now, because you have that 1 k left in your pocket you can cover one rental properties note until you find another tenant no problem.

    However, let’s say BOTH tenants leave out of the blue. Now you are over leveraged because you only got 1k a month net but your note is 1600.

    How to mitigate over leverage? Have reserves and save all your net rental income in that reserve fund.

    3Reply
  • Allan Smith
    Contractor · Nashville, TN · Member since 2014 · 1k+ posts · 1k+ votes
    5y

    I've done a lot of research on historical successes and failures and over Leverage is a very common denominator. I have come to the conclusion that anyone who went bankrupt or even lost a considerable amount of their net worth did not have enough cash reserves to service their debts.

    there are many ways that people run out of cash  so each time that is different, but ultimately it's the first few Dominos that start to fall because  they could not pay their creditors.  Yes, a bank may call a loan due  but that is more rare if you have fixed terms . 

    I will even go as far as to state that  your Equity position or loan-to-value position on your rental property does not matter.  If you are  Leverage leveraged to 105%, where you owe more than the property is worth, most people would say that is over-leveraged. However, the argument I would make is that that does not matter as long as you have cash on the side. Who cares if it's underwater? As long as you can keep making payments and keep the property kept up to have tenants pay you, in a way you are still not over leveraged.

    almost every story I've heard of someone losing their shirt from over-over Leverage involved a hunger for growth that got them off balance. They did not have cash to dig themselves out, their cash was invested in multiple things to help them grow faster.

    most recently I read the bubble in the sun book about the Florida land speculation boom in the 1920s. The four richest men in in the state died poor because they could not stop themselves from buying more and more land to develop even while the boom was crashing around them. They could not stop spending money. They would have large developments underway that they had put all their cash in and would need more cash from other investors to finish the development but since the economy had crashed nobody wanted to invest, and their development became worth pennies on what they had put into it because it wasn't finished. They had spent all their cash so they stopped making payments, the bank comes calling, and pretty soon all their assets come Crashing Down.

    it's good to grow fast but your growth rate should gradually slow down over time to make you sure you keep what you earned. These guys would invest every penny back into the machine but never actually stop and slow down to make a profit.

    10Reply
  • Account Closed
    Specialist · OverTheRainbow · Member since 2020 · 607 posts · 909 votes
    5y
    Originally posted by @Benjamin Sussman:

    I’ve heard that people lose everything when they’re overleveraged.

    When would you say people lose their shirt in RE investing, when debt to equity ratios are to high or when their debt to cash reserve ratios are too high? Or is it a mix of both, or something else?

    Just wondering if owning 10 properties with 5% equity in all of them is a dangerous thing or if that sort of portfolio structure is fine as long as the investor has sufficient cash reserves?

     Oh, if only it was that easy. ;-)

    1. People who have properties with lots of equity are more likely to be sued and lose everything. Attorneys only sue people who have money.

    2. People who don't keep reserves in the bank for downturns are likely to lose everything.

    3. People who think $150 a month positive cash flow per property are likely to lose everything.

    4. Investors who divorce are likely to lose everything.

    5. People using adjustable rate mortgages and balloons (not as common at the moment) are likely to lose everything.

    6. People who think having rentals in rough neighborhoods in distant cities are likely to lose everything.

    7. People who invest with people they don't know are likely to lose everything.

    8. People who bet everything on Red 7 are likely to lose everything.

    9. People who think they are smarter than "cause and effect" are for sure going to lose everything.

    10. People who think their 401(k) and IRA are safe and are going to get them through retirement are going to lose everything.

    11. People who ignore that the Fed has printed $10 Trillion dollars lately, think they are simply great investors and don't have a rabbits hope in a dog kennel of getting out of this one and will lose everything.

    And if you don't understand # 11, "Lord have mercy".

    8Reply
  • Dell J.
    Member since 2010 · 210 posts · 158 votes
    5y
    When the market flips and vacancies are high and property values are to low to sell.   Can you keep up with the debt service and operation cost?

    Originally posted by @Benjamin Sussman:

    I’ve heard that people lose everything when they’re overleveraged.

    When would you say people lose their shirt in RE investing, when debt to equity ratios are to high or when their debt to cash reserve ratios are too high? Or is it a mix of both, or something else?

    Just wondering if owning 10 properties with 5% equity in all of them is a dangerous thing or if that sort of portfolio structure is fine as long as the investor has sufficient cash reserves?

    0Reply
  • Patti RobertsonBusiness Member
    Property Manager · Virginia Beach, VA · Member since 2016 · 2k+ posts · 2k+ votes
    5y

    @Allan Smith - 100% agree!

    757-472-2547
    0Reply
  • Sebastien Hitier
    Rental Property Investor · Hong Kong, Hong Kong Island · Member since 2014 · 188 posts · 114 votes
    5y

    @Benjamin Sussman, leverage depends on the borrower total income. In absolute terms, that 95% LTV or x20 leverage sounds standard for small investors with good income on the side. A conservative lender will let someone borrow 1.5mln with annual servicing of 90k (assuming 6%=3% ppal+3% interest) provided that one's income is above $270k for a 30% income ratio, and not much should go wrong.

    How about borrowing $15mln if you make $270k (or 1.5mln if you make 27k)? Of course, if you have little or no other income source and the real estate earns only 6% net while each $1 borrowed requires 6ct to service, the 30% coverage income rule would only let you borrow 30% LTV, the lender will allow higher LTV because a distressed sale will be ok for lender, but the borrower will likely lose everything. A debt/equity ratio of x3.5 is considered standard (see https://www.investopedia.com/a...) by a real-estate pro. In this case, it is the borrower's responsibility to ensure that he is able to generate the cashflow needed to service the debt. 

    1Reply
  • Jacob Malakoff
    Rental Property Investor · Member since 2019 · 31 posts · 11 votes
    5y

    @Allan Smith great stuff. Having adequate reserves makes sense to protect yourself against a correction. Is there a min cash flow or ROI that would better protect you against a downturn?

    0Reply
  • Mike Dymski
    Investor · Greenville, SC · Member since 2016 · 5k+ posts · 13k+ votes
    5y

    Most of us have cash reserves, retirement accounts, brokerage accounts, lines of credit, steady work history, or some combination of these items, and have properties with low risk of extended vacancies; so, there are zero concerns with leverage.

    2Reply
  • Jay C.
    Walnut Creek, CA · Member since 2018 · 40 posts · 29 votes
    5y

    @Jill F. Hi Jill when do banks do an equity call and what percentage would they require.

    1Reply
  • Jill F.
    Investor · Akron, OH · Member since 2016 · 2k+ posts · 4k+ votes
    5y
    Originally posted by @Jay C.:

    @Jill F. Hi Jill when do banks do an equity call and what percentage would they require.

    I have never heard of a bank doing that, but I know my commercial loans allow the bank to do so. Their loans docs are like my lease, it's written by their lawyers to protect them.

    1Reply
  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    5y
    Originally posted by @Jill F.:
    Originally posted by @Jay C.:

    @Jill F. Hi Jill when do banks do an equity call and what percentage would they require.

    I have never heard of a bank doing that, but I know my commercial loans allow the bank to do so. Their loans docs are like my lease, it's written by their lawyers to protect them.

    maybe never heard it happening because real estate the last 10 years has not been stressed.. most commercial loans have covenants that require certain equity.. the borrower to maintain a certain net worth and the DSCR maintain a certain level.. you right last 10 years most props meet all those requirements.. its when they dont that things start to happen.. there was a TONNE of Cash calls last go around.. And those that could stayed afloat those that could not tubed it .

    Now if your sitting on 30 year fixed debt with no covenants thats a whole nother kettle of fish. you start borrowing from portfolio lenders and you had best read the fine print  :) 

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  • Steve Vaughan
    Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes
    5y
    Originally posted by @Benjamin Sussman:

    When would you say people lose their shirt in RE investing, when debt to equity ratios are to high or when their debt to cash reserve ratios are too high? Or is it a mix of both, or something else?

    The type of debt matters, too. HML or shorter term debt needs to be treated on a different level. Same with seller-financed and commercial. Some 'buy' on a land contract and own nothing. Risky debt.

    RE is a time game.  Reserves and back-up plans buy you time to get through vacancies and unforeseens, but a debt that is due is due.  Be wary of deadlines. 

    1Reply
  • Mark Welp
    Investor/Agent/CPA · Columbus, OH · Member since 2015 · 249 posts · 207 votes
    5y

    @Jill F.

    Have you heard lot of investors getting 30 year mortgages called?

    Just curious. I think 30 year mortgages at a decent rate with at least 80% LTV is pretty safe.

    Have you heard of those kinds of loans getting called? Thanks,

    0Reply
  • Account Closed
    Hayward, CA · Member since 2017 · 48 posts · 55 votes
    5y

    A commercial loans are a different beast, but I believe conforming 1-4 unit loans are not callable based on asset value.

    0Reply
  • Jill F.
    Investor · Akron, OH · Member since 2016 · 2k+ posts · 4k+ votes
    5y

    @Mark Welp I don't think most conventional 30 year prime residential loans are callable based on decreased equity but I don't know about sub-prime or other types of loans- I only know about the limited types of loans I actually hold. My commercial loans are callable but they require that I put up 25% in cash or equity. I feel pretty okay about our position because we usually renovate 25-30% of new units in the first year so we force appreciation and additionally, our markets have been increasing but they are still generally affordable by median income families.

    1Reply
  • Brian G.
    Rental Property Investor · Los Angeles, CA · Member since 2013 · 1k+ posts · 1k+ votes
    5y

    @Benjamin Sussman when you don’t have enough liquidity (cash reserves)!

    0Reply
  • Wale LawalBusiness Member
    Real Estate Broker · Houston | Dallas | Austin, TX · Member since 2018 · 5k+ posts · 2k+ votes
    5y

    @Benjamin Sussman it's a mix of both.

    Is a wise practice to have at least 10% cash reserve for every single property you own. This is for unforeseen issues.

    At the same time I would buy property if I can come out of pocket with little as long as I have at least 3 solid exit strategies.

    Goodluck man 👍

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  • Brian Ploszay
    Investor · Chicago, IL · Member since 2009 · 1k+ posts · 1k+ votes
    5y

    When you are starting out, higher leverage seems natural.  You don't have excess capital to put into real estate deals.  Besides, real estate is expensive. 

    The only way I could ever get into trouble is if there is an interruption to my cash flow.  So keep the properties rented.  Another thing that can kill a deal is excessive repairs / capital maintenance.  

    1Reply
  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    5y
    Originally posted by @Steve Vaughan:
    Originally posted by @Benjamin Sussman:

    When would you say people lose their shirt in RE investing, when debt to equity ratios are to high or when their debt to cash reserve ratios are too high? Or is it a mix of both, or something else?

    The type of debt matters, too. HML or shorter term debt needs to be treated on a different level. Same with seller-financed and commercial. Some 'buy' on a land contract and own nothing. Risky debt.

    RE is a time game.  Reserves and back-up plans buy you time to get through vacancies and unforeseens, but a debt that is due is due.  Be wary of deadlines.

    Steve, exactly I would,  IF i was a betting man,  bet that many that are out there getting Portfolio loans may not fully comprehend the covenants  or the covenants were glossed over in their excitement to take on that kind of debt.. 

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  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    5y
    Originally posted by @Mark Welp:

    @Jill F.

    Have you heard lot of investors getting 30 year mortgages called?

    Just curious. I think 30 year mortgages at a decent rate with at least 80% LTV is pretty safe.

    Have you heard of those kinds of loans getting called? Thanks,

    30 year fully amortized loans that HAVE NO loan covenants cant be called.. the only way they can be is for.

    1. Defaulting on the monthly payment

    2. Dont pay the tax's if they are not escrowed same with insurance.  loan can be called.

    3. Alienation of title without written permission from the note holder.

    4. Waste

    And probably a few more I am missing.. But generally speaking as long as you make your payments pay your tax's keep the insurance current with the lender endorsement Do not sell and wrap on contract or create waste I don't think a lender can just call your loan based on your financial condition.. they certainly can with HELOC's though.. those can just be unilaterally frozen for no reason other than the bank is worried about market conditions etc.

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