Teach me how to bankrupt myself using credit

9 Replies

Hi everyone, so this question might come across a little strange, so I thought I would first give some background information. So as things go, my little fix and flip business is starting to grow and I am starting to think about borrowing against my rental property to fund more flips. I have always been a super conservative investor, only borrowing up to 30% of valuation on one property, and my other properties are paid off in cash.

Now I know to grow my business I need to probably be less conservative, at least for a few years, but before I dive into the big big scary world of leverage, I wanted to see if you guys could perhaps tell me how most investors you have heard of or know get into trouble using leverage.

I'm not talking about people who pull out equity to fund vacations, nice boats and cars etc, but rather how do people get themselves in trouble when they reinvest the money in real estate or otherwise.

The reason I'm asking this question phrased this way is because I've heard the success stories of people who leveraged to the hilt and came away winners (i.e. Donald Trump), but I want to learn the lessons of those who failed or almost failed as well. Stories or advice anyone?

CK Hwang, Redwood Investments LLC | [email protected] | 9496329632 | http://www.redwoodinvestmentsllc.com

Originally posted by @CK Hwang :
Hi everyone, so this question might come across a little strange, so I thought I would first give some background information. So as things go, my little fix and flip business is starting to grow and I am starting to think about borrowing against my rental property to fund more flips. I have always been a super conservative investor, only borrowing up to 30% of valuation on one property, and my other properties are paid off in cash.

Now I know to grow my business I need to probably be less conservative, at least for a few years, but before I dive into the big big scary world of leverage, I wanted to see if you guys could perhaps tell me how most investors you have heard of or know get into trouble using leverage.

I'm not talking about people who pull out equity to fund vacations, nice boats and cars etc, but rather how do people get themselves in trouble when they reinvest the money in real estate or otherwise.

The reason I'm asking this question phrased this way is because I've heard the success stories of people who leveraged to the hilt and came away winners (i.e. Donald Trump), but I want to learn the lessons of those who failed or almost failed as well. Stories or advice anyone?

This is a good topic to discuss tonight at the meeting CK!

My perspective on leverage, since I am in the business of leverage (broker/mortgage originator) is if I can reasonably control the down side and maximize the upside with the terms/rate/cost at which I am borrowing at, such as using a fixed 30 year, limited or no prepays, lower margins, non recourse, caps on adjustment periods, risk/equity share, etc I am okay with leveraging near maximum.

For me it comes down to terms and cash flow as long as the risks can be minimized and the cash flow profit spread is high enough and stable enough even with stress tests (market drops rents go down XX%, business income goes down XX% or my personal income goes down XX% can I still debt service?) I can be okay going to high leverage depending on the upside.

Personally the higher the LTV or leverage for the asset the higher the Debt service coverage ratio I would require. Example is if I am at 80% LTV on asset I may be at 1.35% DCR but to go to 85% or 100% LTV if permitting, I would personally need a much higher DCR depending on risk as viewed from a market and property level, as an example I would atleast 1.50%-1.75% DCR.

Some people may look at it like the above with Debt Coverage Ratio (DCR) on the individual property level or they may look at it from DCR as global cash flow perspective with all personal income, business income, properties, notes, and other investment cash flows or cash flow activities net at the end of the day and stress test that to make sure the debt provides enough mental, emotional, and financial safety for the given increment of additional risk by borrowing X dollars.

I would love to hear other views on how debt is managed or how debt preferences are formulated. I think mine tends to be more banker like because of the scenarios I get wrapped up in on a daily basis.

Medium new american funding logo  Albert Bui, New American Funding | [email protected] | 949‑514‑5106 | http://albertbui.com | CA Lender # 345453, WA Lender # 345453, TX Lender # 345453, TN Lender # 345453

Hey Albert, thanks for the advice, I had a question though. As far as stress tests goes, how does one determine the stress test figures. i.e., stress test if rents go down 90%? If RE market collapses and prices plunge 90%. If so then no amount of leverage would work. What kind of numbers are you working with for a stress test Albert?

CK Hwang, Redwood Investments LLC | [email protected] | 9496329632 | http://www.redwoodinvestmentsllc.com

One way to be bankrupt using leverage is by buying the wrong properties or negative cashflow properties and you hope the property will appreciate.

Another way that people get into trouble is by buying a turnaround property or repositioning deal. This means the property has negative cashflow in the beginning, and then you used leverage to finance the deal and the repairs...but you can easily run out of cash to pay back the debt (and the repairs) because turnarounds can take twice as long and twice as expensive as one can estimate.

Originally posted by @CK Hwang :
Hey Albert, thanks for the advice, I had a question though. As far as stress tests goes, how does one determine the stress test figures. i.e., stress test if rents go down 90%? If RE market collapses and prices plunge 90%. If so then no amount of leverage would work. What kind of numbers are you working with for a stress test Albert?

In a disaster scenario like that of 90% depreciation in price I would probably be more worried about guns, ammo, food, water, etc not my real estate portfolio =D.

I use income decrease of 10, 20, 30 % based on how solid I believe the market is but I would say that if you have to use 40% or more then your market would be highly volatile and you may have to reconsider your stability of your income if we're talking about rentals. I look for multiple suppliers of employment, industries, government, the average median income, cost of living to rent per unit, demographics and the momentum in demographics in that market given the culture, jobs, and lifestyle etc.

Medium new american funding logo  Albert Bui, New American Funding | [email protected] | 949‑514‑5106 | http://albertbui.com | CA Lender # 345453, WA Lender # 345453, TX Lender # 345453, TN Lender # 345453

One way to be bankrupt using leverage is by buying the wrong properties or negative cashflow properties and you hope the property will appreciate.

Another way that people get into trouble is by buying a turnaround property or repositioning deal. This means the property has negative cashflow in the beginning, and then you used leverage to finance the deal and the repairs...but you can easily run out of cash to pay back the debt (and the repairs) because turnarounds can take twice as long and twice as expensive as one can estimate.


Wendell, thanks for your input. For these scenarios you speak of, do they tend to apply more to buy and hold / multi families... or to phrase the question differently, is there a investment type or scenarios that this problem arises?

CK Hwang, Redwood Investments LLC | [email protected] | 9496329632 | http://www.redwoodinvestmentsllc.com

Thanks Albert, ok, I ran the numbers assuming a 30% drop in rental, and the rental returns still covers the PITI, so you think I can assume this to be a "safe" amount of equity to pull out? Is there a figure you use for your simulations?

CK Hwang, Redwood Investments LLC | [email protected] | 9496329632 | http://www.redwoodinvestmentsllc.com

Originally posted by @CK Hwang :
Thanks Albert, ok, I ran the numbers assuming a 30% drop in rental, and the rental returns still covers the PITI, so you think I can assume this to be a "safe" amount of equity to pull out? Is there a figure you use for your simulations?

I guess it depends on your risk tolerance as well. So after the 30% drop is there enough cash for you to weather the storm going forward? Perhaps even 12 months reserves as well to make you feel warm and cozy =)?

Where is the property and is the rental income servicing the debt or is it personal income servicing the debt or other income?

Medium new american funding logo  Albert Bui, New American Funding | [email protected] | 949‑514‑5106 | http://albertbui.com | CA Lender # 345453, WA Lender # 345453, TX Lender # 345453, TN Lender # 345453

Instead of a flat decrease in rent amounts for modeling purposes, I look at it in vacant unit months (ie: if duplex, if 1 of the 2 units is vacant) and with the rent decreasing by various percentages. So you can see if hard times hit and you have a vacancy for 2 months, and the rent ends up being 20% lower than current/target, that you are still in the black for the year.

When you finance out so far that you don't have enough cash flow, you can bankrupt yourself with credit. Say you score a property for 50k (40k loan), put in 20k of work, it rents for 1000/mo and has an ARV of 120k. You have a great rental that probably cash flows $200+/mo. You decide to refinance out all you can for further investments and get a 75% LTV of 80k. You just financed all your cash flow out of that great rental. If you use the 80k to get more great cash flowing properties maybe you can cover a new roof, that was the plan anyway. If instead you have a vacancy in the cash flow property, need a new roof and your car engine seizes... you're in trouble. Cash flow is king.