When Does Leverage Become Too Much?

Question

For landlords building a portfolio:

How do you decide when you've reached your comfortable leverage limit?

Do you look primarily at:

• Monthly cash flow?
• Debt service coverage?
• Loan-to-value?
• Total portfolio debt?
• Cash reserves?
• Something else?

I'd be interested in hearing how investors define “responsible leverage.”

Joseph Zimmerman · Answer

With only two properties (a house and a condo in Chicago that I self-manage from out of state) I am not the person with a portfolio LTV target. What I actually watch is whether each property covers its own debt service after a full expense load, not just rent minus PITI. I run a per-property P&L every month and underwrite vacancy, maintenance, and a CapEx line based on the remaining life of the roof and HVAC. If a property only clears 1.0x once those are in, the leverage is already too much for me.

The second test is a reserve floor I will not touch: several months of PITI per property, held separately from any down payment fund. If buying the next one would break that floor, I am done borrowing regardless of what LTV says.

One thing I underestimated early: escrow. Tax reassessments and insurance moved my payment more than I expected, so the payment you underwrite is not the payment you will have in year three.

David Krulac · Answer

AS I said and wrote, when I first started everything was finaced 100%. Then I went through a phase wher I paid off all but 1 mortgage.  Then 2% mortgages happened and I borrowed more, probably should have refinanced more while the rates were in the 2s. Last year a builder offered me 4.25% and 4.75% rates on new construction, so I bought some of those new builds with that financing to rent out.  I can also see possible either financing more purchases or refi existing propeprty, along the lines of Buy, Borrow, Die, but I would not finance everything keeping some stuff unleveraged, but either investing the proceeds or using some for other expenses.

Dan H. · Answer

I define over leverage if a worse case scenario can force the sell off of properties at an in opportune time.   so  think it is something else (none of those listed).

Monthly cash flow is not guaranteed.   Vacancy can climb.   Tenants in mass can become delinquent.   For the same reason DSC can change.

Total portfolio debt comes into play, but it is not the defining criteria.  Cash reserves would be too limiting.

So what is the something else?   I will provide some hints:

- reduces risk across maybe all investments.

- not as limiting as cash reserves.

- the item can typically generate returns far in excess of cash reserves.

Have you figured it out?   Diversification of assets.   The means to diversify is endless.  Even across RE you can achieve significant diversity.   Same for stocks.   Commodities.  Bonds. CDs.   The possibilities are endless.

My portfolio:

- ~40% RE: residential, senior living/assisted living, development

- ~40% stocks

- ~10% bonds

- ~10%: everything else (mineral rights, non-RE business interests, pension, cash reserves, life insurance, etc)

What sort of melt down could force me to sell at an in opportune time?   Not sure but it would have to be significantly bigger than the GFC or Covid.  It would take out a mass majority of investors before  should be at significant risk.

Make sure you are not put in a position that forces you to sell at an in opportune time.   This can be achieved via diversification.

Best wishes

Patrick O'Sullivan · Answer

For me, it's less a single metric and more whether I could survive my worst case without selling in a panic. DSCR at 1.2x looks fine until you actually run 90 days vacant plus a surprise repair on two properties at once, then see what your cash position looks like. If that scenario wipes you out, you're overleveraged even if the spreadsheet says you're fine on paper.

Also agree with what Joseph said about escrow. Nobody stress tests their taxes and insurance going up, they just stress test the loan amount. In this rate environment, that's probably the bigger risk than LTV, honestly.

I don't have a hard number, it's more a gut check of "if everything went wrong at once for 3-4 months, am I still standing." If the answer's no, I don't buy the next one yet.

David Krulac · Answer

@Linda Murray   The first 11 properties I bought were all 100% financed in 1 way or another.  I had no money was 9 month on a low paying entry level job, so I needed the financing or I could not buy. For me growing was more important than worrying about too much debt.  The debt was the vehicle to grow, with out it I would not have grown.  But I can see, that is not for everybody.  for some the opposite is true, controling debt is more important than growing, perfectly logical

Ali Najjar · Answer

I think cash reserves are a big part of it. A property can have good cash flow and DSCR, but if buying it leaves you with very little liquidity, that changes how comfortable I’d be with the leverage.

I’d rather have a little less leverage and enough reserves to handle a vacancy or unexpected repair than maximize the number of properties I can own.

Vaibhav Puranik · Answer

I guess the simplest answer is Monthly Cash Flow. DSCR is essentially the same, with some buffer on it. The usual norm is to have 1.2x minimum. That means you have 20% buffer. If you are not getting that, then it's too much leverage.

In today's situation, you might not mean DSCR requirements because of higher interest rates such as 6.5 or 7. Even though theoretically it's not too much LTV, it's still too much leverage because the cap rate doesn't support that interest rate and hence it's a too much leverage (or irresponsible leverage).

That's why I am considering all cash these days whenever I can. I can get a loan when the interest rate goes down in next few years! I don't see it happening in couple of years at least!

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