Our world is massively leveraged. This is not only in total dollars, yen, yuan, or euros; but also in percentage of debt to income, tax revenue, and gross domestic product (GDP). I’m personally not a huge fan of massive financial leverage, but the point of this article isn’t to disparage central bankers around the world. The point is to understand the realities of the investment world that we are all operating in and attempt to prepare ourselves to prosper.
The key thing to understand about leverage is that it breeds volatility, both good and bad.
Let’s take a simple example of buying a home. Assume, for this example, that the cost of the average home in the United States is $100. A classic mortgage would have the home buyer putting down 20%, or $20, to purchase the home with the bank financing the other 80%, or $80. In this example, you have four times as much leverage as you do equity, but historically, home prices have gone up (or at least been less volatile) than many stocks or other investments.
In a scenario where prices went down 15%, the homeowner would still have some equity ($5). However, many people have taken out loans where they put down only 3% to 4%. This does a couple of things: first, it pumps returns when prices go up, but second, it deepens losses when prices go down. Let’s compare a homeowner who puts down 20% and one who puts down 3%.
If prices go up 10%, then things play out like below:
Homeowner A, who put down 20%:
- 50% appreciation return on contributed capital ($10 of appreciation/$20 of down payment)
- $30 of total equity
Homeowner B, who put down 3%:
- 333% appreciation return on contributed capital ($10 of appreciation/$3 of down payment)
- $13 of total equity
In this scenario, you would be insane not to put down 3% on about 6 or 7 homes and make 6 or 7 times the money! The problem is that things don’t always go up, and leverage can have the opposite effect.
Here is the scenario if prices go down only 5% from the initial $100 value:
Homeowner A, who put down 20%:
- Still has $15 of equity in their home
Homeowner B, who put down 3%:
- Underwater on their mortgage by $2
Some people might scoff at being underwater by $2 and say that it was worth the risk of making $10. However, keep in mind that by making leverage (3% down mortgages) available, there are now way more owners in the market with that leverage. What can happen is that people get nervous and start to sell en masse, which creates a spiral effect that is only enhanced by the increased leverage. The results from the massive leverage are the increasing volatile swings in values of hard assets.
To put what is happening (again) to the single-family market in context, in 2008 I purchased a stock fund that was an ultra-short stock that was essentially leveraged 50%. I received a letter in the mail from the SEC telling me that investing in this stock was risky because of the large amount of leverage associated with it. I found that somewhat ironic since the stock was shorting real estate mortgages that were leveraged 97%.
Prices are going up right now, and they may continue for quite a while. The Fed is dumping cash from helicopters (read: leverage), and that is a hard train to stop. But it will stop. The argument I hear from many people is that when prices go up, many people increase the equity in their home. Yes, this certainly happens. But there are still a lot of people who are buying the inflated prices with 20% or even 3% down. These people will be in trouble when the market corrects itself.
Even, and maybe in particular, the US government is overleveraging itself. The US government has about a $480 billion federal budget deficit and a national debt over $18 trillion. Federal tax revenue is only about $3 trillion. I’m not making the point that this is right or wrong, good or bad. The point is to understand that our world is massively, and increasingly, leveraged. At some point the market will go down, and in a drastic way because of all the leverage.
Here are five ways to protect yourself as you invest in this maniacally turbulent investment world.
5 Ways to Protect Yourself in a Leveraged Environment
1. Buy properties that have average rents below the median for the area.
I have always been a fan of this strategy. Maybe it was because my real estate career was born in the flames of the Great Recession, where during my senior year of college, in Fall of 2008, I saw 80% of the people working in my real estate office let go. Just as I was about to enter the real world, I saw dozens of high powered commercial real estate brokers who made hundreds of thousands of dollars per year lose just about everything — and quickly.
The question I ask myself is simple: can a family pay rent for my units if they lose their job and need to work for an hourly wage? The goal of this is to limit downside during a negative swing. If you can keep your units in good condition and at a reasonable price point, then you should always be pretty close to full. The same thing goes for buying single-family rentals.
The other benefit of having your rent below the median for the area is that there are necessarily more potential tenants who can afford your units. If you buy the million dollar single-family home with the hopes of renting it to some rich person for $10,000 a month, you may be waiting for a while. It is also more likely that a person who can afford $10,000 of rent will be able to buy a home, even in a downturn.
2. Have ample cash reserves.
This can be a very difficult thing for first time investors. I know because I never was able to have a lot of cash reserves on the first properties I purchased. I don’t have a great rule of thumb, but I usually try to have about six months of expenses available in cash. When I didn’t have the money myself, I made sure to partner with investors who did. Partnering with an investor will likely dull your personal returns, but it will give you staying power and security during a downswing, which is the key here.
Part of saving up cash reserves is resisting the urge to pay yourself out every single dime, right this frickin’ second! I like to defer payments for the first year on any property so that I can get comfortable with the operations and get a sense of what amount of cash I may need going forward. If you are investing in a property with the idea that you need the rental income to stay afloat in your daily life, then you are probably over-leveraged, at least by my definition. Yes, you want to be able to rely on the income from properties — this is the beauty of real estate — but you shouldn’t need it off the bat.
3. Be good to your tenants.
Anyone who has invested in real estate knows that tenants can be fickle. They love you when they need you and are willing to discard you the second it’s in their best interest. It actually reminds me a lot of the girls I usually date! However, in a downturn, tenants become nervous like anyone else. The news and media are powerful influences in today’s society.
Once, when the stock market was getting crushed, I had a tenant tell me that they were really worried about “the Dow going down.” This particular tenant had been renting from me for about eighteen months, and I had given her some leeway when she paid late a few times. I was somewhat surprised to hear that she was following “the Dow,” so I asked her what stocks she owned.
“None,” she said.
“Well, why are you worried about the market?” I asked.
“The last owner I rented from lost his house after the market went down…” was her response.
I told her that I wasn’t going to lose the house and that she had nothing to worry about. She gave me a hug and told me she never wanted to leave. I’m not Robin Hood; my goal is to make money. However, I do believe strongly that being good to tenants is great for business. This lady was going nowhere as long as I owned the property — and particularly if the economy started to falter again. All she wanted was security, which was the same thing I was after.
4. Keep a close eye on cash flow.
I don’t think cash flow and appreciation are mutually exclusive; I look at it more like a spectrum. Which end of the spectrum you fall into depends where you are in your life and career. I do believe that appreciation will make you rich, but you have to have cash flow to stay afloat, particularly during downturns.
Debt service coverage ratio (DSCR) can be a useful metric (there is a great post and thread on BiggerPockets that go into more detail). The key is to understand what your expenses are going to be and purchase properties that have ample cash flow to cover them. Understanding expenses can be difficult and is often the overlooked aspect of cash flow. Talk to your contractor, property manager, and other investors in the area. Really try to nail down the expenses aspect of the DSCR formula, and your cash flow should be fine.
5. Be conservative.
You don’t often hear about conservative people going broke. It’s not the deals you should have done but missed that kill you; it’s the deals you do that you shouldn’t have done. In other words, the bad deals are the ones that break your back. I understand we are in a somewhat euphoric real estate environment right now. Single-family home prices are rising, debt is cheap and increasingly available, and real estate prices always go up!
Well, until they don’t.
Be conservative in your approach, and take the slow and steady route. Buy properties that have cash flow and lower rents than most in the area. Make sure to have lots of cash reserves, or partner with an investor who can keep you afloat when things go bad. And be good to your tenants — because in the end they are the ones that make you money.
Most of all, understand that the world is a leveraged place and that big swings in both directions are coming. Invest accordingly.
Do you agree that a crash is inevitable? What would you do to prepare for a downturn?
Don’t forget to leave a comment, and let’s discuss!