Real estate investments provide a unique opportunity in order to achieve wealth. By leveraging your assets, you are able to acquire more property which, in turn, could produce more income; however, you must borrow with caution to ensure you do not end up buried in debt.
Leverage, or using borrowed capital to make an investment, allows real estate investors to afford many properties, or a more expensive property than they could with just their own money. It is an especially attractive option in today’s low-interest-rate environment, in addition to the interest payments being tax-deductible.
However, debt repayment can become a burden if interest rates increase, property values decline, tenants do not renew or significant repairs are required. Once the debt is greater than the cash inflows, a property becomes “overleveraged” which could lead to bankruptcy and even foreclosure. Finding an optimal balance between debt and equity financing is key to maintaining success for your real estate portfolio.
Tighter Bank Loan Requirements
Tighter loan requirements from banks are here to stay. You may have trouble if a property’s loan will become due or needs to be renewed — or you simply want to refinance it to take advantage of better terms. Loans are based on fair market value (FMV) and, if your property is appraised for less than you expect, you might not qualify for sufficient funds, especially if your bank has tightened its loan-to-value (LTV) requirements.
Even if you are not looking to refinance, you may find that some distressed properties are in violation of their LTV or debt coverage ratios, especially if their net operating income has declined substantially. If so, an uncooperative bank may decide to foreclose or call the loan.
Small differences in personal circumstances and preferences can lead to vastly different investing choices — there is no “right amount” of leverage to use. But while each investor may have a different situation and risk tolerance, there are limits to the amount of leverage that should be applied. Investors who wish to maximize profits through leverage should not repeat mistakes from the past.
One method for determining appropriate leverage is to apply a “stress test” to cash flow projections for a property. Change key variables one by one and evaluate how each change affects cash flow. For example, what would happen if your vacancy rate jumped to two or three times its normal level? What would happen if you had to lower the monthly rent or make significant repairs just to attract new tenants? In today’s highly competitive environment, tenants are expecting top-notch quality. If a newly constructed or renovated property is nearby, would your renters stay?
Think it Through
The fact that a bank will not approve a traditional loan for your latest investment may merely be the result of today’s more conservative banking environment. On the other hand, it could also be a red flag or an indicator that the property is not what you think it may be. If the only type of financing available to you is “exotic” or “extremely creative,” it may be time to reconsider whether you might be overleveraged.
The safest strategy is to never leverage a property beyond the cash flow breakeven point of your worst-case scenarios. In other words, plan your investments so that, even if rent and occupancy rates are down, cash flow will cover the property expenses — including debt and a reserve for major repairs, but excluding depreciation. This way, you will not have to dip into cash reserves to meet the operating expenses of an investment that’s teetering on the brink of negative cash flow.
Find a Happy Medium
Leveraging is a balancing act — you don’t want to overleverage and put yourself at undue risk, but you also don’t want to underleverage and miss out on strategic investment advantages.
For more information, contact Tanya Gierut, at [email protected], or call her at 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.