Over Leveraged?

[Jimmy Humphrey]

Hi,

Listening to some of the podcasts and reading the blog, I keep feeling this inner red flag that keeps popping up in me.  I get the feeling that a lot of folks are advocating being over leveraged and taking on an ungodly level of debt in order to chase what amounts to a mere $100-200 a month in cash flow for each rental property in their portfolio. And that people are cashing out equity in their home to fund their next project, then using the equity in their rental property to fund the next deal and so forth. 

If you have ten properties with a total of 700k of debt and $2,000 of monthly cash flow, there doesn't seem to be a lot between you and a financial disaster. And working on the foreclosure side of a bank, I can't tell you how many folks I've seen have one or two rental properties fail, which created a domino effect that completely wiped them out.  It also doesn't help I've read a lot of Dave Ramsey type stuff and have a strong belief about living frugally and simply.  I've seen a lot of ugly.

To me it almost seems like if one wants to expose themselves to Real Estate investing, it'd be more prudent to invest in a REIT stock with a good dividend (like "O", which has a 5.3% yield). There seems to be less risk involved, and more upside potential. I suppose if one wanted to, they could invest with some margin in order to take on a bit of leverage.

So, what are y'all's thoughts on the risk one is taking with leverage and cash flow? How do you safe guard risk?

Jimmy

[Michael Worley]

Originally posted by @Jimmy Humphrey:

@Elizabeth Colegrove Part of my concern about this entire being heavily leveraged in order to generate an income is that you have a negative net worth because of your leverage. You aren't really generating wealth, you are generating cash flow. And there is a fundamental difference between the two, and part of me worries that a lot of the common REI techniques pitched on here operate without any concern about net worth. It doesn't seem anybody ever ends up truly owning anything lock, stock, and barrel.

And that's not to pass judgment on you or others who employ leveraged techniques to investing in real estate. It's just a thing I'm tossing out there for consideration. 

How exactly do you have a negative net worth if you borrow 80% of the value of a property? You have an asset worth say, 150k and a liability worth 120k. That's 30k of positive equity. Now, how did you come up with the 20%, was it cash, market appreciation, etc.?

REI is all about adding to your balance sheet. To my knowledge, no one is allowing you to borrow over 100% of the value of a property at this time.

Your statement about not added to net worth, only added to cash flow doesn't make any sense.

By definition, if you pay full price for something you've added no net worth. You pay $100 for something worth $100, all you have done is move money from the cash/equivalents portion of your balance sheet to the 'other asset' category. The way you affect your net worth in this instance doesn't matter (i.e. you borrow $80 and spend $20 in cash or you spend $100 in cash to buy a $100 asset has a net zero effect on your net worth).

What matters is the price you pay versus the 'value'. 'Value' is not an exact science either, but the premise behind REI is that in general there is a long track record of RE growing in value.

Leverage does not adversely affect your net worth or cash flow. In general, it positively affects it. For example if the CAP rate of a project is 7% and the interest rate paid on the borrowed funds is <7% the greater the leverage the higher the Cash on Cash return.

As for owning something lock stock and barrel, why would you want to?

Let's say I have two options, Own a $200k house outright with $20,000 in the bank, or Owe $100,000 on a $200k house with $120,000 in the bank. Which is better position for me? Well, you can't pay bills with equity, so if I had a medical bill for $30,000 I'd be better off with leverage. If I have to pay for a child's college tuition bill of $50,000 I can't do that with the equity, I'd have to convert that equity to cash. You get the idea.

Having lots of money tied up in illiquid assets is a recipe for failure if I don't have the liquid assets to overcome a financial hardship.