Am I Over-Leveraging?

Question

November last year, I bought a vacant 9 unit for $210k, put in $40k to renovate and after fully leased, it appraised for $440k. In April, I pulled out 80% or $318k and used $200k to pay off the private loan of the 9 unit and $118k to buy an 8 unit for $265k.

The 8 unit was under performing and by next month, based on the same metrics of the first property and after speaking to my bank, it'll likely get appraised for $400k. At a conservative 75% (lender is quoting 80%), I'll be able to get $150k from it. This money is untouched at the moment because I'm searching for a larger deal (more on this in a bit).

Last week, I bought a 4 unit for $120k and the value will be worth $200k in a couple months with the same metrics as the first property. I plan on getting $160k out of this one and pay off the $120k private loan and using the 40k balance towards the larger deal.

With the 3 deals above, after paying off the private loans, I'll have $190k equity I can use to put into the larger deal along with about $150k of my own capital, or $340k. I just got an offer accepted for a 40+ unit for about $1.6M.

My question is am I over-leveraging? I don't think I am, but after talking to some older folks who are against debt to began with I felt as if my growth was a little too fast and I should be careful moving forward. All the loans above have 10 year to 15 year balloons if it matters. Is there anything my experienced BP members can see that'll cause a hiccup in my plans? If so, what adjustments should I make now to lower my risk?

Thank you.

David Faulkner · Answer

I'm a big fan of "stress testing" my investments. It appears from your profile that you have been in business in one form or another since before the great recession, so you have presumably seen what can happen and how bad things can get ... so, I'd run that scenario ... say, sitting here today is just like 2006, and the market and economy are about to dump as big as they did then. Holding the portfolio you have right now, financed the way you have it financed right now, would you be ok if that turned out to be reality? Or would you be in big trouble? If you would be in big trouble, how could you adjust things so you would not be? I'm not saying this will happen, but this is what I'd be prepared for ... and let's face it, the next recession is never a question of if, only a question of when and how bad.

Another mental exercise I like to go through is what I call the "and" game ... what and how many things would have to go wrong for you to get in trouble on your investments. For example, you'd have to lose Y% your tenants "and" you'd have to lose your job "and" you'd have to burn through $X in reserves "and" you'd have to not be able to sell at a Z% discount to current market value ... the more "and"'s you can throw at it, the safer you are, but if you throw too many "and"'s at it then you will never buy anything because you could always come up with a scenario that would bankrupt you ... so, the question is are you comfortable enough with all the "and"'s you've come up with such that you are reasonably safe (that is for you to decide), and if not, how do you add some more "and"'s.

As for your specific situation, you keep saying things like "will be worth" ... I understand that you are likely forcing appreciation and not talking about market appreciation, but if you have not been doing this for awhile, I'd consider getting the properties you have stabilized and operating at their full potential to validate your value add assumptions before acquiring more. Not only will this reinforce that your going in projections are correct (or not), but also make sure that you can focus on realizing that value and don't over leverage your time and attention (as well as $). Even then, it sometimes takes a decade or so to fully validate some of your projections (like CapEx, for example). I'm not a big fan of the whole "I grew my portfolio to 300 units in 24 months" approach that is touted on the podcasts ... it may be a recipe for attracting advertising dollars for BP, but in the long haul believe that its practitioners are more likely to end up in the poor house as they are to on easy street.

Mike Dymski · Answer

Keep your talks with those folks to 401Ks, mutual funds and other middle class BS and continue to kill it in REI.

On your 40 unit, make sure you structure the financing properly so that you have all the capital you need upfront for deferred maintenance (i.e. don't plan to fund it out of cash flow).

Andrew Syrios · Answer

First and foremost, those sound like some absolutely incredible deals. Well done!

That being said, if you believe these appraisals are accurate, I don't think you're overfinancing. That's especially true since you're taking any surplus cash out and reinvesting it instead of spending it frivolously. To me, this looks like one of the best examples of the BRRRR strategy I've read about it a long time.

I think the key number to look at it when it comes to over-leveraging is debt to equity. How much cash you can't get out doesn't matter (as long as you use that cash wisely). The question is do you have equity in the properties to cushion any decline in the market or allow you to sell them and pull cash out if you need to. From where I stand, it certainly looks like you do, so in my judgement it looks fine.

Rolanda Eldridge · Answer

It really depends on your total financial position..Leverage is ok if plan B exist. Unforeseen events come with any business...Keep it Moving!!!

Jonathan McKay · Answer

@Tony Nguyen this is somewhat off topic, but what are some of the horror stories you have?

George Despotopoulos · Answer

@Tony Nguyen. Those deals sound like home runs. In my opinion, as long as you have 25-30 pts of equity in each cash flowing property you are on the right path to building a great portfolio.

Mike Dymski · Answer

Regarding cash reserves, that is a loaded question because it brings in all your properties, value add plans, personal expenditures and job security.  You could have low leverage on RE but a number of kids in college, expensive home, nice cars, rehab plans, commission based job and need a lot more in reserves.  As someone above mentioned, 6-12 months is a general rule but that will vary widely.  You may be in a spot where you have to spend a day and pencil it all out to see how exposed (or not) you are.

Regard converting 1s to 2s, if that takes cash, I'd recommend including that and any other rehab plans in the original financing.  Improper debt structure and not having needed capital during market turns is what gives investors problems.  Also, funding rehab with cash flows sounds good but is tougher when leverage is high and reserves are low.

Brent Coombs · Answer

Really good to see your bedroom/s value-adding ideas. My little concern is whether your LENDER is leaning towards lending for lendings sake? Shades of 2006-7?

I prefer to see leverage stay below 70%. Hopefully, your "fair share of horror stories" will help keep you rational. Also, make sure you can refi/exit before those balloons burst! All the best...

Andrew Cushman · Answer

@Tony Nguyen First of all, great job finding some good deals and creating value!

For our value-add acquisitions, we are getting permanent and bridge loans at 75%-80% of total acquisition cost (purchase price plus rehab plus some soft costs).  On some properties that means the loan is exceeding 90% of the purchase price.  However, with a clear value add strategy we are comfortable with that, as the LTV will quickly go down.  Furthermore, we make sure that our going in debt coverage ratio is high as an extra measure of safety.

With that said, we are doing two cash-out refi's right now on our stabilized properties, both at 65% LTV.  A lot of the deals we were looking at 5 years ago were from guys who got over leveraged near the top of the last cycle and ended up losing their properties as a result.  While I don't see any big problems for multifamily in the near future, having a ton of cash flow is never a bad thing and will ensure you stay in the game for the long haul.

I am all for debt when used wisely (which you seem to be doing).  Just remember it is a double edged sword - it can accelerate both your accumulation and loss of wealth!

Andrew

Am I Over-Leveraging?

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