When are you overleveraged?

Question

I'm just curious as to how other people define 'overleveraged'? How much leverage is too much? I would be afraid to have a balloon loan or a one year arm. I would be afraid to use hard money. But I do have a 20 year arm adjustable every 5 years and cross-collateralized properties-- I know that's a deal killer for some folks.

I have reserves such that I could run for probably a year with no rent revenue at all (but it would hurt), a decade with 30% revenue and indefinitely at 50% (GPR) revenue which is a little over break even for us. We currently have more than 25% overall equity in our portfolio and I'm still nervous with what looks like a serious recession looming.

Where is your line?

Steve Vaughan · Answer

Commercial,  blanket, private, hard money and seller financed loans to me fall under different measurement metrics than standard GSE residential loans as to how overleveraged one is.

Your blanket loan sounds like my commercial loans I so aggressively got out of or paid off in '17.  They are not only 20 yr with 5yr rate adjusts, but also 5 yr right to calls.  Their decision to call could have nothing to do with you. Uncertainty they feel could get the committee to vote to call. Your healthy, they're not. Your healthy, they're scared. Loan due.

Cross-collateralized loans are dangerous. What are the release terms to let one out from under the blanket if you want to sell one property?  120%?  Anything that reduces exit options has different am I overleveraged or not metrics.

I hope at least the call & rate adjust years are staggered like mine were. I had 3, so roughly every 2 years I had one loan callable vs all 3 the same year. I felt overleveraged so I made changes.  The min reserve amount with these is you rnext callable loan balance. Not feasible or achievable for most.

My fixed resi loans at 5% or less I kept comfortably with standard reserves.  Different animals.

Jay Hinrichs · Answer

to me part of the picture is the quality and liquidity of the asset.. How real Is the value..  IE do you have upper class properties that are in high demand to a wide range of investors.. or is it a narrow niche that is very hands on high touch that maybe there is a smaller market or ability to exit at a good price if one needed to.  there is certainly risk on loans that need to be refinanced in 3 5 7 years.. you never know what the mortgage market is going to be doing then  ( interest rate wise or just availability of funding)  this is what hurt investors in the 08 credit crisis. perfectly good properties that had their balloons come due and no one to take them out..  small banks went insolvent big hedge funds bought the bank loans and gave no mercy to the owners and just forced them into BK or foreclosure..  So exit ( sale) to the open market I think should be part of the leverage equation.   AS you describe your portfolio.. while it may not be fun to landlord your properties for no real gain at least your paying down your mortgages so that is good.   I wrote that thread on how landlords would treat a tenant 2 to 3 weeks ago and vast majority of BP landlords said no pay no stay.. well here we are a few weeks later and reality has set in IE that attitude while fine will not work as govmit has stepped in  in many markets and taken the no pay no stay card away.. So in my mind its treat your tenants really well make them happy make them stay through the trough here and landlords will be fine in a few months.. Just going to miss some revenue .. and if a land lord stress's out and or has financial difficulties because of 2 or 3 months of missed rent.. then they just need to take another look at how they set up their rental business and the necessary reserves.. this should not stress any landlords if it is indeed a 2 to 3 month problem.

Russell Brazil · Answer

The amount of leverage is going to be very individualized.  Fannie Mae standard underwriting requires 6 months of reserves per property. If someone has that much liquidity....they are probably fine, because it is highly unlikely 100% of your properties go without rent for 6 months.  Higher class properties with higher income tenants probably need less reserves than say someone who owns a bunch of D class properties where their tenants may be at risk of taking advantage of the eviction moratorium happening in many places.

I wouldnt be afraid of ARMs per se.  They get a bad rap when not necessary. I have a number of ARMs, and if they were to reset now, my rate would actually drop.   15 years ago, people were doing these teaser loans, with below market interest rates that would rise on the reset. Those types of loans dont really exist anymore. Now that rate is indexed, and during bad economic times, rates drop, so an ARM reset is going to produce a lower monthly payment for almost anyone.

Bill F. · Answer

@Jill F.

I'll copy paste what I wrote in another thread about this topic, with some additions:

Short Answer: if you hold 0-20 year old  B-C class SFRs or small MF with long term fix rate debt (like most of BP), you probably need 6-12 PITI with some extra for CapEx. If you work in a service industry or are hourly wages, you want to be more on the 12 month range since you also have higher wage volatility.

This can be summed up by net debt (total debt- cash). If I have I buy a $100k property with 20% down and have $3k in reserves ( 6 months @ $500/month) your net LTV is 77%

Long Answer:

There isn't a hard and fast rule since every investors' situation strategy and goals differ is different. The idea of Optimal Capital structure from corporate finance, which asks at what amount of debt are the benefits the highest and the risks the lowest, can help.

The main benefit of debt in this case is the tax shield. Every dollar of interest you pay is tax deductible (I know this doesn't' hold true for all BP folks but stick with me). That means debt can lower your tax rate, while also letting you buy more assets.

The risks of debt are quantified by the probability and severity of financial distress (for our case). That is basically how volatile are your earnings and what will result from the distress (deferred CapEx, interrupted renovations, missed payments, foreclosure). This is where the type of debt comes into play. Long term fixed rate loans pose less risks than short term floating or balloon products.

In the business world you see this at work in different industries. Utility companies have really high net debt ratios (what we would call 70% LTV), because since they provide services that everyone needs, they have low earnings volatility. On the other side of the coin, you have pharmaceuticals companies, who often have negative level of net debt (debt - cash) because if their next break through drug may not get approved and their sales will drop.

Thought should be give some thought to what space we are in when thinking about what net debt levels we want (overall leverage and how fast to pay down debt/how much cash to hold). If we own commercial RE with credit tenants (think major McDonald franchisees) in a niche that has limited supply and high demand, we can keep high LTVs and low cash reserves. If we own a bunch of STRs in the same area our income is volatile so we should seek to have high cash and retire debt pretty aggressively.

Each investor has to figure out their own tax shield and risk of financial distress on their own, but it the optimum LTV is tied to the investor's strategy and goals. Location, tenant class, asset type, debt structure all come into play in figuring out rent volatility and risks.

Jill F. · Answer

@Joshua Davies  I'm not really asking if people think I am overleveraged though your're right, I'm sure people will tell me.  However, what I'm really curious about is where other people draw the line for themselves and if they are still okay with their choice going into this pandemic situation. While I'm ok with our situation, I would certainly be happier with fixed rate loans (assuming I got a reasonable rate) but those were not available to us.

Because I have health issues, I'm actually much more worried about catching this virus than I am about my investments :(

Andrew Syrios · Answer

I see overleveraging in two ways; property and overall (or global).

Overleveraging on a property is based on the property's value. So if you buy a property 100% financed, but it's worth 50% moret han you bought it for, you are only leveraged at 66.7%; which is fine. (That being said, it's easy to go over budget on a rehab or overestimate the ARV, so be very careful with this.)

Overleveraging overall is having too much debt to cover your expenses or not enough liquid cash. I would go with the banks on expenses and try to maintain at least a 1.2 debt coverage ratio (net income is 1.2 times your debt service.) I would also want to aim for 5-10% of your assets to be liquid (cash, money market accounts, etc.). It depends on your size, and more would be better. I would want at least $10,000 in the bank if I owned a rental property to cover unforeseen expenses. (More in expensive markets.) It's a bit subjective, but you shouldn't put all your eggs in illiquid assets.

Anthony Angotti · Answer

@Jill F.I would say it's someone that can't handle large expenses all at once. It's more about the cash reserves to me than it is about the LTV. If you have sufficient cash reserves to handle worst case scenario on most properties at once then you're fine, but if you aren't keeping reserves and are spending all the cash flow during the good times you're going to get burned.

Personally we aim to keep $8,000 per smaller property in reserves. We keep this in a high interest savings account so that it's accruing at least a little bit. Sometimes it is less than that, sometimes more, but we don't spend the cash flow and continue to put it towards reserves or to reinvest (either in the market or in RE). For larger properties we keep more based on the building and what may need to be replaced. Typically a roof is the biggest one time expense we experience so we usually aim to have at least the cost of a roof in liquid cash. The additional we reinvest in other more liquid sources (stock market usually). So the dollar amount isn't the important part, what's more important is can you handle your biggest one time expense at once. The more properties you get the more they support each other. We additionally keep a few lines of credit open to handle any overflow that may occur for a true emergency scenario and when we use them we pay them down aggressively.

Jeff S. · Answer

@Jill F. I think the bigger question is how would we be without a job and how bad can things get. In the 80's I saw people lose properties and homes with very little debt so debt isn't the issue, it is loss of income and cash reserves.

Leverage isn't really a choice for many. If you are just starting out then leverage is the only option for most of us. Leverage is good when properties go up and it sucks when prices and rents go down.

For me in my 60's I have no interest in leverage although I believe liquidity is more important than being free and clear on everything.

If you are in your 20's and 30's then take a chance and go for it. Hard to start over when you are old though but not impossible.

Joe Villeneuve · Answer

When you analyze a deal, and the analysis shows (with a minimum down) that the net cash flow with financing is less than  All of your expenses, then you are over leveraged.

Joshua Davies · Answer

@Jill F. I think being 'overleveraged' is subjective to the individual or entity that owns the properties. If any one person is acquiring units at 90% LTV and have insufficient cash reserves then they are likely over-leveraged. However, if they have millions of dollars in cash to ride the storm then in their mind they may not be over-leveraged.

I also think you would see this more with SFH investors and small multi-family investors with properties financed on conventional loans, or floating rate commercial loans. Floating rate debt can work well, and I had many properties financed this way when I was in the small multifamily market, however if you have a balloon payment that becomes due during a year like this with an unforeseen pandemic, it can definitely be troublesome.

Either way I think investors need to fully evaluate their portfolio and balance sheets and determine themselves if they are over-leveraged. Nobody on a forum can really tell you if you are over-leveraged without seeing all of your financials, but I suspect there may be a few who will try.

When are you overleveraged?

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