How would you define Over-leverage?

Question

Hi BP,

I realize again the importance of avoiding over-leveraging especially in this unforeseen recession crisis.

I thought I would never leverage more than I can handle (pay them all back) in the worst situation, but am realizing that this is a pretty vague principle. More importantly, it substantially prevents me from scale up enough.

How would you define over-leverage that should be avoided?

Account Closed · Answer

My definition, based on watching people crash and burn over my lifetime, is not having enough money in the bank to keep you from worrying about a worst case scenario.  Not having enough in the bank to afford to put on a new roof, or pay the mortgage while you fight with your insurance company after your building burns, or you're in the middle of a pandemic all of a sudden and your tenant decides not to pay for several months and you're not allowed to evict them.

I am really against using all equity to put it into another property.  Because you can end up in a situation where everything crashes like dominoes.  I've seen it happen to a family member who also believed in that investing strategy back during the crash in the early 1990's.

What happens is, you have one property get into trouble, and then maybe another one, and you don't have the reserves to bail yourself out of the situation, and one by one, you lose them all.

So, bottom line is being over-leveraged is not having enough reserves to weather emergencies.

Randy Bloch · Answer

@Kenneth Garrett

Kenneth’s explanation is simple and spot on.  You need reserves to make your mortgage payment and cover unexpected expenses.

I will give simple example. I had a city sewer line break within the street and backup into my duplex...two basements cover in raw sewer. Tenants had to be relocated (renter insurance covered), all mechanical replaced and basements repaired. My insurance didn’t cover as I didnt have sewer coverage, even if I would have they would not have covered because it was main city line in the street, not tje line to my duplex. city did not cover as they claimed natural disaster...all in cost me $40k.

I had the reserve to make the repairs and keep my tenant in place...as a younger new investor when I had all Money invested this would have been disaster.  This could caused me to miss my mortgage payment and then get behind on all my properties and lose everything.  I had financial reserves to handle this and as unpleasant as it was I did not lose any sleep over it.

being over-leveraged can get u there quicker...only question is where ”there” is. :) It can make u rich and it can make u poor. The greatest investor of all Time (Warren Buffett) often talks about not being over-leveraged...he managed to become one richest men in the world without using too much leverage and is sitting on $137b today waiting for the right valuations.

I have been investing in real estate for awhile now and have made plenty of mistakes...but time has healed most of those. Buy at the right price and invests for the long term, don’t use too much leverage and u will be rich someday.

Kenneth Garrett · Answer

@Andy Wilson

Leverage means using debt to run your business or in RE using financing to invest in properties.   The purchase of a property at 80/20 is 80% leverage.  You are over leveraged when you can’t meet your debt obligations.  During the time of economic crisis the ability to obtain financing is not possible and you do not have any reserves to meet your obligations.  During COVID-19 if one month of tenants missing rent payments would cause you to miss making mortgage payments you are over leveraged.  You have no reserves.  Many discussions on BP talk about how much in reserves you should retain.  6 months is a typical amount.  If you have many properties you need enough reserves to cover major expenses and emergencies.  This might mean you need $20,000 or more depending on how many units you have.

Account Closed · Answer

Honestly, in my opinion, BRRRRRRR or however many R's it's supposed to be is the definition of over-leverage.  I'm not a fan.

Account Closed · Answer

@Andy Wilson

Less than 6 months rent in accessible cash and/ or negative cash flow if rents dropped 20%. And I mean negative 5yr cash flow, not next month. Probably 9/10 folks here who post numbers don’t allot nearly enough to cap ex & repairs/ maintenance. They show $100 monthly in the positive but don’t account for the $1200 annually to buy a new appliance or fix something. If you’re rents dropped 20% you should still be in the positive long term or you’re gambling.

Sam Shueh · Answer

Your income-tax-obligation<0

You carrying too much debt when compared to its operating cash flows and equity.

Gordon Starr · Answer

To my banker, anything over 70 % loan balance divided by appraised value at origination, loan to value, LTV is too much leverage. To me when you can’t meet obligations and leverage anything over 100 % loan to current cash liquidation value you are in way too deep. As I understand it, it can be a shocking wake up to learn how much less equity is cash in hand from a distressed property sale during hard times.

Andy Wilson · Answer

@Sue K.

So, BRRRR could be dangerous without enough reserves I guess.

Thank you for sharing

Kenneth Garrett · Answer

@Randy Bloch

Good example.  I had a boiler go out in the middle of winter.  I ended up putting the tenants up in a red roof inn for a week.  I had to have money reserves for the boiler and the housing to cover the costs.  Be prepared at all times.  Nothing comes at convenient times for any of us.

Michael King · Answer

This is a good question and I'm along for the ride on it.

How would you define Over-leverage?

Most Popular Reply