Why is being Over-Leveraged a bad thing?

Question

As I read these REI books they keep talking about how you can be over leveraged, meaning you have small amount of capital invested into a much larger amount. Is this the correct definition? And how is that a bad thing??

Bonnie Low · Answer

Yes, that's basically the concept of being over leveraged. It usually refers to owning or buying a property and having very little cash or equity in the property. So if you buy a house with 3.5% down and it hasn't appreciated much, you owe almost as much as the house is worth. Leverage can be a great thing - you're using the bank or someone else's money to help you buy more properties instead of having to come up with your own cash. However, when you're over leveraged, like in the example of the house I mentioned, if the property value drops and you have little equity in it, you can quickly find yourself "upside down" where you owe more on the property than it's worth. Or, in the case of a rental property, your mortgage payment could end up being more than you're able to collect in rent if rental rates decrease. That's the danger of being over leveraged. Hope that helps!

Jenning Y. · Answer

Well, the loan amount(or LTV) itself can not tell the whole story of risk. Another more important factor is liquidity. It is safer, let's say you borrow 100% while hold 20% as cash reserve, than just borrow 80% with no reserve at all. In fact, I am heavily leveraged but I just pulled out about 25% of my equity as reserve. Though I borrowed more but I feel much safer now. So sometime borrowing more is more safer than borrowing less...

Andrew Syrios · Answer

It's not just a matter of needing to reduce rent, it's also inscreased vacancy and delinquency that comes with a recession, particularly a deep one in real estate. Being upsdie down in properties also removes a lot of options as you have to bring money to the table to sell or refinance. Of course, if you have plenty of money in the bank, then that's not a huge problem. But if you have plenty of money, why overleverage? You're just paying interest on debt you don't really need. I'm a fan of using leverage and using it rather aggresively, but there are reasons many investors went belly up in 2008. It's still something you should be careful with.

Jay Hinrichs · Answer

agreed there is no such thing as over leveraged if you have enough CASH in the bank to handle any issue that may come up.

Zachary Ray · Answer

I would say with the lack of capital in reserves, most people that put nothing down tend to not have much. If a high expense were to occur it would wipe them out.

Bjorn Ahlblad · Answer

If you are uver leveraged you can be forced to sell in a bad market or end up in default. Both are bad and might end your REI plan for good. Always have money or access to money in order to weather a storm.

Steve Morris · Answer

You can buy "right" and get a steal that needs work. So you may be temporarily over-levered.

Greg Gaskill · Answer

Ok, so playing devils advocate (I've always believed in low LTV for safety), and out of curiosity; If you only lose money when you sell and make when you buy, and I have no plans on selling during the downs of the up and down cycles, and if my cash flow is unaffected / unrelated to market value swings, and I keep more money in reserve should I over leverage and push LTV to say 95% - is this a bad thing? Am I safer at say 65% LTV or just missing out on an additional 30% cash out to use in various ways, including security against future problems as well as investing for more cash flow? Having more money with which to work is a good thing - spending all of the recovered equity or having no reserve would be bad business practice anyway. Perhaps there is a formula of what amount of reserve will cover yer ass as a percent of revenue based on # units? Is there some hidden clause of mortgage which states when LTV goes beyond 100% or ? as a result of market correction / cycle they can call the loan due and as said previously - shut down your investment plans for good? It would seem cash flow may be impacted some (market value seems untied to rent value), but it seems likely that I'd continue to pay my mortgages, and unless the banks want to be difficult, they would continue to accept my on time payment. It's only when you sell that you take a bath. For buy and hold regardless of what market value does, my costs remain the same, and unless I am forced to reduce rent then my revenue remains the same. And by buying right, my rents more than pay for the mortgage, so there is room there for adjustment and still remain healthy. If I'm missing something, please chime in!

Juan Correia · Answer

I think that's a different way of saying "buying wrong"? Thoughts?

Steve Morris · Answer

"Why is being Over-Leveraged a bad thing?"Because s*** happens and always at a bad time.Idea is for each property to stand on its own (ie CFBT > $0 each month). If you have to feed it or a new roof hits you at the wrong time, now you need to tap other income.With CFBT >$0, then you can build reserves.