Would you feel comfortable with this kind of leverage?

Question

I know the debate on leveraging has been raging for quite a while on this forum and there are several people who are pro leverage (Rich, Will, JScott) as long as it is used responsibly and there are others that talk about playing it safe and owning F&C properties (including primary residence) in the event of things going south. I am a big fan of leverage myself but also want to account for worst case scenarios. So, if you stashed away 6 month reserves for all your rentals into a separate fund, is that good enough to wiggle yourself out of a sticky situation in the future or does it need to be more than 6 months? I am not able to imagine any problem scenarios except vacancies or a major repair. Is there anything else I am missing?

Also, I would think since this separate fund would have a considerable amount of money, it would make sense to keep it working by using maybe 70% of it for private lending and make some return on it. Again, since it is highly unlikely that you would run into problems with all properties at once, I would think, the 30% should cover your immediate expenses and since private lending is short-term anyway, I should have access to all of it reasinably soon. I have other liquid assets that I could use for the reserves but having something sectioned off with a plan in place would just make me feel better about it. Thoughts?

Will Barnard · Answer

Having reserves for buy and holds is always a good idea. I also like your thinking of using the growing reserves fund to gain additional returns from lending, that is the right thought process in my opinion.

To answer your specific question, I would say it all depends on your portfolio and the numbers you used. For example, if you bought at the 2% rule, and apply the 50% rule, then you are already putting aside reserves every month. Obviously, you will not have 50% expenses every month, part of that is vacancy allowance, capital expenses, etc. so if you used those rules for your portfolio, having an added 6 months is plenty more than enough.

On the other hand, if you bought at a 1% rule, and don't apply the 50% rule, you may likely need at least the 6 months, possibly 12 or more.

Account Closed · Answer

I would never advocate using any part of the reserves to buy new properties.  I set minimum reserves for my properties and add to these reserves based on forecasted future capital expenditures and allow for the unexpected.   I also have a healthy credit that I maintain in the worst case where insurance and reserves are not enough to pay for an expense.

My reserves are held in liquid investments that still earn better than 3 percent.

I also do not invest in areas that I might be concerned with the rental market totally collapsing.  People will always need a place to live.  If a city though has very high unemployment, has a decreasing population, has been over built, has little in the way of new industries coming in, it is probably not the best place to have investments.  They might do well for awhile, but rents will probably get pretty skinny in a ghost town.

Will Barnard · Answer

Shaun, I think you are on the right path, your plan to cover the downsides and your ability to have at least break even on your deals is good in my book. I would say you have a good plan and road map.

Don Konipol · Answer

I like Will Barnard idea.  There is no one answer for everyone.  If you are young with little assets, you probably don't have much to protect anyway.  Using ultra high leverage can build great fortunes - or lose them.  Just understand that when using high leverage, for better or worse you are at the mercy of the markets.

K. Mitchell · Answer

The usual: divorce (especially in a community property state), health problem for you or a family member, uninsured/underinsured catastrophic loss for you or a family member (such as a personal injury car accident), a self-employed tax problem/debt, etc.

The less usual: a local water district concluding that the water in the entire area causes leukemia or other cancers and therefore no houses are habitable (which is very possible in some areas of Texas), a prolonged drought that causes the local portable water supply to dry up, a major employer or employers moving out of the area/closing, one tenant (or other person) getting hurt on the property (and getting a multi-million dollar judgment against you), one local tax agency assessing a property tax on your property (I had one try to assess a $100K tax to fund an adjacent highway improvement....), etc.

Will Barnard · Answer

Well said Charles.

Account Closed · Answer

Will Barnard  I agree real estate is not like the stock market.  As investors we have far more control over our investments and with good due diligence can avoid costly mistakes.

I have two basic points.

There is more to evaluating real estate than simply looking at the numbers.  Cash flow is great, but there are other factors to consider.

Real estate though can become essentially worthless.  Property in a ghost probably still has some value.  There are properties though that can have environmental issues, wetland issues and potentially other issues that can become a greater liability than the real estate is worth.

There are homes near me that are beautiful today and probably will remain that way for many more years.  Trouble is that no improvements are allowed.  If something was to happen to the structures on these lots (like a fire, earthquake, ect) it would not be possible to rebuild due to regulations under the Shoreline Management Act.  I'm sure the value of these properties won't go to zero, but clearly their will come a time that the highest and best use of the land will change.  The lot will become unbuildable.

The second point is that yes, if you are going to use your reserve money be careful.  There is more risk in using this money to make loans.  Loans can go into default and you can have protections even in default.  A knowledgeable investor can probably do this very safely.  A newer investor could put themselves into a bad situation.

I think there are investment strategies that some of us have proven  work, but might not necessarily serve newer investors that don't understand the ropes.  Just my take.

There are parts of the country that I won't invest in.  Part of it is because I don't know the markets.  Part of it is looking at some of the macroeconomic factors involved.  Investors that understand the market and understand the economic playing field they are working in can do very well I'm sure.  Some though might invest in these areas thinking they could do equally well without the necessary awareness could have less than desirable results.  Again just my .02.

Will Barnard · Answer

That said, I believe your point really is that investors should really know what they are doing before leveraging reserves from their buy and holds and I can agree with that.

Account Closed · Answer

Time is a very important factor.  My point is that investments can go to zero or nearly so.  If you understand the risk, understand the market  and have otherwise done your due diligence then you may do quite well.

I know many say that you shouldn't plan for appreciation.  I think though that there are those also that don't plan on what may be real loss in values in some areas.

As far as making a blanket statement.  My statement was not to say that others shouldn't invest where ever they like.  My statement was more about my perspective of where I choose to invest.  Every investor has to do their own due diligence.  I expressed my opinion as to why I'm leery of some markets.  Others may have a better knowledge of a local market and a strategy in place to make money even if property values decline.

Account Closed · Answer

I can see the benefit of this.  Not sure that I would advocate it for everyone though.  Using your reserves to buy good quality notes that pay of in a short period could relatively safely increase your reserves.  An investor that understand the risks is probably okay.

Would you feel comfortable with this kind of leverage?

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