Leverage or no leverage?

Question

Hi guys, just wanted to have a discussion about leverage.

With my business just starting up no more than 5 months ago, and acquiring three properties; two flips, one duplex - located in 3 different states, I am looking for your opinion on leverage. Since we are so new, and the market being at the peak levels we are seeing today, we know a crash is coming.. so why leverage?

(Don't worry about our rental, only want to talk about flipping)

My thought process; Since our company has been able to creatively fund an amount of working capital that allows us to purchase with cash, at-least two/three flips, we shouldn't risk maximizing our potential gains with leverage. I know strategic leverage mixed with appreciation can result in serious gains, but the same occurs when deprecation and leverage mix, resulting in serious losses. For this reason, along with "Time in the market is better than timing the market" - Warren Buffet - by not timing for the market crash and hoping we will sell at the peak, and moving slower to see another market cycle by not leveraging - is why I don't feel leveraging flips is worth it in our current position.

As well, our strict buying criteria gives our company lots of room to go over budget on rehab, sell at a discounted price, or hold for a longer term because we pursue deals with great spreads and buy cash. We also will be aiming to pursue flips that we know we can rent out and hold with a positive cash flow in case of a market correction.

... Most of these key points above are limited, if not impossible if we leverage. With higher holding costs due to hard money payments, we have a lower profit take home, forcing budgets to be tighter, and break even selling price to be higher. As well, cash flowing a property that is leveraged with hard money is very hard to find, if not impossible for us at the moment.

In conclusion; I feel with the market the way it is today, between our available working capital, knowledge, and resources, our company is best suited to pursue flips that hold huge profit spreads and low holding costs resulting in the ability to sell quickly, or rent out and be cash flow positive by not leveraging.

Do you guys agree? Disagree? And why?

I appreciate the time guys! Thanks for the input.

Steve Vaughan · Answer

Cash for flips all day if you can. Borrowing costs are huge. My last cash buy saved me over $4k and that's just what a conventional loan would have costed for a smaller loan. A lot of HMLs charge 3 points.I'd rather save $4-7k than have to go and earn an extra $6-10k (after tax). Use cash for short holds if you have it!

Sam Shueh · Answer

I suggest retain 20% equity into these properties that you got now. You can reduce or gain leverage as the economy changes.Keep in mind mortgage payment, interest rate will go up quarterly may be more than 25 basis points. Finished materials, appliance will go up +10% very shortly. Stores can not absorb all those tariff charges. I expect trade war will linger for months. So plan on 25% increase in your material cost assumption after Xmas. As the marketing time increases so are your interests payments. So you will have a smaller profit than before. Good luck,Sam Shueh

Caleb Heimsoth · Answer

I would probably leverage flips if my cost of capital was 8 percent or less. If it’s more that seems to expensive for me and I probably wouldn’t do that

Phillip Denny · Answer

@Nathan Hillier I mostly agree based on this information. I was just posting about this topic the other day as well, albeit thinking more in the rental space. I think so much is personal, but to me it's finding the right balance and strategy that fits in with your life, personality or business strategy. I think what you're touching on is that your risk tolerance is lower because you are somewhat new in the business and can't afford to get caught hold a bunch of inventory if you have to support the debt service.Also, like you mentioned, seems like there comes a point where your inventory holding costs reduce your profitability. Personally when I think about starting in flips, I worry less about ROI and more about pure net profit vs. my time and risk. In your case, it sounds like being a cash buyer provides a strategic advantage for you because you can move much quicker on a deal than someone who needs financing. I agree as well on having an exit strategy and turning them into a rental as a criteria.

Michele B. · Answer

You have to decide what the time value of your money is worth to you in your business. I know many people who will buy a house cash fix it up and hold it for income. If they are doing this it does not make sense to leave a lot of equity there if they could use it to do another project. There is some thought that if you don't have much equity if someone sues you you don't have much to loose. I don't know just a couple of thoughts.

Nathan Hillier · Answer

@Sam Shueh That's an excellent point about the extra tariff charges increasing cost of materials and appliances. The extra costs will absolutely bite into profit, and is something i should start planning for. Thanks for the response! @Steve Vaughan I'm going to have to agree with you on this one. Especially starting out in the peak of a market, its probably best to buy cash. Thanks for the input!

Marisa R. · Answer

Leverage always makes sense when markets are appreciating.

Nathan Hillier · Answer

@Caleb Heimsoth The question is more towards flips and not so much rental properties. I'm sorry if I made it sound like i'm talking about refinancing rentals. Good point though with interest rates, as they start to raise above 7%, maybe look at buying with cash, it makes sense. As it is now, we plan to refinance our duplex get our equity out, and still have a solid cash flow as long as we can get locked in under 7%. But now its the question of leveraging our flips and how to do so without being over leveraged, and getting out of a deal safely.

Caleb Heimsoth · Answer

@Nathan Hillier. People argue this until they’re blue in the face. My opinion is do both. I’m leveraging now and have for several loans under 5 percent interest. I will let those ride. When interest rates are 7 percent and above (like they probably will be in the near future), I’ll probably just buy cash.

Nathan Hillier · Answer

@Phillip Denny I think it comes down to my lack of knowledge as well as risk tolerance when it comes to leveraging flips, and how to make it out alive if all else goes wrong. More of that fear factor and getting caught being over leveraged during a correction - and a drive to stay in the market for the long run. It's a hard position to be in, as leveraging would drastically increase the volume of deals we could pursue, but we risk losing lots, if not everything by over leveraging. How can you find a healthy balance - or tips on structuring a leveraged flip to limit risk and profit loss in the event of a correction.