Leverage and recession

[Amanda Louise Sanchez]

I am a new investor with the goal of purchasing a duplex to houseHack in 2019. After hearing the latest episode (#311), it was advised to leverage as little as possible with the possibility of an incoming recession. My plan is to find deals that could survive a potential drop in the market and increase in vacancy. I do not know how to limit future leverage, since I have limited cash. How do you recommend a new investor reduce their leverage in a potential recession? For instance, should I use larger down payments?

I hope that makes sense, I appreciate any input. Thank you!

[Kevin Dean]

Hey @Amanda Louise Sanchez, congrats on setting that goal and also taking precautionary steps to protect for the downside. Despite all of the noise and volatility in the stock market, positive job growth numbers came out yesterday which show the country is still creating jobs, trade talks are calming and inflation is under control. 

It pays to be a contrarian in investing, and right now everybody seems think that we are headed for a downturn. Usually when everybody thinks the same thing, there is opportunity. The market may be headed for a downturn, but recent data does not support that thesis, at least not in the near term. With that said, I would still proceed with caution when underwriting, analyzing and projecting returns, but, don't simply buy into everyones thought that the market is doomed, just because that's what everyone is saying.

Credit is definitely tightening a bit, meaning less loan proceeds than a few years ago, but banks are still lending with historically favorable terms. (High leverage, interest only, long term fixed rate debt at sub 5% interest rates).

First step would be to develop a realistic view of the current economy. You don't need to be an economist to do this! But just do some research on your own which is supported by data to get yourself comfortable with what is going on in the general economy as well as your desired market.

Next I would take a few practical steps, some of which you have already mentioned. Here are a few examples...

1. If historical vacancy in your market has been 8%, project 10%.

2. If historical rent growth in your market has been 3%, project 1.5%.

3. If you believe the property can support 75% leverage, only finance 70%.

4. Hold adequate reserves. This will be dependent on the age of the asset you buy. The older the asset, the higher amount of reserves. For a 1970s property, a good amount of reserves would be 1.5 months of debt service plus $300 per unit. For a single family property, you will have to hold more depending on the current condition of the property, expected vacancy and expected CapEx (for example an HVAC unit which could go out in the next year or two).

There are a ton of people who have been waiting in cash on the sidelines for a large market correction for the last 5 years. The opportunity cost of not doing anything over the last 5 years has been tremendous. We don't know what lies ahead, but don't let here-say scare you away from reality. Adjust expectations based on reality, protect the downside, and get busy! There are still deals to be had and money to be made.