How to Avoid Getting Buried By your Debt
Leverage — using borrowed money to make an investment — allows real estate investors to afford more expensive properties than they could with just their own equity. It's an especially attractive option in today's low interest rate environment. And, unlike dividends, interest payments are tax-deductible, further reducing the cost of debt.
But debt repayment can sink a deal if interest rates increase, property values decline or tenants don't renew. When a borrower's cash inflows aren't enough to cover its principal and interest payments, the property is said to be "overleveraged," which can lead to bankruptcy and foreclosure. Investors that find the optimal balance between debt and equity financing are best suited to sustain drops in their portfolio's performance.
Tighter Loan Requirements
Banks' tighter loan requirements are here to stay. You may have trouble if a property's loan will become due or needs to be renewed — or you simply want to refinance it to take advantage of better terms. Loans are based on fair market value (FMV) and, if your property is appraised for less than you expect, you might not qualify for sufficient funds, especially if your bank has tightened its loan-to-value (LTV) requirements.
Even if you're not looking to refinance, you may find that some distressed properties are in violation of their LTV or debt coverage ratios, especially if their net operating income has declined substantially. If so, an uncooperative bank may decide to foreclose or call the loan.
Small differences in personal circumstances and preferences can lead to vastly different investing choices — there's no "right amount" of leverage to use. But while each investor may have a different situation and risk tolerance, there are limits to the amount of leverage that should be applied. Investors who wish to maximize profits through leverage shouldn't repeat mistakes from the past.
One method for determining an appropriate leverage is to apply a "stress test" to cash flow projections for a property. Change key variables one by one and evaluate how each change affects cash flow. For example, what would happen if your vacancy rate jumped to two or three times its normal level? What would happen if you had to lower the rental rate or make significant concessions just to attract new tenants?
Also prepare best-, worst- and most-probable-case scenarios for each investment. Would the property still have sufficient positive cash flow to cover a worst-case scenario for a year? If not, would you have enough cash in the bank to survive?
Think it Through
The fact that a bank won't approve a traditional loan for your latest investment may be merely the result of today's more conservative banking environment. On the other hand, it could also be a "red flag." If the only type of financing available to you is "exotic" or "extremely creative," it may be time to reconsider whether you might be overleveraged.
The safest strategy is to never leverage a property beyond the cash flow breakeven point of your worst-case scenarios. In other words, plan your investments so that, even if rents and occupancy rates are down, cash flow will cover the property expenses — including debt and a reserve for major repairs, but excluding depreciation. This way, you won't have to dip into cash reserves to meet the operating expenses of an investment that's teetering on the brink of negative cash flow.
A traditional rule of thumb for accepted LTV ratios among banks and private equity funds is 70% to 80%. But no one says you have to take on the maximum amount of debt your lender is willing to offer. Today, many investors take a more conservative approach, borrowing only 60% to 65% of their property's appraised value. Such a ratio will provide you with the advantages of leverage without putting cash flow or reserves at excessive risk, and thereby making the quest to achieve financing less difficult.
Find a Happy Medium
Leveraging is a balancing act — you don't want to overleverage and put yourself at undue risk, but you also don't want to underleverage and miss out on strategic investment advantages. To find your happy medium, work with your financial advisor.
For questions or to discuss a real estate issue, please contact Doug Collins, CPA and Partner on (973) 328-1825.