Optimal Balance Between Debt and Equity Financing
Virtually all real estate investors use leverage, or borrowed money, in their business. It allows them to reach for higher priced property than they’d be able to afford by using just equity. But can you have too much of a good thing? What happens if you can’t cover the principal and interest payments? Foreclosure and bankruptcy are two possibilities no investor wants to deal with.
What about banks?
After the Great Recession of 2008, banks’ tighter loan requirements are here to stay. This could mean 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. Banks base loans on fair market value (FMV) and, if your property is appraised for less than expected, 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, a skittish bank may decide to foreclose or call the loan.
How much can you lose?
Small differences in personal circumstances and preferences can lead to vastly different investing choices — there’s no “right amount” of leverage to use. While each investor may have a different financial 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 investors can use to determine an appropriate amount of 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 you had to lower the rental rate or make significant concessions to attract new tenants? What would happen if your vacancy rate jumped to two or even three times its normal level?
Also prepare best-, worst- and most-probable-case scenarios for each investment. Look at whether the property still would 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 make it through the year?
Are you overleveraged?
The fact that a bank won’t approve a traditional loan for your 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 scenario. In other words, plan your investment portfolio so that, even if rents and occupancy rates are down, cash flow will cover the property expenses — including debt service and a reserve for major repairs, but excluding depreciation. If you do this, you won’t have to dip into cash reserves to meet the operating expenses of an investment that’s near 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 your balance
The Tax Cuts and Jobs Act still allows real estate investors to deduct interest payments, further reducing the cost of debt. Note that rules may limit the amount of interest that real estate investors may deduct. However, by making an election and forgoing certain depreciation benefits, a business may avoid the interest deduction limitation. But the right amount of debt can differ for different investors. What one investor sees as risky could be a strategic investment advantage to another investor. Consult with your financial advisor to find the right balance for you.