In our last post, we explained the benefits of using good debt to jumpstart your investment strategy. As promised, today we’ll talk about how to take on as much good debt as possible without taking too many risks.
There are three main risks associated with borrowing money: over-leveraging; risk related to loan terms; and counter- or third-party risk.
Over-Leveraging. People often balk at the idea of taking on debt for fear of over-leveraging themselves—that is, taking on too much debt against a property. What is too much debt? A property is over-leveraged when there is not enough cash flow to pay for the debt.
Imagine you had a $10,000 annual debt payment on a property. In a break even scenario, the net cash flow (gross income less operating expenses) on the property before debt payments is $10,000. But as an investor you want to make money, not just break even. Ideally, you should build in a cushion. In technical terms, this is what lenders refer to as debt service coverage ratio (DSCR). Most commercial lenders will require a DSCR of 1.25, which means the net operating income needs to be at least 25% more than the annual debt service. In other words, you can pay the mortgage and still have 25% extra (or $2,500 per year) for unforeseen expenses.
You might ask, “OK, so you’ve got a DSCR of 1.3, but what happens when something happens to that property that requires more than the extra 30 percent you’ve set aside?” The best way to prepare for the worst case scenario is to have a prudent cash reserve on hand. A good rule of thumb is 4-5% of the asset value.
Where people often get into trouble is dealing with residential lenders and conventional loans on smaller residential properties. Lenders in this arena do not care about DSCR. They care about the value of the property and the borrower’s ability to repay the loan. This makes it extremely easy to become over-leveraged. Here’s an example: Joe Shmo earns $60,000 a year and decides he wants to buy a $100,000 house. He has $10,000 saved for a down payment and no problem qualifying for a $90,000 mortgage. A few years later, Joe accepts a job in another state. Unfortunately for Joe, the market hasn’t been strong and his house has depreciated. To make matters worse, Joe has all his equity in the house and just discovered that the house will not generate enough income as a rental property to cover his annual mortgage payments. Joe would not be in this position if he had considered the DSCR before purchasing the house. But such is the nature of residential loans—they are tied to the borrower’s ability to repay, not the asset’s ability to generate income.
Loan Terms. Loan terms are another source of risk in taking on debt. Balloon payments and adjustable rate mortgages (ARMs) are the two most common examples.
One of the biggest risks with commercial loans is taking on a balloon payment that comes too soon (after three years, for example). Under certain circumstances short term loans are viable, but we usually do not take on loans with a balloon payment sooner than ten years from the date of origination. Historically – even if you start at 2009 – property values tend to recover over a ten year period. Three years, however, is risky. If you took out a loan in 2008 with a three year balloon payment, in 2011 that property would be much less valuable. That creates a problem, because not only would the value of the property be insufficient to cover the loan, but you’ve also had very little time to pay down the principal balance. With a ten year balloon payment, even if property values plummet in year ten, you’ve had ten years to pay down the loan and are much less likely to find yourself underwater. Shorter term loans become less risky as the loan-to-value (LTV) ratio decreases or in situations where real value (renovations or rent increases) can be created quickly. The real risk is taking a high LTV loan for a short term, in which case a shift in market conditions can put you underwater very quickly.
Risk also comes in the form of rate repricing through ARMs. This is what got a lot of people in trouble in 2008. If loan payments change every month based on some sort of index, then that creates uncertainty and risk. Many commercial loans have fixed dates for rate changes—three, five, or seven year price adjustments. However, like most risks, if you’ve planned accordingly, a rate adjustment is not going to sink you. If you’ve got a property with a 1.35 DSCR, for example, a rate adjustment may eat into your cash flow but it’s highly unlikely to be a deal killer.
Counter- or Third-Party Risk. When you take on debt, you bring another partner to the equation. Lenders have the right to take back the property if you mess up or don’t follow the loan agreement. You may also be affected if the lender gets into trouble due to external economic factors beyond your control. While worth mentioning, this is a fairly small risk.
Key to a successful debt strategy is making sure you always have cash in reserve. Whenever you pull equity out of a property, you should set some aside for a rainy day fund. How much is enough? We use two rules of thumb, depending on the circumstances. One, as we mentioned earlier, is 4-5% of asset value (typically used for stabilized assets that we plan to hold for the long term). On a $1 million property, we hold at least $40,000 in reserve to cover emergency expenses. The second is 6 months’ holding costs (we might use this figure when completing a renovation project, for example). In the highly unlikely scenario that your property goes completely vacant, then you can afford to carry the building for six months while you work to restore it to full operational capacity. When it comes down to it, these two numbers – 4% of asset value and six months’ holding costs – are often comparable.
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PO Box 222, Fort Lauderdale, FL 33302
Phone: (855) 563-8273
PO Box 222, Fort Lauderdale, FL 33302
Phone: (855) 563-8273