When am I Over Leveraged in Real Estate?

Most real estate investments require substantial amounts of capital hence why these transactions need financing through debt capital. Leverage is the utilization of borrowed money to fund real estate investments.

Leverage in real estate financing is beneficial when property and rent values are rising. Leveraging allows you to “make money by utilizing other people’s money.” Investors choose leverage when they do not have money to purchase the property they want and when they need to maximize returns using less cash into each property investment.

Benefits of leverage

  1. Higher return on investment – Using leverage to invest in rental property will give you more return on the invested funds than buying it using cash.
  2. You obtain more for less – leveraging real estate will enable you to acquire more investments than you would by paying all in cash. You can buy multiple properties in a year instead of waiting for years to get one.
  3. Profit from inflation – investing in rental property is a great way to hedge yourself against inflation. As inflation increases the value of the dollar reduces. You continue repaying the borrowed funds in diminished (nominal) dollars instead of inflation-adjusted real dollars.

The difference between the value of real dollars borrowed and the reduced nominal dollars you are paying back is how you benefit from inflation.

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Types of Bank loans used to leverage real state

#1: Conventional Loans

This is the most common real estate leveraging method. This loan has standard requirements set by Freddie Mac or Fannie Mae. One of the requirements is giving a down payment to lenders 20% of the income property’s purchase price. Lenders also look at investor’s credit scores.

Investors must prove that they can afford the existing mortgage and set a minimum of six

months’ cash reserves for loan repayment. This type of loan can either be conforming or non-conforming. Conforming have a figure below a specified maximum and nonconforming loans are for higher amounts

#2: Home Equity Loan

This loan allows the use of an investor’s home equity to take a loan for obtaining another property. The loan is valued based on the difference between the investor’s home equity and the property’s current market value. Lenders do a credit check and appraisal on an investor’s home to obtain creditworthiness.

If the investor cannot repay the loan, the bank repossesses their property and sells it to cover the remaining debt.

#3: Commercial Investment Property Loans

An investor should have a good credit score and a business plan to get this loan. This loan requires a down payment of anywhere between 15%-30% of the purchase price lasting from 1-3 years with an 8%-13% interest rate.

Borrowing can increase your return on investment but only under certain conditions. Taking a loan to fund real estate projects may sometimes lead to being in debt and hence the need to understand the circumstances under which an investor may be over-leveraged or under leveraged.

What is Over leverage?

Over leverage in real estate happens when an investor utilizes borrowed money to buy a property, and the borrowed funds have a higher cost or interest rate than the return made on the investment.

Utilizing the borrowed funds can cause a situation where the funds borrowed reduces the total return on the investor’s equity capital, compared to the internal rate of return that the property would attain without utilizing borrowed funds.

Over leverage is caused by the high cost of financing the loan compared to the return and cash flow generated by the property. An example of over-leverage is when an investor gets a loan at a 5.5% interest rate to build an apartment and generates a 4% return on this investment. They get a negative 1.5% return on equity.

Calculating over-leverage

When the cost of financing is more than the return on investment then the investor will be over-leveraged.

Cost of financing = Annual Debt Service/ Principal amount

Return on investment (ROI) = Net operating income (NOI)/ initial investment (purchase price)

For example, Brian buys a property valued at $1.5 million with a 5.5% rate of return without any borrowed money. Brian then considers a 20-year mortgage loan with a cost of financing of 5% and a loan to value ratio of 70%.

Loan taken = 70%* $1.5 million = $ 1.05 million

The annual payment for this loan is $84,254.72, meaning the cost of financing the mortgage is 8.02%. Loan repayments include interest and principal payments.

In this case, Brian is over-leveraged since the cost of financing the loan (8.02%) is more than the expected return of 5.5%

Causes of over-leverage

#1: Ending up with lofty payments

Higher leverage comes with a higher payment. You should only take a loan that you can afford to repay.

If the market softens after taking a loan or you experience more-than-expected vacancies in your properties, you could find yourself unable to service the higher mortgage payments that seemed fine at the beginning.

#2: Counting on high levels of appreciation

Real estate is usually predicted to increase over long periods anywhere from 10 to 25 years. There is however no guarantee that it will increase in one, two, or three years.

Even if there has been an increase in real estate for the past five consecutive years there is no guarantee that the next years will experience the same growth. Expecting high levels of appreciation will make you overpay for properties. If the properties lose value, you can easily be overleveraged.

#3: Making bad investments

Do not allow the allure of leverage to force you into wrong investment choices. If throwing in more cash will lead to lower interest rates, then that would be the better option. Higher loans do not always translate to more profit.

#4: Forgetting that cash flow is very important

You need to ensure you have excellent cash flow. Your rental income minus expenses and mortgage costs should give you a good return. This will ensure you have cash flow in case your property does not gain value in any given year

What is Under leverage?

Under leveraged happens when an investor borrows funds to buy a property and then returns on the property give a higher interest rate than the rate at which the money was borrowed. This means the investor has too little debt.

For example, Ann buys a rental property for $300,000. The annual income from the property is $37,000. Annual expenses are $12,000, the Net operating income will be $25,000 obtained by ($37,000-$12,000).

Its return on investment (ROI) will be: $25,000/$300,000 = 8.3%.

Ann has a 30-year amortization period with a note of 210,000. The interest rate is 4.5%. Payment will be $1,064 per month ($1064*12=$12,768 per year)

Cost of financing = Annual debt service (12,6780)/ (Principal amount) $210,000 = 6.08%

The Cost of financing (6.08%) is less than the Return on Investment (8.3%) hence positive leverage. This means the profit from the project is more than the cost of the loan.

Evaluating if the use of debt will result in over-leverage or under leverage?

Miles and Wurtzebach (1994) state that the evaluation of whether borrowing will lead to over-leverage or under-leveraged can be done by comparing the cost of financing the loan with the unleveraged return of the investment. If the cost of financing the loan is higher than the anticipated unleveraged return, then borrowing funds will lead to over-leverage.

Assessment of whether leveraging in real estate will lead to over-leverage can also be done by comparing the unleveraged and leveraged internal rate of return (IRR) of the project. Leveraged IRR considers the use of borrowed funds, unleveraged return assumes no loan is used.

Evaluation using this method will consider loan amount, periodic loan payments, and repayment of the remaining loan from the resale of the property. If leveraged IRR is lower than the unleveraged IRR taking a loan will result in over-leverage,

Overall, it is good to understand how to use leverage appropriately. Informed real estate investment decisions will have high returns. Uninformed strategies could easily lead to over-leverage.

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