Should I finance my short-term/vacation rental? Didn’t that cause the housing crash of 2008? Is it safe? A huge debate over financing investment properties is raging in the real estate investment community. This question is not a yes or no, but how much risk can you handle and sleep at night. For example, a highly leveraged property is more at risk of foreclosure. On the other hand, if you own your property, there is no risk of the bank taking it. Used properly, leverage can be a key tool in your real estate investing and wealth building. In this post, I will be discussing the topic of leverage; the good, the bad, and the ugly. To read more about buying a property, see our post “Finding the Perfect Property.”
What is Leverage?
Leverage is another name for the loan to value ratio. A highly leveraged property has a loan that is 80% or more of the property’s value. A small leveraged property is just the opposite. For instance, if the property has a market value of $250,000, a high-leveraged property would have a loan of 200,000 or more.
Also, the term highly leverage has to do with the market conditions. In hot markets, the 80% loan to value may be considered highly leveraged, while, in fearful/cold markets, 80% may not be considered high at all. In hot markets, the houses tend to be overvalued; so, a $250,000 house may only be worth only $210,000 in most markets. In the example above, the loan to value of $250,000 with a $200,000 loan is 80%. Now let’s say the housing market cools and the same property is only worth $210,000; the new loan to value is 95%. Yikes! This is not unrealistic; my property in Florida increased in value by 30% in one year. Most likely, it will not retain that value after this current market cools.
The good side of leverage
On the one hand, leverage is good. On the other hand, the property value appreciates on the total value, not just how much you have put into the property. Let’s continue with our $250,000 example and assume it appreciates 5% per year. At the end of the first year, the property would be worth $262,500. So the property increased by $12,500. In the first case, assume we paid $250,000 in cash for the property, i.e., no loan. So, we would have made $12,500 on our $250,000 investment or a return of 5%. In the second case, assume we only put $50,000 down (20%) and financed the rest of the property. In this case, we would have made $12,500 on our $50,000 investment or a return of 25%. So it is obvious to see that instead of putting $250,000 down on one property, it would be much better to put $50,000 on 5 properties. In this example, we would make $62,500 on our money.
As you can see above, you are using (leveraging) the bank’s money to make a larger profit. So the more you leverage, the higher your returns are. This highlights how helpful leverage is to your wealth-building. Let’s take this example to ridiculous extremes. If we only put down $5,000 on 50 properties($250,000 total), we would have made $625,000 on our original $250,000. This would be a 250% profit per year. Furthermore, you can see how crazy this can get using $1000, $100, or even $1. At $1 down per property, the profit would be $3.1 billion per year. Now, I can handle that kind of return.
The bad of leverage
In the extreme example above, we would be billionaires in one year. Why doesn’t everyone do this? As banks become more relaxed on loan to value(LTV) ratios, money becomes easier to get. Before the housing market crash, it was common to see LTV of 95% or more, i.e., you only need to put 5% down. Towards the extreme end, some banks were giving out loans at 125% LTV. That means that you could take out a loan of $125,000 loan on a property worth $100,000. This allowed you to pocket the extra 25%; you were paid to take out the loan. This is what lead to the saving and loan crisis and the housing market crash.
In the above examples, everything goes fine as long as the property values keep rising fast. Of course, the property values rise, so the LTV gets smaller each year. When we get to extremes like the $1 down, and property values go down (even a little), people owe more on their properties than they are worth. At this point, many of the people walk away/foreclose on the property, causing market prices to go down even further. When you owe more than a property is worth, it is called upside down in the loan. In 2008 due to a complex variety of factors, banks called most of the upside-down loans due immediately to try to get a handle on the financial market, causing even more foreclosures.
The ugly of leverage
Let’s walk through one more example. For example, let’s imagine that you bought a $100 property and put 50% down. So, you still owe $50 to the bank. For discussion purposes, let’s say the market goes does 25%. Also, nobody is renting, so you are having trouble paying the mortgage. The property is now only worth $75. So now, how much equity(the amount you own) do you have in the property? The math goes as follows: $75 (Value) – $50(Loan) = $25 (Equity). With $25 equity, you can still sell the property, pay the closing costs, keep from foreclosing, and retain some of your money. Not great, but you survived. Let’s run the example one more way. For example, let’s imagine that you bought two – $100 properties and only put 25% down on each. So, you owe $75 to the bank for each property. Just like previously, the market goes down 25%, and nobody is renting. So, the property is now only worth $75. So now, how much equity(the amount you own) do you have in each property? The math goes as follows: $75 (Value) – $75(Loan) = $0 (Equity). With no equity, you will not be able to sell the house because you can’t pay the closing costs. So, the bank will foreclose on both properties.
The power and dangers of leverage
On the good side, leverage is an incredible investing and wealth-building tool. Basically, the property appreciates on both your money and the bank’s money, i.e., total value. Best of all, you get to keep all of this appreciation. This allows you to leverage your money. Also, leverage allows you to get started with less money/capital.
On the dangerous side, leverage is what causes people to foreclose on their properties. If you owe $0 on your property, you will not “ever” forclose on it. It is yours. Likewise, the less you owe on the property, the less likely you are to foreclose because you can always sell it to retain some of your initial investment. As a side note, even if you do not owe anything on the house, there are other costs like taxes and HOA dues that can cause you issues if you do not pay them.
Another point of view
Several celebrity financial advisors recommend only buying real estate investments with 100% cash, i.e., no financing/leveraging at all. This is a very valid way of proceeding. It is the most conservative approach. With this approach, as mentioned above, you are guaranteed to never foreclose on a rental property. On the other hand, since you own 100% of the property, only your money grows, and all the benefits of leverage are negated. Their point of view is that you get to keep all of your profits and sleep at night.
The balancing act
What is the right amount of leverage to have in your real estate portfolio? On new properties, I like to have at least 30% equity or down payment. This allows for some breathing room on new properties. Also, 30% is the magic number for private investors to loan you money. For older properties, I like to retain 40% to 50% in equity. This gives a solid portfolio. Cash on hand is another factor to consider when talking about leverage. If people stop renting your place, like in a global pandemic, how many months of bills/mortgage could you cover with cash on hand? The longer you can float the place, the less equity you need. Think about it. If you can cover a year’s worth of bills, it is improbable that you will forclose before you have time to sell the property. So, cash on hand and leverage work together. As an investor, you will need to figure out your own risk tolerance. It is always better to start overly conservative and, as you gain experience, use more leverage.
Remember, if this sounds overly complicated, Relaxing Condos offers consulting services to get you started with any of your vacation rental business needs. If you found this useful, please share it on social media using the buttons below. Also, don’t forget to sign up for our monthly Newsletter, Special Hot Tips, and our cost estimating guide delivered to your inbox!