The Short Answer
Leverage in real estate can be a powerful tool for investors to maximize returns, however it can also lead to over leveraged real estate. In this case, a real estate investor is in more debt than they can financially handle, or the amount of debt on the property is higher than its current market value.
To avoid becoming over leveraged, investors should make sure to do due diligence on the property and the real estate market, establish all the property’s expenses upfront, maintain a debt-to-equity ratio of 70% or less, stick to only a few investment properties at once, and choose the right loan.
One only needs to look back at the financial crisis of 2008 to understand the risks of too many property owners being over leveraged. During the 2008 crisis, the housing market collapsed due to irresponsible lending practice. There were too many homeowners that didn’t actually have the financial means to service their loan agreements. The net effect was the collapse of the 2008 housing bubble, which had a major impact on both the US and global economy.
Thankfully lending requirements have become much stricter since then, but there are still plenty of US homeowners that find themselves over leveraged. To back up this claim, you need only consider the fact that there were 185,000 foreclosure filings in the first of 2023.
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What Is Real Estate Leverage?
Real estate leverage is a powerful tool that can be used by real estate investors to increase the potential returns on their investments. When an investor uses leverage to finance a property, they are able to acquire more real estate assets than they could with their own capital alone.
By using borrowed funds or OPM (Other People’s Money), an investor can put less money down and spread their investment capital across multiple properties. This, combined with some of their own equity in the form of a down payment, can diversify their real estate portfolio and reduce their overall risk. The key advantage of real estate leverage is that it allows investors to magnify their returns.
Let’s say, for example, that an investor has $100,000 to invest in real estate. They could use that money to purchase a single rental property, or they could use leverage to acquire multiple properties with the same amount of capital.
If the investor were to buy a rental property with a purchase price of $100,000, with their own funds, and the rental property increased in value by 5%, they would earn a $5,000 return on their investment. However, if the investor were to use leverage to purchase five rental properties with a purchase price of $100,000, each with a 20% down payment, and those rental properties also increased in value by 5%, the investor would earn a return of $25,000 ($5,000 x 5).
Almost All Real Estate Loans Involve Leverage
It is important to point out that even a stock standard mortgage is a form of real estate leverage.
For instance, if you purchase a $250,000 home, with a 10% deposit, you’ve only invested $25,000. If the property goes up in value by 12% over the course of a year, your $25,000 deposit has effectively secured equity growth of $30,000.
- Initial Property Value: $250,000
- Down Payment: $25,000
- Property Value After Appreciating By 12%: $280,000
- Equity Growth: $30,000
The reason that almost all real estate loans have leverage built-in is because of the stability of real estate as an asset class.
Over the long term, real estate assets tend to hold its value or appreciate in value. As a result, banks and other lending institutions are willing to take on the risk of funding property purchases.
If the borrower ends up defaulting on their loan, it is relatively easy for the lender to foreclose on the house and simply sell it to recoup any potential losses.
What Does It Mean To Be Over Leveraged In Real Estate?
If an investor has borrowed more money than they are able to repay, or the amount of debt on the property is higher than its current market value, this means they are over leveraged. While this may sound like something that doesn’t happen too often, it can happen easier than many investors may realize.
Investors who take on debt for a real estate investment, without considering the risks involved, can quickly find themselves in financial trouble. For example, market changes can cause interest rates to go up and increase the monthly mortgage payments on a rental property, which investors may not be prepared for, and the rental income may not cover. Investors who cannot afford their monthly mortgage payments, in this case, are over leveraged.
Being over leveraged in real estate essentially means that an investor has borrowed more than they can pay back. This can lead to major financial issues and eventually foreclosure and bankruptcy, if investors cannot find a way to cover their monthly repayments, or if the value of the property declines too much.
What Causes Over Leveraged Real Estate Investments?
Real estate investors should pay close attention to the points listed below which can lead to over leveraged real estate investments. Over leveraging is a risk that investors should be aware of, and do what they can to avoid, and this starts with being aware of what causes over leveraged real estate investments. Another important part of mitigating the risk of being over leveraged is to contribute a substantial down payment.
Interest Rate Increases
Even a minor increase in the interest rate of a mortgage can have a major impact on a buyer’s ability to service their repayments. What’s more, interest rate increases tend to come in waves, where the basis points of a loan are increased several times over the course of a year.
It is perfectly understandable that some homeowners may find themselves over leveraged when interest rates rise. It has a direct impact on the cost of owning a property, and a negative impact on the cash flow status of the owner.
Loss Of Income
Simply put, a job change, pay cut, job loss or business failure can serve as the trigger for a homeowner to become over leveraged.
In this scenario, the income generating abilities of the homeowner are compromised. This can make the mortgage repayments financially impossible, either resulting in a voluntarily sale of the house, or a forced foreclosure.
Neither of these scenarios are desirable, but they ultimately serve as an escape route for debt-laden homeowners.
Big Drops In Market Value
It is not uncommon for certain cities in the US to drop in value by more than 10% over the course of a year.
For instance, Kirkland, Bellevue, Redmond, and Sammamish all dropped by between 11 – 12% over the course of 2023.
If drops like this continue for several years, the value of the mortgage may exceed the value of the house. This is called an ‘Underwater Mortgage‘ where the principal amount of the loan is greater than the market value of the property.
If a homeowner finds themselves in a scenario like this, it may be in their best interests to sell the home, unless they are willing to take a long term position on the home in hopes that it will recover the lost value.
Underestimating Property Expenses
There are significant expenses that come with property ownership, which are required to keep the property operational each month. If investors don’t account for these correctly in their budget, they may find themselves in a situation where they cannot generate enough rental income to cover all the expenses, as well as the mortgage payment. This means that they are over leveraged.
Unfavorable Loan Terms
Investors should carefully consider their loan terms before choosing a loan, because these can have a huge impact over time. For example, high interest rates or balloon payments can leave investors in a position where they cannot meet their mortgage payment obligations. Leaving them over leveraged, and potentially facing foreclosure.
High interest rates and balloon payments should be considered at the outset and should only be used if an investor is certain that they will be able to generate enough income to cover the mortgage payments and the balloon payment.
Incorrect Assumptions About Future Performance
Real estate investors who incorrectly assume the future performance of their property could end up being over leveraged. Incorrect predictions about the rental income increases that they will receive on a rental property or the property’s value appreciation, can result in investors taking on more debt than they can pay off. It’s vital to be realistic and err on the lower side of any future predictions about a property’s performance.
Portfolio Too Large
Investors who purchase too many rental properties can end up being over leveraged if they haven’t taken into account the operating costs, financing and other expenses correctly. It can be difficult to budget accurately when there are multiple properties within a portfolio. Investors who are taking on more than one rental property should do so cautiously, and carefully calculate all their costs to avoid becoming over leveraged.
How To Avoid Over Leveraged Property Deals
To avoid getting in over your head financially and ending up with an over leveraged real estate investment, we’ve got a few useful tips.
1. Do thorough due diligence.
Due diligence should be done on both the property and the real estate market, before investing. For example, this includes analyzing a rental property’s potential rental income, expenses, and vacancy rates, as well as researching the local real estate market to ensure that property values are stable or increasing.
2. Figure out all expenses.
Putting together an accurate account of all the expenses associated with a property, before committing to the purchase, is a key aspect to avoiding becoming over leveraged. These include, but are not limited to, maintenance, repairs, property management fees, and loan payments.
Getting an accurate idea of the property’s expenses in entirety will allow you to budget accordingly and make sure that your income covers the expenses, and you can maintain a positive cash flow.
3. Debt-to-equity ratio of 70% or less.
To avoid over-extending yourself financially, maintaining a debt-to-equity ratio of 70% or less is key. An investor’s equity in the property needs to be such that they can deal with any fluctuations in the market, unexpected costs, and other unforeseen circumstances.
4. Don’t invest in too many properties at once.
One of the pitfalls of investing in too many properties at the same time is that it gets tough to manage them all and it’s easy to become over leveraged if you aren’t paying close attention. For new real estate investors particularly, it’s important to focus on a smaller number of properties that offer good quality deals, which can be given enough attention and won’t lead to an investor over committing financially.
5. Choose the right loan.
Loan terms are one of the most significant aspects of real estate investment, so picking the right loan is crucial to this. Loans that have favorable terms are less likely to result in an investor becoming over leveraged.
For example, low interest rates and reasonable payment schedules are two favorable loan terms that can help real estate investors keep up with their payments over the long term. On the other hand, loans with balloon payments can lead to investors being over leveraged if their real estate deal doesn’t go according to plan.
Should You Sell Over Leveraged Investment Property?
The decision to sell an over leveraged investment property depends on a variety of factors, including cash flow, market conditions, equity, future prospects, and tax implications. It’s important for real estate investors to carefully weigh the pros and cons of selling, before making a decision. Let’s take a closer look at the factors that play into this decision.
- Cash flow: Maintaining a positive cash flow is key to achieving success in real estate investing. A positive cash flow means that the income received always needs to cover both the operating and ownership expenses and more. Therefore, if a property is not generating enough income to cover all expenses and pay off the debt, it does not have a positive cash flow, and the property should be sold.
- Real estate market: The market conditions at the time will play a large part in the decision of whether to sell an over leveraged investment property or not. If the real estate market is strong and property values are rising, this may be a good time to sell. However, the converse is true if the market is weak and property prices are declining.
- Amount of equity: The amount of equity that an investor has gained in a property is a deciding factor on whether to sell or not. A property in which an investor has a significant amount of equity could be better off sold, as this will help them recover what they put into the property. However, a property with very little equity may result in a loss, if it is sold.
- Property potential: If the property has strong potential to generate income and appreciate in value in the future, it may be worth keeping. Whereas, if the property doesn’t have good future prospects for wealth building, it may be best to sell it.
- Tax consequences: There are tax implications to selling an investment property, and these should be carefully considered before selling. Capital gains tax is one of the tax consequences that can be applied to a property sale, another is depreciation recapture taxes. Understand the tax implications before making a decision on whether to sell an over leveraged investment property or not.
Additional Tips For Investing In Real Estate Responsibly
Investing in real estate responsibly requires careful planning, research, and decision-making. Here are some tips to help investors invest in real estate responsibly:
- Set realistic goals: Before investing in real estate, set realistic goals based on your financial situation and risk tolerance. Determine the type of property you want to invest in, and the potential returns you can realistically expect.
- Conduct thorough due diligence: Research the local real estate market to determine the potential demand for rental properties in the area and analyze the rental property’s potential rental income and expenses. Hire a professional inspector to assess the condition of the rental property and identify any potential issues.
- Invest in quality properties: Avoid taking unnecessary risks by investing in high-quality properties with strong rental potential. Consider the location, property condition, and potential for future appreciation when choosing a property.
- Maintain a reasonable debt-to-equity ratio: As mentioned earlier, it’s important to maintain a reasonable debt-to-equity ratio to avoid becoming over-leveraged. This can help minimize the risk of defaulting on loans and losing the property, as well as help maintain a positive cash flow.
- Budget for unexpected expenses: Real estate investments can be unpredictable, so it’s important to budget for unexpected expenses such as repairs, maintenance, and property management fees. Build a contingency fund to cover unexpected expenses and avoid being caught off guard.
- Stay informed about legal and regulatory requirements: Real estate investing is subject to a range of legal and regulatory requirements, so it’s important to stay informed and comply with all relevant laws and regulations. Consult with an attorney or other professionals to ensure that you are in compliance with all applicable laws and regulations.
- Diversify your portfolio: Diversify your real estate investments across different types of properties, locations, and markets to minimize risks and maximize returns.
By following these tips, investors can invest in real estate responsibly and minimize the risks associated with real estate investing. Remember that real estate investing is a long-term game, and success often comes from making smart, conservative investment decisions over time while always bearing cash flow in mind.