inv
All Posts
Welcome to Passive Real Estate Investing and another episode of Ask Marco, where I answer your investing related questions.
Today’s question comes from Jon and he says, Marco, I just discovered your podcast in the last couple of weeks. And I’m considering working with your firm.
Thank you.
I have my first meeting with your team this week. My question has to do with how much leverage is too much. I know leverage is largely a good thing in terms of amplifying capital to work harder for me, but I assume there is a point where an investor can be over-leveraged. How do you look at leverage in terms of how much is just enough and how much is too much?
Well, this is a great question.
Now, Jon goes on to ask another question here, which is not exactly related, but I’m going to read it out. He says, I’ve been listening to Bigger Pockets for several months and they tend to favor the BRRR strategy, which really minimizes the capital left in the average property. Thus theoretically, accelerating the velocity. But this strategy is high leverage.
Now that was a mouthful. And for those that don’t understand it, don’t worry. I’ll try to explain it. I’m not sure I fully understand that question, but he goes on to say, this is something I’m trying to get clarity on how much leverage is too much. So that’s the underlying question here is how much leverage is too much?
So he says, thanks for the podcast. I’ve learned a lot already – Jon
Download your FREE copy of: The Ultimate Guide to Passive Real Estate Investing.
If you missed our last episode, be sure to listen to Money “Secrets” Of The Wealthy
– – – – – – – – – – – – – –
Download your FREE copy of: The Ultimate Guide to Passive Real Estate Investing.
Get your FREE coffee mug by leaving us a Rating and Review on iTunes. Here’s how.
See our available Turnkey Cash-Flow Rental Properties.
Please give us a RATING & REVIEW (Thank you!)
SUBSCRIBE on iTunes | Stitcher | Podcast Feed
Jon, you’re welcome. So I’m going to cover a couple of points here, and I’m going to just start off with some general concepts, but then I’ll ultimately tell you how you can determine for yourself how much leverage is too much.
We all need to understand from the beginning, fundamentally, there are two kinds of debt, good debt, and bad debt. So debt by itself is neither good nor bad. It’s like saying a knife is good or bad or a gun or pistol is good or bad. It really depends on what you use it for and how you use it. And whose hands is that debt in. So generally speaking bad debt would be consumer debt. It would be something that you borrow and then apply towards something that has no residual value or does not go up in value. In other words, it depreciates things that tend to rust or just become obsolete. That would be bad debt borrowing on a credit card and going on a vacation is bad debt. But if you can take debt, whether you’re borrowing a hundred dollars or a hundred thousand dollars, and you can turn that into an asset, so that debt is still there and better yet you turn that debt into an asset that generates cash flow.
So now you’re receiving a return on that investment or return on the debt. Now it becomes a smart investment and real estate is the primary example of how to do that. And the best way to do that. This is where good debt becomes a very powerful tool because now you can use that debt bank lending, conventional loans, the mortgage to acquire real estate, a portfolio of real estate that now is an appreciating asset with tax benefits that generate cash flow. And it becomes a very powerful thing. So that’s the first thing you have to understand the difference between good debt and bad debt because if you can borrow money that makes you more money on that money, that becomes a great investment. And then the question becomes, well, if that works and you can do that and you can do it more than once, how often do you want to do it?
So that leads to my next point. And that is the very vague question of how do you become a millionaire? Well, the simple answer to how do you become a millionaire? As I’ve said in a previous episode, probably five years ago is go into debt for $1 million. Now more specifically, as we just talked about that would mean go into debt for a million dollars in terms of good debt. So if you build a real estate portfolio and let’s just say it’s worth $1.3 million, and 1 million of that $1.3 million of assets is debt. Guess what? Over time that $1 million of debt will be paid off, it’ll be paid down and paid off. And that debt, what was once debt is now equity. See how that works. So the key to making this work is to invest in assets that pay for themselves and pay the debt service. In other words, they amortize that loan the debt.
So your Net Operating Income, the NOI from your real estate, which is the income minus the expenses leaves the net operating income. That’s, what’s leftover for you to pay off your debt or service your debt. And then what’s leftover after that is cashflow positive cash flow, real spendable cash. So if you have an investment property that has enough net operating income to service the debt, then you have positive cash flow and you are now making money every month and every year. And your loans that debt is being paid off. That is a beautiful formula because that million dollars of debt in your portfolio will now become a million dollars of equity. Plus you’ll have the appreciation that comes over time with that same portfolio. And so now your equity is actually the debt that was paid off and is now actual equity, plus the appreciation of additional equity on top of that.
And that’s how you go from having $1 million worth of debt to potentially 2 or $3 million of total equity over time. So when you build this out, you want to pace yourself. And the key there is to stabilize your portfolio with each and every property. So if you’re buying one at a time, that’s fine, two at a time, five at a time, this is where you pace yourself. The important thing is that you actually stabilize each property and you’ll probably buy these, like, especially if you’re buying turnkey rental properties, whether from our company here at Norada real estate investments or another company, or are you doing this on your own? You want to make sure that each and every property is performing and stabilized. Then you have a predictable, consistent income coming in every month. Once those are running smoothly, you move on as quickly as you can to the next property and the next one and the next one.
And that’s how you build your portfolio, whether it’s single-family homes, duplexes, fourplexes, or if you choose to go larger than that outside of the world of residential real estate to commercial property, even if it’s an apartment that’s considered a commercial property. So be it, but pace yourself, stabilize each and every property. So the key to servicing that good debt is to have enough net operating income. That way your tenants are actually paying off your mortgage for you. And that $1 million of debt now becomes $1 million of equity. So that is a lot of the fundamental stuff that you need to know, but I’m going to take this one step further and go along the lines of answering the question of how much leverage or how much debt is too much.
And the next thing I want to just tell you about is something that you could call stress testing, regardless of whether you have 1 property, 5, 10, a 100, if you can stress test, which is similar in concept to what the federal government kind of pushed on to the banks back after the 2006, 2008 financial meltdown because of overleveraged housing and overleveraged people. And just that whole thing that happened back with the great recession. If you can stress test your existing portfolio, then you will know if you are over-leveraged. You know, so what does this mean? Essentially, what you’re going to do is take a look at your existing portfolio, even if it’s just one property and you’re going to create a range of scenarios. And what we’re talking about here are the different variables that are involved. So vacancy rate is a variable appreciation rate, or what you predict to be appreciation is a variable, the interest rate on your mortgage loans. Assuming you have a variable rate loan, not a fixed-rate loan would be a variable, what you are budgeting or expecting in terms of repairs and maintenance. Also, while we talked about vacancy allowance, but that would be another variable. So these variables are the scenarios that you’re going to play with and create.
So you’re going to create some best-case scenarios and some worst-case scenarios. You’re going to make some predictions about what that might be realistic predictions. You’re going to take some best-case scenarios and some worst-case scenarios. And you’re just going to play with the numbers on your properties or play with the numbers on your portfolio as a whole. And what you want to see is that if you are experiencing higher interest rates or higher vacancy rates or above normal maintenance and repairs, these types of things, you want to see where your portfolio sits. Are you still cashflow positive on your properties? Maybe not every property may be some properties go negative under that scenario, but overall, the aggregate portfolio is still cashflow positive and you can weather through a storm, whether it is a local down market, a economic recession, maybe we go into a depression, whatever it is if you could weather through a storm, whether it is a real estate down cycle, an economic recession or some other difficulty, then you are essentially going to stress, test your portfolio and see if you could weather through those storms.
The bottom line is that you want to make sure even under stressful conditions locally and economically, if your portfolio can weather through that and you’re cashflow positive and you can service the debt through the worst-case scenario, or maybe the second worst-case scenario, depending on where you sit in terms of risk tolerance, then you’ve essentially stress-tested your portfolio and you will know, or you will feel, but you will know if you are over-leveraged or not. If you have too much debt or not, this is something that, although sounds a little bit emotionally based, it is actually something that is a database because you are going to run the numbers. And based on the numbers at the end of the day, you’re going to have what you might look at as a risk-reward matrix. You’re going to see your best-case, worst-case scenarios, and everything in between.
And you are going to decide whether you have the risk appetite to weather through any kind of upset or longterm, like one or two years plus a negative scenario. And really nobody can make this decision for you at the end of the day, but you just need to figure out if your portfolio is positioned to weather through economic storms, difficulties, recessions, higher interest rates above normal abnormal, increased maintenance and repairs and vacancies and whatnot. I think you get the point. The point is you just want to stress test your portfolio and see if it can last. And if it can last, if it can weather through these difficulties, then you know, you’re in good shape. Because at the end of the day, you don’t want to be having to dip into your own pocket or your savings to kind of service the loan or cover expenses.
Now, granted, if you have to do that for one month or a short period of time or a one-off situation, just because there was something very unusual, very abnormal that’s okay, I’ve done that myself in the past, but I just knew that it was an anomaly. It was a onetime thing. So that’s the key is understanding good debt versus bad debt. Knowing that the net operating income pays off your debt. And the more debt you have, the more equity you’re going to have as that debt is paid down or paid off and paced yourself work within your comfort zone. But don’t stop moving forward. Don’t lose momentum and last but not least, make sure you stress test your portfolio as you go. You should do that every year. Just so you have a comfort level with it. That’s really about it. I don’t think I really want to get into the whole burst strategy on this particular episode, but just for those people who are scratching their heads saying what’s that BRRR really just stands for Buy Rehab Rent, Refinance, and Repeat.
This is not a passive approach. This is not a turnkey approach. You are essentially capped by your funds. You often will need hard money loans. If you don’t have the entire amount to buy renovated rent and then refinance a property to go through that whole cycle. But the reason some people talk about it a lot, and there’s nothing wrong with this strategy. It’s just a different strategy where you are more actively involved. And the goal at the end of it all is to renovate a property with limited funds and be able to increase the value enough where you can go back to a lender and refinance that property and pull out the initial capital that you used to buy it and renovate it done, right? If it goes according to plan or what you might call textbook, you should be able to pull out all your funds that you put in, but I’ve done it myself.
And I know it doesn’t always work that way. I think in the end, I probably ended up putting in five to 10% on the properties that I’ve done the BRRR method on. But anyway, like I said, it really isn’t for everybody. Most investors don’t go this route and they don’t use the burst strategy as part of their overall investment plan. Maybe it’s mixed in with their, you know, passive investments, their turnkey investments.
All right. Well, I hope that helps Jon. Maybe that was a little bit long-winded on the whole thing, but hopefully, that is going to help you out. All right. Well, I appreciate the question and I’m glad you’re a listener. Thanks for listening to the podcast. If you are new here, remember to subscribe, click that subscribe button so you’ll never miss an episode. Download our free report, The Ultimate Guide to Passive Real Estate Investing, and you will find that on our websites at noradarealestate.com or passiverealestateinvesting.com.
Thank you for listening. We will see you on our next episode.
– – – – – – – – – – – – – –
Download your FREE copy of: The Ultimate Guide to Passive Real Estate Investing.
Get your FREE coffee mug by leaving us a Rating and Review on iTunes. Here’s how.
See our available Turnkey Cash-Flow Rental Properties.
Please give us a RATING & REVIEW (Thank you!)