Over-Leverage: How to Avoid Real Estate Investors’ Worst Nightmare

I was prepared for an unexpected downturn. Were you?


Every few years, something happens in the real estate market that throws it out of whack and devastates a lot of unprepared real estate investors. This usually happens during downturns when unemployment rises to high levels, like from the periodic recessions that are simply inevitable or a rare depression or an even more rare pandemic.


Unemployment hits hardest at the lower and medium income segments of the population, since they rarely have sufficient money cushion (or none at all) to absorb loss of income.


If you own rentals, many of these lower and medium income households are your tenants and when sheepdip happens, they may have enough cushion to pay for food, but maybe not the rent. If your tenants can’t pay full rent, you still have to pay your mortgage loan, property taxes and other expenses.


We all know that you need to leverage OPM (other people’s money) to create wealth and passive income through rental real estate. This works absolutely great in good times. Many of you newer investors who started investing after the last real estate crash in 2008, experienced up to a decade of good times for rentals with positive cash flow and appreciation.


Then a 100-year pandemic hit and the government instituted a moratorium on evictions that looks like it will last about a year. At the same time, you still need to pay your mortgage, property taxes and other expenses.


Many of you are experiencing negative cash flow and it hurts.


The pandemic was certainly unexpected. But periodic recessions are not unexpected.


Since recessions and high unemployment are expected, you must be prepared to cope with these situations since they are inevitable. The timing of recessions is not predictable but their occurrence is guaranteed to be predictable. They happen on average every 11 years and most landlords keep their rentals longer than that.


In my lecture “Leverage of OPM: The Good, The Bad and The Ugly in Real Estate Investing”, I talk about how much leverage is good leverage and how much leverage is bad leverage. I talk about the fact that good leverage generates wealth and income. Good leverage has a third crucial characteristic and that is that it weathers downturns.


I also talk about the main characteristic of bad leverage.


Bad leverage looks like GREAT leverage until a downturn and then it can be devastating. I know quite a few investors who were overleveraged in 2008 who LOST EVERYTHING by 2011.


I will share here one of the practical guidelines I teach in my lecture “Leverage of OPM: The Good, The Bad and The Ugly in Real Estate Investing.”


The following mental exercise takes 5 minutes and may save you from Chapter 7!


As you read this mental exercise, be aware that I started teaching this publicly in 2015 when times were great, unemployment was low, mortgage rates were low and distressed properties could be easily bought at a discount. In other words, it was a great time to be a landlord and no one wanted to waste 5 minutes thinking about anything negative. I am sad to say that not enough investors listened to this lecture and did not perform this 5-minute mental exercise.


Here goes.


When you first by a rental property, you do your calculations to figure out your positive cash flow and cash-on-cash return. You know the rent, you know your mortgage payments, you know your property taxes, you know your insurance costs and if you paid close attention to my other lectures, you even know your average costs for vacancy, repairs and administrative costs.


In other words, you know your positive cash flow before you buy the rental property. That is the way it should work and I trust that you all did these calculations that are at the heart of the rental business.


When you look at these costs, the biggest cost factor for most landlords is the mortgage payment. The mortgage loan is what enabled you to buy this cash flowing rental in the first place.


But there is one number that is larger than the mortgage payment and that is the rent.


The rent is what makes this whole business work. The rent must cover the mortgage payment and all the other costs in order to have a viable business.


The mental exercise that I ALWAYS do when I buy a rental property and I teach in my lectures takes only 5 minutes and it is to assume that the very next day immediately after I put in the first tenant after buying and preparing the rental property, the economy goes into recession.


I then put into my spreadsheet a reduction in rent. I don’t know anyone else who does this, but I do it. It is easy to do.


I look at varying levels of rent reduction in the spreadsheet and I see how much rent reduction I can tolerate without going into negative cash flow.


It is free and easy to plug numbers into a spreadsheet. There is no excuse for not doing this mental exercise! It is not pleasant, but it is free and it is easy.


If you find that you can tolerate a TEMPORARY 5% rent reduction, a 10% rent reduction, a 20% rent reduction (!!!) and still not go negative on cash flow, you now have an idea of how well or poorly you can survive a downturn.


One of my extremely reliable tenants had perfect rent payments of $1,900 per month. The COVID pandemic hit in March 2020. The primary bread winner lost his job in April. By June, they were struggling but able to make some payments. By September, the hardship was such that there was no way they could pay $1,900 per month, especially since a federal stimulus deal was not renewed.


What could I do as landlord?


After all, one cannot expect a 100-year pandemic to happen, right?


While I didn’t expect a 100-year pandemic to hit my rental business, I DID my recession analysis mental exercise when I bought the single family home in 2016 and I knew how much rent reduction I could tolerate temporarily if a downturn hit. The pandemic was unexpected. A downturn was not unexpected.


A DOWNTURN SHOULD NEVER BE UNEXPECTED!


In this case, I reduced the rent from $1,900 to $1,500 per month for 6 months. The tenant can handle that until he gets a job and his skill set and determination are such that I expect they will recover. All of this is happening during an eviction moratorium and I am getting paid $1,500 per month, not $0 per month.


Of course, I am not enjoying high cash flow during this hardship period, but I am also above not in negative cash flow territory.


I knew I could tolerate this level of reduced rent without going under because I invested 5 minutes to do the simple and free mental exercise back in 2016 when the market was going gangbusters.


How could you protect yourself from an over-leverage disaster in advance?


The answer is that you should do this simple 5- minute mental exercise to see your sensitivity of positive cash flow to rent level AT REDUCED RENT LEVEL. If you are so over-leveraged due to high mortgage payments due to high purchase price, high interest rates, low down payment, etc., then you should not buy that particular rental property and buy a different one that meets your criteria for prudent risk tolerance.


The saying ‘no deal is better than a bad deal’ is especially important when anticipating a downturn. If you are not willing to invest 5 minutes during your due diligence to anticipate a downturn, you are doing yourself a huge disservice that may carry the risk of financial devastation that I have witnessed friends suffer.


Do you want to know what else I did to make sure that I can weather downturns?


Watch my lecture “Leverage of OPM: The Good, The Bad and The Ugly in Real Estate Investing.”


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About Part Time Investors LLC

Marc Halpern started Part Time Investors LLC after being tired of the hype promoted by most real estate gurus. Marc presents valuable technical content with zero-hype in all of his presentations and blog posts, including the advantages AND disadvantages of every investment strategy discussed. Marc Halpern has a Ph.D. in organic chemistry and makes decisions based on in-depth due diligence. Marc achieved financial freedom through part time investing, excellent strategic planning, data analysis and a fiscally conservative approach.

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