Using debt to leverage one’s position is a common strategy for investors. However, the amount that an investor leverages can vary depending on their short – and long – term goals. Below we will outline why it is beneficial to get a loan, and why I believe low leverage is the most strategic approach for many investors.
Benefits of Getting a Loan
Its undeniable that there are many benefits to leverage. Here are a few:
- Debt improves your purchasing power. For example, if you have $900,000 cash and you acquire a property using a 30% LTV, you can purchase a property that costs almost $1,300,000.
- Debt is covered by your income: The tenant’s monthly rent payment will pay down the principle – Investor’s will not be out-of-pocket, but instead rather just reduce their cash flow.
- Once it’s paid off, has a very low amount of principle left, and/or has increased enough in value. You can refinance to gain capital for another acquisition.
- Lastly, leveraging your equity you can boost your return and improve your earnings.
Why You Should Consider Low Leverage: 10-35%
Now, let’s look at how much you should leverage in your investments. Many investors maximize their leverage on a property so that they can increase cash flow and their buying power. However, by considering low leverage and focusing on safety instead of immediate returns, you can improve your position as a property owner. This strategy takes patience, but can provide stability and steady growth in your investment over the long run. Here are reasons why investors should consider low leverage:
- With a larger down payment (lower LTV), lenders tend to provide investors with better terms on their loans. This may include lower interest rates, lower prepayment penalties and an amortization period’s that will work for your plans. Lenders may also give you non-recourse loans which means that you wont have to personally guaranty the loan.
- Your debt service is more manageable. In other words, lower leverage equates to lower debt service. This is important because even in great locations, you may experience vacancies; and, once those vacancies are leased, investors will often have rent abatements for a few months. So, having low debt service reduces your risk in these times.
- You will be in a stronger position to pay the balloon payment at the end of the term. This is a very important factor for investors to consider; a poor position can result in the loss of property, which is what happened to many investors during the 2008 financial crises. For this reason, let’s explore this further.
- When you take out a loan on a commercial property, there will be a loan length also called the loan term. For this example, let’s say 10 years. This is the length of time that you will be paying on the loan. However, most loans are amortized over a longer period of time; for this example, let’s say 25 years. This means that at then end of the ten years, you will have a balloon payment, which is equal to the outstanding principle of the loan in that moment. At this time, investors can either pay off the balloon payment or they can refinance the property. If rates are high, lending terms are unfavorable, or lenders’s aren’t making loans because of a downcycle then making the balloon payment may be the only option. However, if you have leveraged yourself too much on the property and you are unable to make the balloon payment, then you risk losing your investment. Low leverage keeps the balloon payment to a manageable amount.
- Lower leverage gives the landlord negotiation power and flexibility. This is beneficial for when a commercial tenant does not want to extend their lease or wants to change the terms and rent according to their needs. Its common for big corporations to try this tactic on landlords. Unfortunately, many landlords will be forced to succumb to the demands of their tenant because they need the income to cover the loan. However, if you are lower leveraged position then your costs to having a temporarily vacant building wont be as big a deal and you can make a lease decision based on good business rather than cash needs of a property. At times, you will be able to re-tenant the space at a higher rent, providing you an opportunity to increase the value of your asse and having vacancy is actually the better decision.
- Even strong commercial leases have a Force Majeur clause and other early termination rights. These clauses give tenants a right to terminate their lease for some external force that is beyond the control of either paty, landlord or tenant. It can be terrorism, riots, etc. It would free up both parties. The issue with this regarding debt is that it can create an obstacle with a lender and can sometimes trigger an acceleration of the loan meaning the loan becomes fully due. If you have low leverage, it is an much smaller debt situation to deal with.
- It cannot be stressed enough. You will be much more likely to survive the economic down cycles. For all the reasons above become exponentially magnified during a downcycle.
In the end, low leverage gives you security. If you have a manageable loan position and are not dependent each loan payment on your tenants survival, then you will be in a strong position to build and grow your wealth for the long term. Keep this in mind because you will see that this is a commonly used strategy throughout long term successful real estate investors.
Read about another important factor that will protect your asset – The Reserve Account. Also, another key variable a lot of successful investors use is Diversification. Read our article The Magic of Diversification and Why You Need It.