When are you too levered ?, Thoughts on Leverage, interest rates and risk Options

[ThomasBeyer]

Leverage is a two edged sword. It works well if the yield (or CAP rate) of a property is higher than the interest rate.

It works especially well if the markets goes up.

It does not work so well if interest rates are on the rise, and thus yield expectations rise and thus, property values potentially fall with lower or even flat income.

When are you too levered ?

Mortgages are usually set for a 5 year term in Canada. Expect 5 years rates to nudge up gradually over the next few years .. from a current high 3% range to 6% or so in 3-4 years ! 6% is what you pay TODAY for commercial non-CMHC money and that will likely go to 7.5 or 8% in 3-4 years .. with higher bond rates but lower spreads !! (spread being the premium the lender charges over their cost of money, which is the 5 year bond)

==> Hence: analyze any deal @ 6% with 25 year amortization .. and stress test with an 8% mortgage. You are too levered if it does not cash-flow at this level.

A highly levered deal at 4% interest rate is risky and works only if proven rental upside is there so that in 5 years you don't say "oops" or hand the property keys to the bank !!

If the property cash-flows at a 90% LTV with a 3.5% mortgage .. great .. but test it with 6% and 8% anyway .. especially if you take a very risky 30 or 35 year amortization as the risk in 5 years is quite high ! Then assess what you would do in 5 years if market is fairly flat and rates are at 6% and your mortgage is not substantially lower than at the start !

With a 25 year amortization you pay the mortgage down 10% in 5 years, so if you are levered at 80% going in you'll have a more comfortable 72% LTV in 5 years if values don't go up in 5 years .. or around 65% if values go up 10% in 5 years. This is our risk tolerance level, with the right blend of great ROI and sleeping well at night.

A related post on ROI based on leverage using certain yield assumptions is here:
http://www.myreinspace.com/forums/index.php?showtopic=1224

Those are my thoughts .. what are yours ?

This post has been edited by thomasbeyer2000: Jul 14 2009, 09:37 PM

[BDFI]

Thomas,

I agree with your stress test of 6%/25yrs (I had been using 5%/25yrs). I am currently looking at a property that does well when you use current numbers 4%/35yrs but would basically break even with your stress test numbers. Would you still proceed on a deal if it would do well for the next 5 years with a chance (would require no rental increases/interest rates of 6%) of only breaking even in five years time? Do you also take into consideration the leverage of your total portfolio when considering individual deals (ie deal leveraged to 85% but overall portfolio may be leveraged to 65%)?

Everyone's thoughts would be appreciated.

Thanks,
Bart

[ChrisDavies]

Thomas, I'm surprised you haven't commented on my suggestion that a good short term tactic is to drop your payments and bank the cash only so you can strengthen your reserve fund, as equity is becoming more difficult to leverage. http://www.chrisdavies.ca/2009/04/top-6-th...est-rates-drop/

[wgraham]

Great post Mr. Beyer!

I think a lot of people get caught up in the idea of leverage at todays market and forget to think about the refinance at the end of the term and what the market will look like then!

My quick stress test has been to see if the property will cash flow at 5% and 100% levered. This is simply at filter for me and doesn't mean that I lever 100% but what it does mien is that if my values drop, rates go up and I need to refi I can probably make it happen and not loose the property. In other words my worst case scenario.

I do agree with Chris and his "cash in the bank" strategy. With the old saying one in the hand is better than two in the bush we have lowered our payments to put cash into our bank account and build reserves.

All the best,
W

[ChrisDavies]

It struck me last night that it'd be a great strategy to bank the difference between your actual payments and the 25yr/6% level payments until you have 6 months rent in the bank for each property. Then you can divert that positive cash flow to other purposes.

[ThomasBeyer]

It struck me last night that it'd be a great strategy to bank the difference between your actual payments and the 25yr/6% level payments until you have 6 months rent in the bank for each property. Then you can divert that positive cash flow to other purposes.

indeed a good idea .. a prudent reserve !!

[ThomasBeyer]

Thomas, I'm surprised you haven't commented on my suggestion that a good short term tactic is to drop your payments and bank the cash only so you can strengthen your reserve fund, as equity is becoming more difficult to leverage. http://www.chrisdavies.ca/2009/04/top-6-th...est-rates-drop/

yes that is a good idea .. but then the cash is easy to spend for bling-bling .. so a 25 year mortgage has a forced amortization (aka savings account) that can't be spent

[greg12]

So Thomas, what do you think about vendor financing? If the 1st mortgage is 80% LTV, and there is an opportunity for the vendor to carry the 20% via an RSP 2nd or some type of creative VTB. Would you do the deal? In essence this would be 100% financing just like using a secured PLC for a downpayment. Is that too levered?

[ThomasBeyer]

So Thomas, what do you think about vendor financing? If the 1st mortgage is 80% LTV, and there is an opportunity for the vendor to carry the 20% via an RSP 2nd or some type of creative VTB. Would you do the deal? In essence this would be 100% financing just like using a secured PLC for a downpayment. Is that too levered?

usually YES .. as most bansk won;t let you get an 80% mortgage in that case .. as at some point you have to pay back the VTB and 1st mortgage .. and then you may be hooped ..

UNLESS there is significant value-add opportunity and a proven way to pay the VTB in a year or 2 through a re-finance .. and for that, significant cash is usually required !!

[investmart]

Great discussion.

It sounds like in general we should prefer putting more down (i.e. 25% down payment is better/less risky than 10%) in order to reduce refinancing risk significantly. this means buying properties at a slower pace.

Interestingly, this contradicts Don's initial recommendation to put as minimum down as possible in his book. well, of course situation was different when writing the book plus as mentioned above depending on the property's performance it might still make sense to put less down for obvious reasons. just more difficult to meet the required "risk reducing criterias".

Cheers,
Neil

This post has been edited by investmart: Apr 25 2009, 08:18 PM

[ebolaman]

A very timely and prudent string. I have just sold my primary residence and have around 110g's in the bank. I am building a new home and it will cost around 400g. Would it be prudent to put down 20-25%, obtain a SLOC on this equity and then look to do my first deal, or should I put down less and take the CMHC hit in order to keep cash on hand for a deal? I would prefer the first option and don't know how receptive lenders are to this sort of thing. Our combined income is around 150g per year. Any thoughts?

[RogerPanchuk]

especially if you take a very risky 30 or 35 year amortization as the risk in 5 years is quite high ! Then assess what you would do in 5 years if market is fairly flat and rates are at 6% and your mortgage is not substantially lower than at the start !


Why dose Rein teach us to take 35 yr. and to lower the payments when intrest rate drop ? Don has said ( as investors it is not our job to pay off the mortgage,we should maintain the property and ride the wave ).

I agree with Thomas,I think its a great idea to lower your level of dedt. The lower your dedt the less it matters how high intrest rates get

We lowered a few of our payment that are on variable rate mortgages but have chosen to leave the remainder of them as is. With prime minus .50 &.85 we are hammering the principle hard. I think we will appreciate the morgage paydown that we acomplished when its time to refi.

We deffinately got rapped up in the idea of re-fi and pull money out to buy more property. Seemed like a great idea when things were going up, as Thomas has said that sword has two sides . The way the market has changed so much and so fast , that sword can be very sharp. In todays turbulant times we would feel more comfortable with a few less doors and a lower dedt ratio.

Thomas's sugestion of testing a properties ability to cash flow @ higher rate's and shorter am's is an excellent defence measure and should be something that Rein is talking about and teaching.

My thought's

[ThomasBeyer]

A very timely and prudent string. I have just sold my primary residence and have around 110g's in the bank. I am building a new home and it will cost around 400g. Would it be prudent to put down 20-25%, obtain a SLOC on this equity and then look to do my first deal, or should I put down less and take the CMHC hit in order to keep cash on hand for a deal? I would prefer the first option and don't know how receptive lenders are to this sort of thing. Our combined income is around 150g per year. Any thoughts?

don't confuse getting a high ratio mortgage at sub 4% with stress testing your mortgage at 6 or even 8% !

most lenders, especially CMHC, will use fairly conservative guidelines today on rental properties, so getting even an 80% LTV mortgage today is difficult on a rental property .. but if you can get one at 85% LTV @ 3.89% then take it .. but be mindful of consequences in 5 years !

This post has been edited by thomasbeyer2000: Apr 26 2009, 09:18 AM

[ChrisDavies]

especially if you take a very risky 30 or 35 year amortization as the risk in 5 years is quite high ! Then assess what you would do in 5 years if market is fairly flat and rates are at 6% and your mortgage is not substantially lower than at the start !


Why dose Rein teach us to take 35 yr. and to lower the payments when intrest rate drop ? Don has said ( as investors it is not our job to pay off the mortgage,we should maintain the property and ride the wave ).

The whole point of REIN is a 360-degree view of your properties and portfolio. Taking longer amortizations and lowering payments to stabalize your properties can be great. Like Thomas and I have both said, you should make sure you have significant reserves and you're paying significant attention to the market. If you're a member, don't skip a meeting and keep in regular touch with your team (broker/banker, lawyer, accountant, property manager).

There's an awesome underlying theme here which is risk and I think that it's important for us to discuss more.

[kboughen]

Would it be prudent to put down 20-25%, obtain a SLOC on this equity

Generally speaking, a SLOC is a tool used to access up to 80% of the equity in your home. If you are going to put down 20%, you are already at 80% LTV and therefore a SLOC would not be an option.