Why overleverage is risky?
I've been thinking about this question for a while and wondering what makes overleverage sound such risky? Assuming we're using crazy amount of leverage but the property has positive cash flows and longer term debt. My thought is as long as we don't sell if something goes wrong and be patient to wait for market recovery, it would be really difficult to realize a loss?
“Having a large amount of leverage is like driving a car with a dagger on the steering wheel pointed at your heart. If you do that, you will be a better driver. There will be fewer accidents but when they happen, they will be fatal.” — Warren Buffett
I completely agree with what he says but in the situation I mentioned, it seems like there's really no forseeable risk of property being taken. The returns could be lower but almost impossible to realize a loss unless the specific market like Detroit completely crashes and take much longer time to recover
What are you talking about RE: "there's really no forseeable risk of property being taken"?
I assume we would both agree that in nearly all reasonable circumstances, overleverage is pushing your DSCR to the absolute bottom line it can hold while still remaining in accordance with debt covenants. So, assuming a 100-unit multi-family property is 100% leased, and your DSCR is being maintained while everything is going perfectly, all it takes is 1 tenant to delay payment or one unexpected R&M expense to occur for you to be in default of your loan and having the property at risk of being taken back.
Lol bruh
What if your anchor tenant decides not to exercise their option, or goes bankrupt and closes, triggering a bunch of co-tenancies and resulting in a 20%+ drop in occupancy? How are you going to manage that when you're barely making debt payments already?
What if another COVID happens and half your tenants stop paying rent and you can't make debt payments, and your lender decides they don't want to work with you?
This is an absolutely foolish post.
Overleverage is risky for two main reasons. (But there are many more). If something goes wrong and it effects your cash flow, you can’t pay your debt service. If values drop while you are holding the asset, there is a higher likelihood your equity will be wiped out. Additionally, when you go to refi or sell, if values have dropped, you have less equity in the property, so similar to the refi scenario - your equity can be wiped out.
Most people in real estate lose their property due to timing / refi issues. In the GFC, people lost their property because the capital markets freezes up and couldn’t refi or sell. Leverage amplifies this issues because it means you need to either refi for a larger loan if you don’t want to put equity in or sell for a higher amount to not effect your equity.
with all that said above, if you can find a property that is cash flow steady guaranteed (you can never do this), theoretically high leverage is fine. If you think of the LBO industry, they buy stable cash flowing companies and lever them to high hell to drive returns.
Thank you, this is really helpful!
Overleverage is a problem to the extent that the interest rate is high. Interest expense sits high in the cash waterfall structure right after Opex is paid and it can trigger a default under the finance docs. This is a general point not directly related to RE.
I mean, in this hypothetical, I agree with you. But in practice you won't see this.
You are proposing that you find a property that has a ton of free cash flow, enough that you can take 100% leverage (lets say) and still hit your DSCR requirements. Mind you, we're talking about long term fixed rate debt, which is going to be super expensive. Also, why is anyone lending to you at this rate? The whole point of credit and risk assessment is to make sure that Sponsors have enough cash in to (a) be responsible stewards and (b) buffer the bank if they have to repossess.
Anyway, the point being that if this asset is throwing off that much cash... someone else is going to buy it for more than you will. If you already own the asset, then almost by definition anything the cash flow can support isn't "over-leverage".
In other words, it is genuinely hard to imagine this scenario existing in the real world.
If you can service the debt and meet all loan covenants when things go wrong, then it's not crazy amount of leverage.
When market turns south, the assumption that a property's cash flow will always be secure goes out the window: long-term credit-worthy leases may default and leasing market dries up which means there may not be liquidity to service debt or pass DSCR hurdle; asset valuation may also take a dip as appraisers underwrite more conservatively which means LTV tests will fail. With high leverage comes high hurdles, and when things go wrong it's so much harder to jump over the hurdles even with long-term fixed-rate debt.
In a downturn scenario, the "patience" is not so much doing nothing but to actively work out a mechanism with the lender that would allow some breathing room to ride it out but that obviously that comes with concessions which usually involve some forms of equity commitment.
The majority (something like 80-90%) of defaults in the GFC were maturity defaults, so if that is not specific to just the GFC but recessions overall, to an extent you are directionally right. But typically when people overleverage their deal, they are introducing CMBS debt or mezz debt into the equation. That is a different type of lender with different incentives and capabilities than a bank. As others have said, leverage magnifies outcomes - both good and bad. And in a downside scenario, more debt starts to put a ton of pressure on you. If you have a tenant leave, or rents drop in tandem with higher vacancies, you won't have the cushion to make up for it.
Where you'll likely get eaten up though is at maturity. Most lenders will probably work with you if you are covering you debt payments each month. But if you have $10M of debt on a property worth $8M, you're either writing a check at closing, giving the keys to the lender, going through bankruptcy, or you'll have $2M of personal liability if you signed on for recourse.
Id vitae eius consequatur voluptates dolorem voluptas tenetur atque. In dolores in et inventore dolores totam sint. Aliquid provident aut ipsam dolore maxime.
Laudantium veniam doloremque et qui facilis sunt. Voluptatem aliquam est molestiae accusantium voluptas sequi rerum.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...