Use Leverage Wisely
When you’re ready to make a real estate investment, there are a lot of bases you need to cover, but none is more important than financing. You can get everything else right, but if you over-leverage, you’re gambling instead of investing.
Over-leveraging is the biggest financial error I see in real estate investing. Before the financial crisis, it was common for investors to borrow over 90% of the value of their new properties. And have limited cash on hand as a rainy day fund. Using other people’s money to earn a return can be great, but it also creates very real risks. Unforeseen market changes or property problems can flip a highly leveraged investment from an asset to a liability, where you owe more money than a property is worth on the open market. Or where you need to sell an asset quickly, at a loss, just to get cash to cover costs on a different property. I have seen more than a few hotshot investors humbled by this mistake.
Real estate is an up and down business, tenants are often difficult, and we need to be prepared to weather hard times. Even without a wider downturn, unexpected costs like capital improvements, leasing commissions, carrying costs during vacant periods, etc. are going to strike. It’s a matter of when, not if, so keep a capital cushion.
Decisions about financing projects also depend on where your return will come from. Are you planning to run a property for fixed income or resell it for a profit? If you want to operate as a long term landlord, then it’s all about stable tenants or high tenant demand. When it’s clear that the risk of vacancy is low, then I feel comfortable borrowing a little more.
Other times, an investment might depend on profits from reselling. This requires a very careful look at how a property might be used and who might be interested. For example, a small building zoned for retail might only attract interest from local investors, which limits your pool of potential buyers down the road.
Meanwhile, other properties might interest national investors. For example, large commercial or industrial spaces can be repurposed by national chains. A big resale market is great news, but reselling is less predictable than renting, so be careful about high leverage. Incidentally, borrowing less reduces upfront financing fees, which are usually based on total loan value.
Finally, when raising capital for a real estate investment, be sure you fully understand the terms you are committing to. This might sound obvious, but many investors are surprised when they are hit with a big balloon payment 10 years after taking out a loan. That is another reason why it’s so important to have a strong team. When you have long and trusting relationships with your bankers, investors, and attorneys, you will know what is coming and raise high quality capital. That means smoother, faster, and more confident deal-making.
No matter how you finance your investment, make sure you have a solid capital cushion to protect you from hard times and a clear picture of how you will get your money back out. Anything less is just gambling.
Call me at 847-317-0077, email me at [email protected], or tweet me at @benreinberg or @alliancecgc if you can submit us a property to acquire and/or would like to invest with us. For further information on investing with Alliance, please click here.
My Best,
Ben
