How to Avoid Over Leverage in Real Estate (2024)

How to Avoid Over Leverage in Real Estate – Video

Video Transcript

Kathy: We often say don’t sell your property. Refinance it if you can. If you refinance a property, you don’t tax on that cash that you take out, at least not currently. You pay taxes when you sell, unless you 1031 exchange it. You don’t want to sell and pay taxes, so why sell?

Just refinance, get the cash you need, keep the property, and keep renting it. Just keep refinancing it till you die, and then pass it on to your kids, it gets stepped up to market value, and your kids inherit the property and don’t have to pay all the back taxes. It’s a beautiful thing. If you must sell, consider 1031 exchange, like I said, so you don’t have to pay those capital gain taxes.

All right, so what are the risk of high leverage? Well, if the property values decline, obviously, this is a lesson millions of people have learned. If you get over-leveraged, and you buy a property 100% financed, and the value of the property goes down. Now you’re upside down. Now you’re in trouble.

Don’t buy anything that looks like there is a risk of the value declining, if you’re doing high leverage. We want to make sure that some of the areas that we’re buying in, there just no way prices can go down. $73,000 house that’s been fully rehabbed, how can the value go down now? I just can’t see it. That’s the risk.

If you can’t make the payment, let’s say there are some vacancies, or something happened, maybe your tenant got sick or loses their job, you have to evict them and put someone else in. You need to be able to cover those payments. We always say, put at least six months reserve in the bank account. Don’t touch it, for those emergencies, if you want to be really saved, put 12 months in.

If you don’t maintain the property properly, you can really be at risk. You’ve got to make sure you’re maintaining it, or have someone else who is, like a really, really good property manager. I just found out that parts of taxes when there is a drought, it can really cause foundation issues on properties that aren’t properly maintained.

This is really something I didn’t know. This is why you want to have a local property manager tell you. This is why you don’t want to not have a local property manager because you just wouldn’t know that. I mean how would you know that? Maintenance is key.

Balloon note, those are scary. We’ve been in them, no fun. To get into a balloon note, what that basically means is, let’s say you got a three or a five year loan, and you didn’t have the means to refinance or sell that property or pay it off, or whatever. You’re in a bad situation, because you have got to be able to pay off the loan, and if you can’t do it, they take the property. Be careful of balloon notes.

Construction loan, the same thing. This is the big thing that happened in 2008. Lehman Brothers went down, they have offered a lot of people construction loans. People started construction. One day, they just got a notice saying, “You know what, we don’t have any more money, and there is nothing you can do.” A lot of people were mid-construction when all of a sudden, they have no construction money, and they got in trouble.

We’re now picking up those properties as a network, and finishing off the job, and making the profit that the person who was in it originally should have got. Be careful of construction loans.

Hard money loans, again the same thing, they tend to be short term, they tend to be high interest. If you know what you’re doing, then great. If you don’t, there are a lot of hard money lenders who lend just with the hope that the person won’t be able to make the payment, so they can take over the property. Not all, but some. Just be careful with those.

Take action. First and foremost, if you’re looking to use leverage to acquire property, check your credit health. Make sure you’ve got good credit, and don’t worry so much if you don’t have good credit. There are so many good companies out there that can help you fix your credit. If you need a referral to a good company that can help you fix your credit, let me know. I am constantly doing credit repair because when you use your credit a lot, it often needs repair. It’s not that expensive for the value.

Find out how much you can borrow, talk to a lender, find out how good your credit is, and I should say your ability to borrow. Do you have a lot of debt, and if you do, that might cause debt income ratios. You need to make sure you don’t have too much debt, and you want to have plenty of reserve funds. Either way, just to get the loan, but also to make sure it’s a successful investment. You want to make sure you have those reserves.

Get expert advice on where and what to buy. My very, very sweet and lovely niece texted me this morning, on my morning hike, and said, “Hey, you know, I’m driving up to Santa Rosa because somebody just told me they got a great deal up there, they got a duplex for $250,000 and the total income is $2,200 and, wow I want one.” She just qualified for a loan and she can do it so I said, “Well, are you talking about gross income or net income?” She wasn’t really sure and it turned out it was gross income.

Basically what that means is the rents were coming in at $2,200, but that’s not net, I mean there’s expense to pay and so forth and I don’t know what kind of condition the property is in, does it need repairs? Is it in a bad part of town or are you going to have trouble collecting your rent? Are there people, are there jobs in the area and if there aren’t, how are your tenants going to be able to afford the place?

There’s just so many questions I had that I said, “You need to check these things out.” Too often people say, “Oh, this looks great I’m going to do that.” Or, they trust a real estate agent who really knows nothing about investment property, no offence to real estate agents, it’s just most specialize in owner occupied. Investment isn’t for everybody, not everybody understands it, so you have got to make sure that when buying an investment property you’re working with someone who really understands investment.

In this case, this person who bought this property never even talked to a property manager to find out about those things I said. It could be a high crime area or there might be a lot of vandalism, might be an area where there’s not many jobs, might be a house that needs a ton of work, so the return on that could vary and you just need to make sure you got expert advice.