Why You Must Not Over-leverage Your Deal

One of the greatest strengths of buying cash-producing multifamily real estate is the ability to use leverage to buy that property. The US is one of the few places in the world where you can put down a percentage of the total on a large multifamily deal, finance the rest at a good rate and term and make a nice return month over month after you pay the note.

However, the one mistake people make getting into their first deal is overleveraging.  A highly leveraged loan comes at the expense of a higher monthly payment, and probably at a higher rate. If you use too high leverage, it will be difficult to cash flow the deal or there will not be enough margin to make the returns for you and your investors. When this happens, there are a couple of ways that your deal can go sideways and come back to bite you.

The First Way to Bite You: You Hit a Higher Than Expected Vacancy
If you have a multifamily property and your vacancy increases, your loan’s debt coverage ratio (DCR) will drop. This is true for all multifamily, but if you’re overleveraged, it may make it impossible for you to make the higher payments to meet your obligations. This is especially true for smaller multifamily, where each vacant unit has more impact on the overall income of the property.

The Second Way to Bite You: Your Underwriting is too Optimistic
This is particularly important for new real estate entrepreneurs. If for any reason, your underwriting is not thoroughly done, having more equity in the deal can save you from a loan default because your payment will be smaller and you can still have cash flow.

Your first deal may not go smoothly and you will probably make a few mistakes, especially if you’re doing it alone. It may be due to not getting your rents up as you specified in your proforma or you may get a bump in vacancies. And that’s OK; getting experience is meaningful in your first deal. Just don’t get overly optimistic with an overleveraged loan. A good success is always better than a default – losing money for you and your investors.

So, you may be wondering, how to find the right leverage for your deal:

First, be conservative with your underwriting. You are looking for the worst case scenario. If you are using a good model, you need to stress test the deal to know how low the vacancy can go before you start losing money. You want to try to kill the deal and understand what it will take for that to happen. Run the deal at lower rents, lower cap rates, and higher interest rates. As you go through the thought process, you will keep an eye out for the worst case after you close.

Second, structure the deal toward the worst case scenario so no investor or lender will think that your inexperience is sending you down the wrong path. If you analyze the deal and your model says you will have a 19% cash on cash of return, don’t tell your investor that. Scale it back to 9 or 10%. If you hit your targets and deliver a better return, it’s better to surprise them than to disappoint them.

Getting your first deal nailed down will take some time, but study and train. Go to meetups and talk to mentors. Read, listen to podcasts. Learn from the mistakes of others. When you are ready, get in the game. Whatever you do, don’t over-leverage to get into your deal.

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