When to lever up, and when not to

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Regular readers know that I’m not a fan of using lots of debt. Debt (“leverage”) magnifies outcomes… so if you’re highly levered and the deal goes well, you do REALLY well, but if it goes badly, you get crushed.

There are, however, some nuances to my view and it has to do with where you are in a given real estate cycle.

If you are at or near a bottom, for example the years 2009-2011, then you want to load up with as much leverage as possible. The reason is simple: You’re going to have relatively strong cashflow (cap rates usually go up when the economy is recessed / depressed), so you will be able to service the debt. As the economy improves, your cashflow is likely to improve, too, because rents will grow. And the likelihood is that prices will increase over time as the market heals, meaning that your equity will increase and your loan-to-value will decrease.

If, as is the case now, you’re in an up-market, where rents and prices are high, you want to be very careful. It’s going to be tempting to lever up, because banks are loose with debt. But, whether you’re at the actual top or just approaching it, the likelihood is that you will experience rent and/or price decreases within some relatively short period after making your acquisition. If you are highly levered, you will be at risk of defaulting on your debt.

Obviously, the problem with the above advice is that it’s very hard to call the top of the market. You might follow my advice, under-lever, and then find that the market continues to rise for years, meaning you missed out on returns you could have got had you used more debt.

But our game is about longevity. It’s about hitting singles and doubles, lucking into the occasional homerun and, most importantly, avoiding striking out / hitting into double plays. It’s about the certainty of being rich in the long run and not about staking it all on a roll of the die.

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