Leverage – When is it Good, When is it Bad?

Mike: Welcome back to the flipnerd.com REI Classroom, where experts from across the real estate investing industry teach you quick lessons to take your business to the next level. And now, let’s meet today’s expert host.

Patrick: Hi, my name is Patrick Donohoe with Paradigm Life and I am the host of today’s REI Classroom. And the topic that we’re going to discuss is leverage, the good, the bad, and the ugly.

Mike: This show was sponsored by PassiveRental.com.

Patrick: So getting into leverage, leverage, which is essentially getting a mortgage or a loan against a property, is one of the reasons why real estate is so amazing. But at the same time, typically, leverage comes from banks or lenders who are acting like a bank. And whenever there is bank lending, you often have lots of documentation, whether it’s the note or personal guarantee. And banks essentially prepare for the worst.

And often times, as individuals, as investors, we’re not really advanced in how legal language works really until we’re in the circumstances where we need to understand it. And I think a perfect example of that is back in 2008. And this is kind of the ugly example with leverage. Back in 2008, I mean, leverage is really what bolstered up the real estate prices and the real estate bubble that subsequently came crashing down. And when it came crashing down, obviously there were price declines and those that had leverage were put in kind of a conundrum.

Now, they could have been in a negative equity position and been underwater and as long as the rents would cover the mortgage payments, they were okay. But when there was essentially less rent than the mortgage payment or operating expenses, that’s when really people started to have to deal with the legal recourse of having leverage. And so really, in those times, leverage really became the worst nightmare of individuals because banks in the end are ruthless. They don’t really have a soul. And so they don’t negotiate with you. It’s basically, “Here are the terms of the note and if you don’t meet them, we are going to foreclose on you.”

And that really puts a person into dire straits, forcing them either into bankruptcy or into foreclosure. And so the tip that I have for the ugly, and this is when I’ll get to the good in the bad, when it comes to the ugly, it’s really understanding the mortgage note, understanding your equity position. And I think one of the most important things about the note is really the legal side of it when it comes to the state that you have the note or the mortgage in.

Now, there are nonrecourse states and recourse states. I’d really pay attention to what those recourse laws are. When I was doing business, we’ve been in business since 2008, in 2008, 2009, 2010, we saw a lot of this happening and individuals that were in essentially recourse states would get foreclosed on and essentially the property would be sold at less than what the mortgage amount owed was. And what would happen after is the bank would come after the individual personally for the deficiency on a deficiency judgment.

And this really put people in a difficult position because they couldn’t just get foreclosed on, they’d actually file bankruptcy. Because if they were foreclosed on, that’s one thing, but if the bank is going to come after you for a deficiency judgment, that is when they can garnish your wages, they can take money from your bank account and so forth. So anyway, understand the note, understanding what state you are in as far as recourse is concerned and what those laws are, vitally important.

So another kind of good side of leverage, leverage obviously increases the return of a property. I think most of you guys know that. But at the end, going to where the leverage stands as it relates to the economy and also as it relates to the value of the house is really important. And I’m a proponent of really having a good equity position in there because what it does is it hedges you.

Now, what do I mean by a hedge? So looking at inflation, inflation is one of those things where debt becomes cheaper over time. Now, there are different theories out there as to if there is going to be inflation or if there is going to be deflation. If you go back to 2008, 2009, 2010, there was deflation. There were huge price declines when it came to asset prices. And so really, individuals, if they did have a mortgage, they put them in a negative equity position. That’s really, really risky.

Now, looking at what’s going to happen in the future with our economy, there are arguments, really good arguments, on both sides. And so really, to hedge from an inflation standpoint and a deflation standpoint, it’s really good to have, in my opinion, in my research, and it’s not just me that’s come to these conclusions, but to have about a 20 to 30% equity position if you’re going to have leverage or essentially have a good cash reserve that will shore up whatever the deficiency is.

So leverage, in the end, is, I would say it’s a really good thing. I believe in leverage, but at the same time, leverage can really put you into a difficult spot it there are major shifts in the economy. Right now, with everything that’s going on, there could potentially be shifts. There might not be. But in the end, it’s good to be prepared for all scenarios. So basically with leverage, know what you have, know the note, know the mortgage, be strategic about your equity positions, and I think you’ll do fine and you’ll weather the storm. So if you want to learn more about Paradigm Life, we teach a lot of these concepts. You can visit www.paradigmlife.net.

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