By The White Coat Investor, originally published at The White Coat Investor.
By
Jim Dahle,
WCI Founder
<!–An amazing number of investors, even white coat investors, don’t understand the math behind investing with leverage, aka borrowed money, debt, or “other people’s money.” They take on large amounts of leverage risk, and then when that risk shows up, they feel they must have been scammed when they lose their entire investment. Sometimes there is a scam, but not most of the time. Most of the time, it’s just math.
Let me demonstrate.
An Example of How Leverage Can Destroy the Investment
Let’s imagine a typical real estate syndication. A group of investors goes to buy a large apartment complex. The complex is worth $20 million. The group decides to put 25% down, or $5 million. There are 100 of them, so they each put down $50,000.
To keep the interest rates as low as possible (and thus the potential profit as high as possible), the investors use a variable interest rate loan. They hire a manager/operator/general partner/syndicator (usually the fella that convinced them to invest), and that manager starts running the investment. Now, something bad happens. The property goes down in value for some reason. Capitalization rates go up, perhaps as interest rates rise. As the interest rates rise, the cost of the leverage goes up. Perhaps vacancies rise, too. And maybe maintenance costs more than expected.
All of a sudden, the property has negative cash flow and starts eating into its reserves. It’s all good for a few months until the reserves are nearly gone. Now, everyone is in a panic to refinance that debt. But they can’t because the cash flow is lousy and the value of the property has fallen. So, a capital call is issued by the manager. Maybe the investors meet it. Probably they don’t. The manager starts trying to sell the property as it is falling in value. He finally finds a buyer. The property is sold for $15 million, and the proceeds are used to pay off the $15 million mortgage.
What happened to the equity investors? The property only fell in value by 25%. Yet they lost 100% of their investment. Their principal (capital) is all gone. They’re lucky they purchased using a limited partnership or LLC structure, which prevented them from losing even more than 100% of their investment. But they’re not happy about it. Some of them try to sue the operator, figuring he must have done something wrong. Why couldn’t he foresee vacancies and interest rates rising?
“I paid him all those fees and lost all my money anyway,” says an investor.
“He must be running a scam,” says another.
“I’m going to sue him and get my money back,” says a third.
“I’m going to tell everyone not to invest with him on the internet,” says another.
You see these posts on forums all the time—especially 2-3 years after the rapid interest rate rise in 2022 when interest rate caps expired and it was time to refinance.
More information here:
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When Risk Shows Up
People think they can avoid this risk just by finding the right syndicator and avoiding the bad ones. Experience helps for sure, but mostly this is just a function of risk. You took a lot of risk, and the risk actually showed up. There were lots of ways to take less risk while investing in real estate, such as these:
- Put more money down (less leverage risk).
- Invest on the debt side (the debt investors got all their principal and interest back in the above hypothetical failed syndication).
- Avoid more speculative deals trying to knock the ball out of the park (ground-up development, Value-Add, etc.) in exchange for some boring old Class A “Core” real estate investments.
Or all of the above. Your likelihood of losing principal pretty much rises as the expected return from the investment increases. High return = High risk of low return. If you’re expecting 8%-12% returns, it’s probably not all that risky. If it’s 18%-25%? Hang on tight and hope no hiccups come along.
It can be even worse investing in stocks with leverage. Usually referred to as margin investing, you almost always have to use variable-rate debt and usually at a higher interest rate than real estate. But it’s even worse. Yes, real estate debt might only be for three, five, or 10 years before a balloon payment comes due or interest rates change. But a margin call can happen any time, and it usually occurs in the worst of economic times. Take on too much leverage risk, and you just end up being forced to sell low.
Be careful with leverage risk, my friends. Yes, it can boost returns. But leverage works both ways. It can both magnify returns AND losses. Limit how much of it you use (no more than 15%-35% of your assets) and try to make what you do use as high-quality (non-callable, fixed interest rate, long term, low interest rate) as possible.
WCI’s No Hype Real Estate Investing is the best real estate course on the planet and the best way to get started in this exciting (and profitable) asset class. Taught by Dr. Jim Dahle and more than a dozen other experts, this course is packed with more than 25 hours of content, and it gives potential investors the foundation they need. If you’re interested in real estate investing, you can’t afford to miss the No Hype Real Estate Investing course!
What do you think? How much leverage risk do you take with your investments, and why?
The post How You Can Lose Your Entire Investment When Investing with Leverage (Borrowed Money) appeared first on The White Coat Investor – Investing & Personal Finance for Doctors.
Dr. Jim Dahle
WCI Founder
James M. Dahle, MD, FACEP, FAAEM is a practicing emergency physician and the founder of The White Coat Investor. After multiple run-ins with unscrupulous financial professionals early in his career, he embarked on his own self-study process to become financially literate. After seeing the benefits of financial literacy in his own life, he was inspired to start The White Coat Investor to assist his colleagues. At the time, there was nobody providing unbiased financial education to doctors at any point in their training. Now, more than a decade later, financial wellness is widely recognized as a critical life skill for all physicians and similar professionals. Dr. Dahle remains committed to the original mission of The White Coat Investor to “help those who wear the white coat get a fair shake on Wall Street.”
He currently serves as the CEO, a columnist, and the host of the podcast. Dr. Dahle is a proud father of 4 children and spends his free time adventuring around the world. If you can’t find him, he is probably hiding in the mountains or desert of his home state of Utah.
See more about Jim Dahle
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The White Coat Investor writes at The White Coat Investor. Read this article on their site.
