The best real estate investments combine leverage for financial growth and non-recourse lending to mitigate risk. It has been an interesting week for me since I made that assertion in my last blog post. It is clear from my conversations this last week that many people have never heard of non-recourse lending. It is also clear that many people have heard of the risks of leverage.
As one physician put it in our conversations, leverage is a “double-edged sword” it cuts both ways. While it can magnify your gains, it can also magnify your losses. This is absolutely true if you use leverage wrong.
First off, when money flowed freely and easily, some people over-leveraged properties. The banks allowed them to overpay for properties they couldn’t afford in bad markets with as little as 10% down. Worse yet, they used full-recourse loans to buy those properties. A full recourse loans means that the borrower is on the hook for the full amount of the loan and the bank can come after his or her personal assets for settlement. In contrast, a non-recourse loan limits the investor’s exposure to potential loss to his or her initial capital investment and nothing more. That last sentence may not have sounded like much, but it is HUGE.
Current Fannie Mae Underwriting Standards for multifamily investments are much stricter. In fact, the current foreclosure rate for properties that conform to these standards are a meager 1% – 2% nationally. Compare that to business. We have all heard that 9 out of every 10 businesses fail. High failure rates are not just limited to small businesses. Every year, big businesses fail too. Names like Enron, Mervyns, Hostess, and Circuit City have all gone belly up. Many more teeter on the brink of insolvency.
In the top markets in the country, Fannie Mae will allow experienced syndicators to put 25% down and leverage the rest. In these same markets, they will allow for a debt-service coverage ratio (DSCR) as low as 1.25. Also known as debt-coverage ratio (DCR), this number is net-operating income divided by the mortgage payment. DSCR is a safety marker and all things being equal the higher the DSCR, the safer the investment. Consequently, in markets that Fannie Mae designate as riskier, their underwriting standards become tighter. They demand less leverage (higher down payments) and a higher DSCR in these markets to obtain their loans. Non-recourse loans are standard in the multifamily space for loans above $1.5 million. Below this level, including most residential loans (1-4 units), the loans are full recourse.
So again, I assert that the best real estate investments combine leverage for financial growth and non-recourse lending to mitigate risk. While all investments have risk, non-recourse lending decreases the risk of leverage. However, I take this statement one step further by saying that leveraged, non-recourse lending in the hands of a good syndicator is far less risky than residential real estate and unleveraged stock or mutual fund investments.
Let me make my case here through an example, and ultimately you decide which has the most risk. Let’s compare three different investors utilizing three different investment strategies each in $2 million worth of assets. The first will be a $2 million dollar apartment complex purchased with 25% down using a non-recourse loan for the remaining 75%. The second investor also has $2 million of leveraged real estate putting 25% down. However, he bought ten single family homes worth $200,000 each with ten full recourse loans. The third investor purchased $2 million worth of unleveraged mutual funds paying for them in full.
|Investor I||Investor II||Investor III|
|Initial Capital Investment||$500,000||$500,000||$2,000,000|
|Leveraged Bank Financing||$1,500,000||$1,500,000||$0|
|Value of Asset||$2,000,000||$2,000,000||$2,000,000|
|Exposure to Potential Loss / Worst Case Scenario||$500,000||$2,000,000||$2,000,000|
|% of Initial Capital Lost / Worst Case Scenario||100%||400%||100%|
As the above table shows, if you worst case scenario the purchase of three different $2 million assets, the least risky asset is the commercial multifamily property that used leverage through a non-recourse loan. While the percentage lost is the same as stock and mutual funds, the actual dollar figure lost is four times less than when it is unleveraged. On the other hand, full recourse loans carry a great deal of risk. I don’t recommend them and this is why some people say that leverage is a double-edged sword.
However, if you invest fractionally in bigger properties like I do, you can decrease the risk to the individual investor even further. Take the above example in which one individual put $500,000 down to buy a $2 million property. Now let’s say that ten investors pooled $50,000 each to come up with that same $500,000 down payment. Now each individual investor has 40 times less exposure to potential loss than the investors in scenario II and III ($50,000 versus $2,000,000).
It’s important to mitigate risk when investing your hard earned money. Non-recourse lending is one of many tools the smart investor can use to do just that. Consider combining non-recourse lending with fractional investing in the best markets in the country in multifamily assets that conform to Fannie Mae underwriting standards. Do this right and you will be on your way to financial freedom and early retirement.
P.S. Leverage makes the best real estate investments create accelerated financial growth, while non-recourse lending decreases risk.
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