Today is another AMA Episode. Ramon from Los Angeles asks,
I have several investment properties with reasonably low debt, <50% LTV, >1.6x DCR. With interest rates so low and the potential for inflation caused by central bank currency printing, I am considering refinancing a few properties to increase their debt, 70% LTV, 1.2x DCR. In addition to letting this potential inflation help wipe away the debt over time, I will get the added benefit of pulling cash out to take advantage of opportunities which may become available if distressed sellers start to sell and foreclosures begin to hit the market. On the other hand, by doing this I would be adding risk by increasing my debt service at a time when there is downward pressure on rents and increased rent collection risk. What is your perspective on responsibly loading up on as much low interest debt as possible?
Money comes to you in one of three ways.
1) Earned income
2) Residual Income
3) Capital Gains
The choice of how much debt to take on is a function of several factors. If you take on more debt, the residual income from the business will go down. A lower debt service and a higher debt coverage ratio means higher cash flow for you at the end of each month. If your goal is cash flow, then taking on more debt is going against your residual income or cash flow objective. But if you’re willing to defer a portion of the residual income in order to grow the portfolio and increase your total portfolio, that could be a winning strategy.
I’m going to make up some numbers following your example. Let’s say that you have a portfolio of $10M and you’re going to refinance the portfolio to increase the loan to value ratio from 50% to 70%. So you’re going to take on an additional two million in debt. The debt coverage ratio will fall from 1.6 to 1.2. You’re quite right in pointing out that the lower debt coverage ratio has more risk associated with it. The risk is that the portfolio might experience negative cash flow if you have something unexpected happen.
You’re going to borrow an extra $2M within that $10M portfolio in our example. This will give you the ability to put down up to $2M on a new property which could significantly expand your portfolio. But as you rightly pointed out, you would be taking on more risk.
What if instead of sinking all $2M of new money into a new project, instead you invested $1.8M. You could put the extra $200,000 in a reserve account to protect the portfolio from any short term cash crunch, if the need arises. It will require a lot of discipline not to spend that money.
To summarize, borrowing additional funds to buy another project, and increase your war chest cash reserve on your balance sheet could be the best of both worlds. You can improve the safety of the entire portfolio and at the same time, acquire another project.