Real Estate and Leverage: Finding the Right Balance

Reader's Question: I'm 28 years old. My wife and I both work as electrical engineers in jobs that pay well. Using our savings we have been buying income-producing real estate to replace our employment income, and now own 11 units. Is real estate the best vehicle for achieving our goal of becoming financially independent to free up time for activities we consider more meaningful? I have not found other investments that offer such handsome cash yields and permit a similar degree of leverage. Also, regarding leverage, what is the optimal amount of overall leverage for our property portfolio? Is it wise to "lever to the max" with exotic strategies (like wrap notes on properties purchased subject-to), or would we be better off de-leveraging our portfolio so that we don’t need to keep as much cash on hand to cover downside risk associated with leverage? I am struggling with the correct amount of property to purchase given our cash reserves.

In asset allocation and capital structure, the two areas of portfolio management your questions relate to, there are many different investing approaches, each of which has its own merits and unwavering supporters. Rather than try to show in any objective sense that one approach is always superior to the others, I will provide a personal perspective based on my own investing experiences, going broader than your specific inquiry to provide a fuller picture of what has worked for me over the past 25 years. I hope anyone reading this article is able to benefit from what I have to say; however, since even small differences in personal circumstances and preferences can sometimes lead to very different choices and approaches to investing, I encourage you to consider my opinions only as a point of reference, while proceeding to seek out advice from professionals who have the time and expertise to understand your situation thoroughly and work with you more closely to achieve your goals.

Real Estate Investing During the 1980s and 1990s

Since you are targeting a high cash yield and refer to your real estate as "units," I assume that you own apartments (though office buildings, neighborhood retail stores, mixed-use properties, storage facilities, mobile home parks and other real property are also all capable of generating predictable cash flow).

During the early 1980s, I made my first income property investment using a few thousand dollars I had managed to save from my job as a teaching and research assistant while studying for my graduate degree at an East Coast university and living frugally in a shared student house. I invested in apartments in California through a partnership run by an experienced general manager familiar to me through friends and relatives. We were leveraged at about 70% loan-to-value, and the property produced good cash flow distributions. With California real estate steadily appreciating, the investment did well throughout the 1980s.

Following graduation in 1985, I took a high-paying job on Wall Street and continued to invest my (now more substantial) savings into other apartment buildings in Southern California. With occupancy above 95%, rents rising at above 5% per year, and limited available land for new development, rental properties continued to appreciate. I recall at the end of 1990 receiving an unsolicited offer for a 16-unit property of ours at a price of $1.15 million (or $72,000 per unit, a very attractive price at that time), which on paper produced a total return-on-equity of 150% in less than three years!

But good times, of course, don't last forever. The U.S. recession beginning in late 1990 hit Southern California hard. Real estate prices softened and buyers evaporated. Realtors and investors caught in the fallout coined the phrase "Stay alive till '95," expressing their confidence that the market would recover by the middle of the decade. Recovery, however, was slower than expected, and significant market strength did not return until around 2000, a full decade following the 1990 peak.

During the market nadir in the mid-1990s, the vacancy rate in one of our buildings rose to 15%, we had to reduce rents by about 10% and offer move-in specials in order to attract new tenants. In the worst year of operations, cash flow became negative by about 1% of property value (which would have been worse if we had been leveraged more highly).

After what in retrospect was a long roller-coaster ride, partially buffered by not being over-leveraged, we ended up selling the properties, mostly during the market runup from 2000 to 2005. During my total 10- to 15-year holding period, I achieved acceptable but unimpressive, single-digit compounded annnualized returns. This muted, bond-like, long-run performance of an equity investment is largely a reflection of the extended market slump during the mid-1990s, but perhaps the more important outcome from this experience is that we survived and even managed to make a little money during a period when a number of more highly leveraged investors and developers faced foreclosure and bankruptcy.

Lessons from the Last Time Around

With attention to leverage and cash flow, a few observations may be helpful:

Cyclicality: Despite a strong secular tendency to rise indefinitely, real estate markets also exhibit significant cyclical behavior. On a timing clock, with 12 o'clock at the market's top and 6 o'clock at the bottom, I would pair up the following times and dates:

9 o'clock: Market rises in late 1980s

12 o'clock: Market peaks at end of 1990

3 o'clock: Market falls during early 1990s

6 o'clock: Market bottoms around 1995

9 o'clock: Market recovers in late 1990s

Though it may still be too early to judge conclusively, I suspect that we will likely look back at 2005 or 2006 as defining another 12 o'clock real estate market peak.

Leverage and Cash Flow: Leverage slices both ways, producing quick double-digit returns on the way up (as during the middle and late 1980s) and often even quicker negative double-digit returns on the way down (as from 1990 to 1995). As a general principle, I believe it prudent never to leverage a property beyond the zero-cash-flow breakeven point between positive and negative operating cash flow (after debt service and a reserve charge for major repairs, but before depreciation and amortization). A conservative rule of thumb for determining appropriate leverage is to apply a stress test by bumping the economic vacancy rate up to two or three times its normal level (e.g., 5% vacancy becomes 10% to 15% vacancy) and making sure that the property still has either sufficient positive cash flow or adequate cash in the bank to cover this worst-case scenario for a full year of stressed operation.

Total Investment Return: While prudent cash flow management and avoidance of over-leverage (of which a wrap note can be a tell-tale sign) are important for survival during times of protracted rental market weakness, investment returns are often more impacted by property price appreciation than cash flow. Particularly for investment horizons of 10 years or shorter, market timing tends to matter. Admittedly, buy and sell decisions are difficult to get exactly right and each time around is different from the previous times, but I believe that it is possible to cultivate a type of "wisdom" about the markets by observing the macro and local economic forces and their influence on prices over many cycles, thereby developing a slight edge over less diligent players.

Don't Forget About Alternative Markets

Between 2000 and 2005, while I was selling my units in California, I seriously looked for replacement properties in the Washington state area where I now live. My target was a 15% return-on-equity over a pro forma five-year investment horizon, consistent with an 8% cap rate, at 70% loan-to-value, 7% debt service (principal and interest), a 10% cash-on-cash return, and 3% annual property price appreciation, fully accounting for property management fees during the holding period and brokerage fees upon sale. During my property search, I made a handful of offers but was unable to close on a desirable investment property at my price target.

What drove my direct investment target was an investment alternative: indirectly investing in real estate by buying shares of publicly listed REITs. At that time, which was in the wake of the dot-com bubble when office vacancy rates had risen to 20% in high-tech centers, shares of office REITs were trading at depressed price levels consistent with my 8% cap rate and 10% cash-on-cash return target. I viewed office REITs as more attractively priced and having more upside pootential than apartment, retail and other REITs, and proceeded to roll my sales proceeds from the California apartments into shares of Equity Office Properties and Trizec. As good fortune would have it, these two office REITs ended up getting bought out at premium prices in late 2006 and early 2007 by large private-equity buyout funds, providing me with returns that well exceeded my original total return target.

The message here is that, before concluding that direct ownership of income-producing real estate is the best way to meet your investment objectives, I would encourage you to give serious consideration to at least the REIT market and, more generally, the overall stock market. Since the middle of last year, with the subprime crisis feeding recession fears, REITs have taken a fall and are again beginning to look relatively attractive. In my opinion, HRPT Properties (NYSE: HRP), an office REIT with class A and class B properties in both major and more minor cities, is worth considering, since it is now trading at just 65% of book value (equivalent to a "see through" 9% to 10% cap rate with a 14% to 15% cash-on-cash return), and offers an 11% dividend which looks stable. This or other REITs or other dividend-paying stocks may also provide you with the sense of financial independence you are seeking through direct ownership of real estate.

Although I currently own no real estate other than my own residence, I expect again to buy investment properties when an attractive opportunity presents itself. My guess is that the U.S. real estate market as a whole is now at about 3 o'clock on the timing model mentioned above, and could have another year or two to go before reaching the 6 o'clock bottom. The Seattle market where I am is still performing stronger than most other markets, which leads me to believe that I could have even a longer wait if I keep my local focus. On the other hand, I'm sure that there must be a few markets in other states (including your area?) where great deals may be found even this year.

When a Job Can Be More Than Just a Job

Your desire to generate investment income to give you financial freedom to pursue other activities you believe will be more fulfilling than continuing to work at your job as an engineer is a common goal of many people in our 21st-century society dominated by large corporations driven by efficiency and profit objectives. For better or worse, within a few years on the job, most of us Americans come to view our occupations primarily in financial terms, i.e., exchange of our labor for money, while disregarding less tangible benefits such as constructive participation in an endeavor for the good of society, contributing to the smooth operation of our economy, making widgets that we all need and use, helping others by applying our individual talents, etc.

Given the focus of so many Americans on becoming financially independent and retiring early, I was surprised recently to run across an interesting statistic indicating the extent to which America has become less aristocratic over the past century. In 1929, 70% of the income of the top 0.01% (or 1 out of 10,000) earners came from investment income derived from ownership of income-producing assets such as real estate, stock and bonds. By contrast, in 1998, again among the top 0.01% of earners, just 20% of income came from income-producing assets, while the remaining 80% came from wages and entrepreneurial income. (From Piketty and Saez, "Income Inequality in the United States, 1913-1998," as cited in Rajan and Zingales, Saving Capitalism from the Capitalists, 2003, p. 92)

I find it intriguing and even inspiring that the bulk of the income of top earners comes from business endeavors that these top earners are actively involved in as wage earners and entrepreneurs. What this indicates is that today in America, even moreso than a few generations ago, tremendous opportunities exist for anyone clever enough, bright enough and enterprising enough to apply their talents constructively to provide products and services in high demand. In other words, we should view our labor not just as a simple exchange of our time for money but also, at a higher level, as a contribution to the advancement and betterment of society with potential for phenomenally high compensation for the highest achievers. I'm not sure how you are planning to spend your time if or when you do one day leave your current job, but here's a suggestion: how about aspiring to rise to the level of those one-in-ten-thousand hardworking wage earners and entrepreneurs who are making a difference in our world? Generous financial and personal rewards are apparently available for those who succeed.

Certainly, investing to achieve self-sustaining personal lifetime income is a worthy goal to have. But, let's not stop there. Anyone focussed and fortunate enough to get that far should, I feel, both for one's personal satisfaction and for the good of society, actively proceed to find ways to share one's expertise and continue contributing to improving the lives of everyone.

Comments

[sansbrook]

I started investing in real estate when I was 22 and single. I had a good job and could handle risk. In the late 70s I started buying single family homes using cash from friends and advances from my credit cards. Not too long after that in the early 80s the market was frozen by the government jacking up interest rates to almost 15% for mortgages.
I say frozen because like politics, all real estate is local. In the Midwest here, the property values did not go down hardly at all and vacancy rates did not rise. Vacancy rates are governed more by the job market in your area than the overall real estate market. Some areas in Michigan lost value over the last 5 years while almost everywhere else real estate values skyrocketed. It all had to do with jobs. No jobs? People move out and values go down. I have never had vacancy rates above 5% in 30 years of investing. That is due to the slow but steady growth in the area that I invest in.

I stopped buying properties for a while in 1980 due to the interest rates but cash flow was able to cover what I already owned. It was at that time I started to invest new money in the stock market. The timing was good and I continued to put money in the market ever since. The stock market and the real estate market do not rise or fall together and it is easier to sell stock for quick cash than sell a property. During the 2000 stock market melt down however, my properties were still holding up and spinning off cash.

I will retire shortly at 55 based on both my real estate and stock investments and the cash flow they throw off. I own REITs but mostly other types of stocks. There is some correlation between REITs and your real estate investments (interest rates for one) but they don’t run in lock step. They may open a landfill next to your apartment complex but it won’t hurt your REIT stock. Look into oil and gas investment trusts if you want the big dividends. You are on the right track. You understand the beauty of real estate investing. Start early and invest like it's important to you. Make your own future.

My advice is to look at the amount of risk you are willing to take. If you can't take any, put everything in a passbook savings account or bonds but be prepared to work till you are 65 and worry about what the government is going to do about Social Security. Most advice like Lloyd’s will be on the conservative side. While anything can happen, what is the likelihood that it will? That is managing risk.

You need to prepare only for the things that are most likely to happen, not what can happen. Look at your lifestyle, your income and your investments. Make a “what if” plan for real problems that may come up. Some you may need to take action (insurance, will, savings etc.) and some may need only a plan for action. Do put your properties each in a separate LLC though.

One last thought. I bought my best properties in the mid to late 80s as we were just coming out of the interest rate mess. I bought when everyone just knew that real estate was a bad investment and the party was long over. I was able to negotiate prices and terms because the sellers were desperate.