Mortgage funding (leverage) is a double-edged sword every homeowner should know about

Introduction

The latest national census indicated that nearly 65% of single-family (SF) and multi-family (MF) residences under family ownership rely on mortgage funding. However, real estate economists advise homeowners to invest no less than 20% of their property appraisal value. Thus, one must depend on a regional lender or bank to fill in the gap up to 80%. Despite this line in the sand, over half (i.e., 55%) of the mortgaged financed acquisitions in 2018 invested, on average, only 6% of the transactional value. For first-time buyers, 72% came in at the low watermark. Moreover, the recommended mortgage payment shouldn’t be higher than 28% of one’s monthly salary. If that’s true, it makes the average monthly salary $3750 (i.e., based on the census showing $1050 as the median mortgage payment.)

Believe it or not, the stats above are significantly improved compared to when the financial crisis hit around 2008. Before that date, home buyers could buy homes with 100% leverage and not lay out a cent. Many pundits say the latter represents the debt concept running amok – a hazardous scenario. As a result, it’s no surprise that things ended in disaster, with a tsunami of bank foreclosures and investor bankruptcies flooding the economy. It’s arguably one of the darkest moments in US financial history.

Why all this preamble on asset loan funding (leverage) for real estate? Because it’s critical for anyone buying a home to understand that every leveraged reward has a commensurate risk, which can change like the wind. If you want to know how and why read on.

A case study

In 2010 Joe bought a SF house for $500,000 in Birmingham, Al, with a pre-approved loan of $400,000, conditional on him investing the remaining $100,000. Interest rates were steadily lowering, and he negotiated it at a 5% fixed rate, interest-only for ten years (i.e., before principal payments kicked in.) He finds the house of his dreams and is comfortable paying the $20,000 interest per year (i.e., $1400 monthly).

Joe estimated that if his home appreciated by an average of 4% annually over ten years, he could sell it for $740,000. Things go to plan, and after redeeming the loan, Joe is still up $340,000 versus his original outlay of $100,000. Now, Joe never lived in the house but rented it out at break-even for the ten years (after deducting closing costs). Therefore, his capital gain represents over 13% internal rate of return (IRR) on his investment. If his leases did better than break-even, then 15% return on investment pa (plus) is in the cards.

The case study above reflects an astounding IRR multiple of at least three times the asset’s 4% escalation over the decade. So, looking at borrowing funds through this viewfinder shows how appealing real estate is to professionals who know what they’re doing with leverage over extended periods.

The other side of the leverage coin

Real estate traditionally appreciates over time, but it doesn’t always go in a straight line. There can be long stretches where growth remains subdued, only to spurt skyward at unexpected moments. In fact, during the Great Recession, we saw years of real estate depreciation until a reasonable market balance returned. It’s misguided to think there’s “a pot of gold at the end of the rainbow” with all real estate. Many pitfalls await us on our journey when we borrow money on an 8/1 or even a 7/1 ratio (as homebuyers traditionally do). Here are the most dangerous ones people like Joe must consider before taking the mortgage plunge:

1. If they intend to lease, entering a stabilized rental environment is vital. In other words, suppose tenants fail to pay enough rent to cover the loan interest and the landlord can’t cover the difference. For example, like the two years during the COVID-19 Cares Act lessee protections. In that case, servicing the mortgage becomes a severe challenge.
2. If owners want to live on the premises, their jobs establish a basis for going forward. So, what happens if they lose employment or go through a life crisis like divorce? A couple can quickly fall behind on loan payments.
3. Then, assume the home suffers severe damage from fire or flood, and the insurance can’t cover it. Alternatively, the tenants abuse the asset, and the deposit is only a fraction of the damage they cause. Moreover, the homeowner doesn’t have the cash flow to remedy the problems, thus rendering it unrentable to new tenants.
4. Borrowers like to ride on the back of a 3% variable rate but often neglect to fix it in time. Two years later, it has doubled, and they can’t meet the increases.
5. Beyond 2022 (like in 2008 to 2012), the markets in recession once again may decimate values, pulling the home prices below the mortgage value. It’s called “being underwater.”

It’s crucial to realize that leverage exaggerates returns when things look bright in the markets but expands losses when the clouds cast shadows. Of course, there’s real estate risk with or without mortgage funding, but leverage in downturns multiplies it many times over. When loan arrears are piling up, and contractors are attaching liens to your home, then chances are you’re heading for:

• A short sale. OR
• Foreclosure, where you can’t salvage any equity.