| LSUAlum wrote:|
| RIArules wrote:|
Look, we have pranced around this subject before, but leverage comes with its own unique set of risks, particularly for private/small business. There is a reason that I made exactly 1 SBA guaranteed loan in the last 8 or so years in that biz - if the loan was worth making, it shouldn't require an SBA guarantee. There were some intriguing options for lenders willing to sell off the guaranteed portions and retain service (much like selling an A share fund, but with some additional incentives from a bank leverage standpoint), but we came to the determination that it was more headache than it was worth.
Now, explain to me why you think that an SBA loan is cheap (2% plus upfront fee, prime plus 2.75% interest), and how are you going to de lever when the floating rate (which 99% of them are) is expensive?
Ok, leverage is cheap unless the interest rate is unsustainable. I'll use real estate as an example since an extreme form of leverage (and of course you used Donald Trump as your tongue in cheek remark
I can buy a house for say 100k. If I am allowed to buy it for 90k in borrowed funds and 10k in my own funds (and lets assume I have 100k as an option to pay cash instead). I can either buy one house or buy 10 (assuming I can maximize my leverage).
Even if the return I can get on Cash is LESS THAN the return I can generate with borrowed money in cash flow it's not a bad idea assuming the thing I'm buying has a greater TOTAL return.
Scenario A) Buy 10 houses, each with a 3% appreciation in value per year (stricktly inflation) Boy, that worked out well over the last 5 years (snort). Borrowing cost is 7% interest on 100k. Scenario B) Or buy 1 house with 0% borrowing cost. Assume each house rents for 1000 per month.
A) 10 houses = 10,000 per month cash flow = 120k per year cash flow in. Debt Service for 900k loans = 6,000k per month (30 year amortization).Which lender do you know of (even before the credit crisis) that was willing to amortize a rental property loan for 30 years. 15, POSSIBLY 20, but 30??? And there is a risk associated with balloons that no-one took into account, but I digress. Cash flow from leverage 48k per year. Cash on Cash return = 48% for year 1. Until you have a combination of vacancy/delinquency of > 40%. Then your ass is in a crack, because you plunked your entire $100K into maximizing your investment, and set aside no reserve. And this doesn't even take into account taxes, insurance, reserves for replacement and/or repairs, which would further reduce your cash flow and coverage ratio, making your margin of error even thinner. Are you going to manage these properties, or will you be paying for that too? There is a reason that you can't margin rental property at 90% (or if you did, it would be completely imprudent). If you need the numbers for a true world scenario, I will be more than happy to oblige, but it will have to wait until I have some time and access to my 12B.
I have plenty of real world numbers. I currently own 3 said rental properties in the DFW metroplex. All of them bought with 30 amortization non-owner occupied loans. BTW Fannie allowed 10 such properties and the 30 year financing still occurs on the A paper conforming loan side for Non-owner occupied. Fannie & Freddie were not formed and/or chartered for that purpose Interesting, 1-4 family four-plex? No, SFR.You can still, to this very day, buy rental property for 10% down and margin it up 90%. I'm not sure where you get your numbers but if you want, I'll be happy to send you some information on normal, everyday conforming Fannie/Freddie loans. I never claimed to be a mortgage broker, I used to originate/manage in-house lending programs. I guess it is possible that Fannie/Freddie would allow up to 10 non-owner occupied homes. Although my gut tells me that there are some second-home shenanigans going on there How would non owner occupied have anything to do with second home shenanigans? Non Owner occupied is Specifically NOT for second homes, as those are considered a different risk class and owner occupied. You obviously have no clue about uncscrupulous mortgage brokers, I will give you the benefit of the doubt and will not argue. I do, however find it laughable that you would hold Fannie and Freddie out as the poster children of prudent lending standards.
As for real world numbers, whether you use leverage or do not use leverage those expenses are constant. No, they are variable.By constang I mean they are independent of the financing options. A broken A/C unit has zero correlation to whether you paid cash or financed. I would love to see your rental properties in 30 years Leverage does not increase your risk. What leverage does is require your numbers to be more exact. Whoop!! Leverage doesn't increase risk? All my clients are going into 3X ETF funds this afternoon. No, leverage does not increase risk. Whether I pay cash for a business or finance the business has no bearing on if the business will have revenues or not. The risk is 100% about the certainty of your business numbers. If you overstate revenue projections your business will fail. All leverage does is require your numbers to be more precise. Leverage isn't the risk, uncertainty in your projections is the risk. And your clients buying a 3x ETF is exactly that point. The degree of certainty they have in the movement of the underlying index is what causes the risk, not the 3x OF THAT MOVEMENT. The margin of error for you numbers decreases as you lever up. However, using your example the Leverage actually REDUCED my risk. You see, if I paid cash for the house and the house was vacant I now STILL have the risk of repairs but no cash to accomodate that. What about the cash inflow that you don't have to pay the bank? Or in the case of a really bad problem, a home improvement loan that you would otherwise not be able to get because you have no LTV margin? So, if I paid cash for the house would I have had MORE cash to pay the bank the mortgage payment? No, there would be NO mortgage payment. Duh.... Using up capital in lieu of leverage causes this risk to AMPLIFY. As for the Home Improvement Loan, if you leveraged up from the get go, you now can pay CASH for the home improvement. The bottom line is that the leverage reduced the risk . By leveraging up my asset base I've spread that risk over 10 houses instead of one.
B) 1 house = 1000 per month cash flow, 12k per year. Debt Service = 0, Cash from no leverage 12k per year. Cash on Cash return 12%.
Leverage increased my return by 4 fold even at a higher interest rate. The only point at which leverage in this case would be a bad idea is if my cash flow from operations decreased to the point where my cash on cash return was less than an unlevered operation.
So lets look at the interest rates you provided in your example.
Prime = 3.25%, 2% upfront, SBA rate P+3%(rounded up for simplicity). Assume again a 100k total investment needed. At 10% down (your example numbers) I'd have 10k in the business and 90k debt. Lets just say we're using a 10 year amortization (typical amort schedule). Ha! More like 5 years tops conventional bank debt, 7 max SBA, but lets not quibble.
The SBA will loan up to 25 years for property and up to 10 years for working capital under the 7 (a) loan program. Those are the federal guidelines. SBA has monkeyed with their website to where the loan grid is not easy to find, but the guideline used to be 5 years tops for working capital, with a typical 7 year amortization for a WC/office equipment blend loan. The 25 years was for real estate. I know it was for real estate, hence the part where I wrote UP TO 25 YEARS FOR PROPERTY.
90k debt service at 6.25% (10 year Am schedule) = 1012 per month or 12144. I have 12k in the transaction (2% upfront fee not rolled in and 90% LTV). Assuming the business generates at least 36k per year in revenues (This business has no expenses? No problem, I'll let that slide) (which is quite low by the business plan) Which is an educated guess, as oposed to the monthly bank nut, which is set in stone. In my experience it is just as likely that you will experience negative cash flow, at least in the first couple of years. Comments at end of post.my IRR is still 27%. It pays to leverage up when your IRR is that much higher than the Cost of Funds. The NPV using those calculations assuming the required discount rate of 6.25% (the cost of funds) then the NPV of 90k at these rates is 85k.
So, As long as the loan is over 85k using these numbers it's SOUND BUSINESS FINANCE to lever up. Unitl you hit the real world. Say your wife leaves you for the cabana boy, or decides she doesn't want to do it anymore. Maybe the Feds cut reimbursement for OT. You have to remember, in this scenario, you are offsetting your loan with an essentially worthless asset. Comments at end/
The leverage risk just means your numbers you use has to have less wiggle room, not that the leverage itself presents more inherent challenge.