Open any news website.  Headlines scream with companies going bankrupt, small businesses closing, even cities running out of cash from tax revenues dropping like a hot rock.  In every article, you’ll likely find a similar thread.  Tug on this thin thread and the whole business unravels:

“{insert business name here} is grappling with a heavy debt load and contemplating bankruptcy filing….”

The ancient principle of Leverage is reintroduced and borrowers are re-learning about Leverage’s evil twin brother:  Risk.

Leverage is easily illustrated by the nutcracker at the top of this post.  With Leverage, you can do things that manual strength, or “natural” strength, cannot accomplish.  You can crack open walnuts easily.  But put too much leverage in place, and you get crumbs instead of nice nuts to enjoy with your evening libation.  And you have a mess to clean up, too.

In other words, when you borrow money for your business it can perform at higher levels than the natural resources of the business provide through operational cash flows.  Here is the math equation:

DEBT equals LEVERAGE and LEVERAGE equals RISK

As the equation proves, it is impossible for a business to borrow money (in order to increase their leverage) without increasing risk to the business.

Nothing earth shattering here, right? Here’s how it applies to rental properties and how Landlords might consider new metrics for their operations:

  1. Larger Down Payments–Instead of 20% down payments when purchasing rentals, consider a 25% down payment.  The extra 5% will allow you to skip escrow for property taxes and insurance, allowing you to control your cash flows and pay those at your whim instead of mandatory monthly payments.  The extra 5% cushion on LTV/Equity position will also give you a cushion should you need to exit the property quickly and unexpectedly.
  2. New Minimum Emergency Fund Levels Per Property–The “old standard” used to include Landlords plugging in a month of vacancy expense into their proforma each year.  This means they can expect 11 months of net cash flows into their wallets.  Solid returns when done correctly.  However, given the “new standard” for eviction moratoriums established under the CARE ACT and local Governor’s 120 day moratoriums on evictions, I would expect that this new legal standard might be resurrected the next time we have a ‘crisis’.  So, consider establishing a new minimum of emergency funds you set aside for each property.
    1. Perhaps 4 months should be the new norm?
    2. Perhaps 6 months?
    3. Your fund level depends on many factors, most of all how much stomach acid you can handle the next time we hit a ‘crisis’ and contractual agreements get overridden by elected officials.
  3. HELOC’s for new acquisitions–borrowing money from your primary residence equity to fund a rental property is a bad idea.  This is the ultimate gambler’s throw of the dice.  It jeopardizes your home base.  If this is your last resort, reconsider owning rental properties as your operation is simply under capitalized and you may find yourself one of the upcoming statistics on landlords going bankrupt.

As always, if Polaris Property Management can assist you in the rental market, we’re here.  Just like the North Star in the night sky, we remain firmly in place to help guide you.

Until next week, here’s to your Financial Freedom!

Dan Baldini