What is the "right amount" of real estate?
For most investors, this isn't an issue. A family home or perhaps a second smaller vacation home are all the real estate that needs to be considered. This is as simple as making sure the mortgages are paid and financed at a decent rate.
However, for those who own real estate as an income source, the question quickly arises. What amount of investment real estate is correct? Today's environment provides ample liquidity. Banks and alternate lenders will loan huge sums at very attractive rates to real estate investors. It's important not to overextend ourselves as we approach what is undoubtedly a very volatile market.
What is debt to equity?
A general measurement is a debt/equity measure. Companies use this to determine exactly how big their debt load is. Investors can do the same by simply adding up all of your liabilities (mortgage, auto loans, personal loans, etc) and dividing by the amount of equity (home value minus mortgage, auto value, cash, investments, etc.). D/E values can range from 0 (no debt) to 3+ (very high debt). An example is below.
Debt
Mortgage - $200,000
2nd property mortgage - $100,000
Auto Loan - $16,000
Student Loans - $20,000
Total debt - $336,000
Equity
Home - $100,000
2nd property - $50,000
Auto - $20,000
Total equity - $170,000
D/E calculation
$336,000 / $170,000 = 1.976
The D/E of 1.976 is high and should be considered before taking on any additional debt (buying another rental property). For example, let's examine this situation two years later (numbers below). The debts have been reduced due to additional payments, the equity in the properties has increased, and the family has been able to save some cash.
Debt
Mortgage - $190,000
2nd property mortgage - $95,000
Auto Loan - $6,000
Student Loans - $16,000
Total debt - $307,000
Equity
Home - $120,000
2nd property - $65,000
Auto - $16,000
Cash - $10,000
Total equity - $211,000
D/E calculation
$307,000 / $211,000 = 1.455
The debt / equity ratio was reduced from 1.976 to 1.455, a much lower and sustainable level of debt for the household. It is important that we identify the type of debt as well. Typically we are assuming that short term debt with high interest rates ( "bad debt") is entirely paid off before talking about buying additional rental properties or increasing our long term debt amount.
It is important to also do an estimate of your D/E after a large change like buying an additional real estate property. For our example above, let's assume an additional home was purchased as a rental property. They used their cash and some of the equity in another home as well as a $200,000 mortgage to buy the home. The debt increased by $200,000, but the equity remains the same (but will grow with mortgage payments/market valuation).
Total debt - $507,000 (financed $200,000 for the home)
Total equity - $211,000 (cash goes into home equity, no change)
D/E after home purchase = 2.4
This purchase may be stretching the families wealth too far, as the families equity is almost entirely dependent on the value of their now 3 homes. In the event of a market change (think 2008/2009) the D/E for this family could balloon to 5 or more. They would be unable to refinance in the event they couldn't make payments. See DTI below to evaluate the cash flows.
What is debt to income?
D/E can help you measure where you are as well as track how you're doing over time. It provides the long term picture of your household debt. Another measure which is used by your lenders is the debt / income ratio. This DTI is more common when applying for loans and can be an easy check to determine if your loan will go through. It's also a great way to identify if you are over leveraging your cash flows. The DTI is a shorter term view of your household debt. A high DTI indicates that a high amount of your monthly cash flow is going to servicing debts.
First, add up all of the monthly bills that include a balance behind them. This includes an existing mortgage/real estate costs, auto loans, signature loans, credit cards, and student loans. It does not include normal monthly bills like electricity, phone, and internet. An example is below.
Monthly debts
Mortgage - $1300
Auto loan - $300
Student loans - $100
Total = $1700
Monthly income = $6000
DTI = $1700 / $6000 = 28.3%
A DTI of 28.3% is considered on the high end, as most lenders look for a DTI below 30%. Some aggressive lenders will accept higher 40-50% DTI but also charge higher lending fees. It's important to also do the calculation of where you will be after an additional loan is taken. The below numbers assume an additional mortgage was taken at $1300/month and the additional property was rented at $1500/month.
Total debts = $3000
Total income = $7500
DTI = 40%
The 40% DTI is doable, and this real estate loan will likely go through. Keep in mind that this means that 40% of the families income will go right back to servicing their existing loans. In the event one of their properties goes without a tenant, this number will quickly rise and reduce the families spending power substantially.
Making the decision
When applying D/E and DTI to the decision to purchase/sell real estate, a judgement must be made. How much leverage is safe given the possible outcomes? Will a property go empty for months? Will interest rates change, affecting the housing market? What is the short term risk, the long term risk? It's best to get these numbers down on paper, or in a spreadsheet, and think of the before/after of your decision. Then, only when you're comfortable with the decision, take action.
