"Leverage: The Double-Edged Sword of Real Estate Investing"

You’ve probably heard the phrase “Live by the sword, die by the sword.” This common saying finds its origins in the Bible, specifically in Matthew 26:52, after Peter cuts off the ear of the servant of the High Priest. Jesus said, “Put your sword back in its place, for all who draw the sword will die by the sword.”

Today, however, this saying serves as a broader metaphor for the idea that the manner in which one chooses to live can dictate their fate.

So, what is the proverbial sword in the realm of real estate?

Leverage.

A sword can be a powerful tool in the hands of an experienced swordsman. Picture this: there's Sir Lancelot, master of the blade, slicing through problems with precision, leading his team with the poise of a true knight, and metaphorically pruning away the dead branches of inefficiency.

But now, imagine handing that same gleaming, sharp sword to a toddler. Not just any toddler, but one decked out in a tiny, oversized business suit, complete with a little tie that's longer than their legs. This little tycoon, let's call him "Little Leverage Larry," is now standing in the boardroom, sword in one hand, a stack of real estate deals in the other.

The point here is, leverage in real estate, like a sword in the hands of Little Leverage Larry, can lead to chaos if not handled with the maturity and expertise it demands. When toddlers in suits try to play in the big leagues of real estate with such a dangerous "toy," the results can be both comical and catastrophic. This is why leverage should be approached with the seriousness of a seasoned investor.

The goal of buying real estate is to keep the real estate, thereby almost ensuring long-term wealth. Here's the catch: the more debt on your property, the higher the risk of losing it. This scenario is now becoming painfully evident in the real estate syndication space. From 2020 to 2022 we saw an influx of new sponsors, or "real estate toddlers," pitching deals with projections based on unrealistic rent increases and artificially low exit cap rates. But real estate is always a great investment, right? What could possibly go wrong?

Many of these sponsors are now losing their properties, and investors are facing significant losses, even though the fundamentals of these deals were promising — great locations, high occupancy, and favorable demographic trends. So, what went wrong? Simply put, they miscalculated their debt strategy.

In real estate, there's a key metric known as the Debt Service Coverage Ratio (DSCR). Lenders typically look for a DSCR around 1.25 to ensure that the net income from the property can cover the debt. For example, if your loan payment is $1,000 per month, the lender would want to see at least $1,250 in net income to satisfy their DSCR requirement before issuing a loan.

However, many of these deals used short-term bridge loans with initial rates around 3-4%. When interest rates surged in 2022, these sponsors faced renewals at rates up to 2-3 times higher. Suddenly, their $1,250 net income wasn't enough to cover the new $3,000 loan payment, leading to capital calls and substantial losses.

So, how can you ensure your real estate investment doesn't meet the same fate? Here are three strategies we focus on at Missional Capital Group:

• Fixed Debt: Opt for long-term fixed-rate debt to eliminate the unpredictability of interest rates. At Missional, we ensure our debt strategy is viable for the entire lifespan of the investment, making any refinancing a bonus, not a necessity.

• Reasonable Leverage: Don't shy away from putting more equity into the deal. While high leverage might promise higher returns, it also increases risk. At Missional, we keep our Loan to Value (LTV) ratios around 50% to provide a cushion against various market shocks.

• Room for Rent Growth: With national rent averages around $2,000, and rents taking up a larger slice of income, we focus on markets where rents are below the national average. This strategy allows for sustainable rent increases over 7-10 years while maintaining ethical considerations for tenants, ensuring a healthy DSCR without aggressive rent hikes.

We recommend you consider this list as you vet and evaluate your syndication sponsor. And remember, the highest advertised IRR is rarely the best and most sound deal.  And when it comes to leverage - the key to wielding leverage effectively is not just in the strength of your swing, but in the wisdom of your strategy. Stick to fixed debt, keep leverage reasonable, and ensure room for rent growth, and you'll be more knight than toddler, securing your kingdom in the realm of real estate.