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Real Estate Debt – The Debt Worth Having

by Leon Yang on February 16, 2013 · 34 comments

  
Real Estate Debt

I used to think wealthy people do not have debt. If they have so much, why would they ever borrow from anybody? However, the more time I spent working in the real estate business and reading about successful business people, the more I realized debt was one of the more crucial tools to generating wealth.

What makes debt so amazing is that it allows you to take action where normally you would not be able to afford. It is through debt that people and companies like Michael Dell and Blackstone are able to own companies several times over their wealth. Entrepreneurs like Richard Branson could not have been a billionaire today if he was not able to finance his business’ expansion (as a matter of fact, one of Branson’s biggest grudge was on a bank that all of a sudden stopped financing him and nearly forced him to stop his business). Lastly, it is through real estate debt that many people, whether they be a teacher, a restaurant worker, or an immigrant who cannot speak English well, to reach financial freedom and security.

All of those above could reach their goals because they used debt as a way to “lever” their strategy. They knew how to utilize their energy and own capital, but with those alone it was not enough. It is as if Sisyphus, the king in Greek mythology who was punished by being forced to roll an immense boulder up a hill only to watch it roll back down, suddenly was able to borrow the strength of five other men, and thus had enough strength to roll the boulder off the hill. The same concept applies to taking a multi-billion company private, financing record store expansion, and buying a $200,000 house.

Why This is the Best Time to Borrow in Real Estate

Today is one of the best times to have debt. Debt has never been so cheap before. In the early 1980s, mortgage rates touched the highs of 18 and 19 percent, rates that would make a credit card company blush! Look at the interest rates that pasted on the glass of banks today and you’d realize how cheap debt has become today. Let’s just see what it would cost to finance a $200,000 house today compared to the 1980s with a 20% down, 30 year fixed mortgage:

At 19%, the monthly payment principal plus interest equals: $2,542
At 4%, the monthly payment principal plus interest equals: $764

Over 30 years, that’s approximately $640,000 more in interest you have to pay in the 1980s compared to now.

With such low cost of debt and the depressed market, you can purchase more real estate than you could have been able to in the past and be able to service the debt much easier as well. With the type of payments you are paying you can easily rent the house and have the tenants cover your payment. It is much easier to borrow and purchase 10 houses today than ever before.

Additionally, real estate is a great hedge for inflation. With the current loose monetary policies enacted by the Federal Reserve, we could be looking at some intense inflation in the medium term. Thankfully, inflation is actually a debtor’s best friend. As inflation continues to devalue money, it also devalues the value of your debt. So if inflation was at 100% and the house’s value inflated from $200,000 to $400,000, you still owe $160,000. That means the monetary value of your debt just went down by 50%! So as a result, holding real estate is not only a good protection for inflation, but has the potential to discount your debt.

With Great Debt Comes Great Responsibility

While debt is good to have right now, not all debts are good. Credit cards? Bad. Car loans? Bad. You should not have debt that does not earn you any money (for your own house, it is the opportunity cost of renting that you are earning). Do what you can to avoid that kind of debt.

A real estate investor also needs to watch his/her own real estate debt like a hawk. Unlike tenants who can stop paying rent, you cannot stop making your monthly payments and simply find another place. You have to account for any dangers of vacancy. And as you continue to build your real estate assets by taking on more debt, you have to be careful that you can handle the monthly payments even if something catastrophic occurs. For instance, if you borrowed 10 houses, can you still make the payment if 5 of your tenants suddenly decided to stop paying? So be sure that you either have large cash reserve or you do not take too much risk. Even if on each leverage deal you are cash flow positive, you are adding on risk every time you buy an additional house. So be careful not to grow too fast. Take your time. Real estate is a game that is long, but ultimately rewarding.

What is your opinion on debt? The same as mine? Let me know in the comments below.
Photo: chedder

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{ 33 comments… read them below or add one }

Karen Rittenhouse February 16, 2013 at 10:07 am

For the first 2-3 years of investing full time, my husband and I argued constantly about the term “good debt.” To me it was just wrong, an oxymoron, made no sense. Debt was never good.

And, Donald Trump. Self-made billionaire (?) brought to his knees when the banks called their loans. So, even his “wealth” was on paper, not in his pocket.

Today, years later, I get it. We have leveraged properties and partnerships where we pay interest to use that ever glorious OPM (other people’s money). Without leverage, we would have maybe 1/10 the net worth we’ve been able to accumulate.

As you said, Leon, caution – always caution. Even Donald Trump was not too big to fail.

Thanks for your article.

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Jeff Brown February 16, 2013 at 2:12 pm

Hey Karen — What The Donald learned the first time around was to insist that next time, nothing but non-recourse debt for him. Given the huge size of his projects, that has indeed made the difference for him, the second time around.

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Marian June 24, 2013 at 7:09 am

Hi Jeff,
I have a non-recourse property from my self directed IRA. having hard time to refinance it from few selected non-recourse loan bank.
Any advice or route to refinance the property I have so I could buy and flip again?
I am stuck and frustrated with this non-recourse investment. Please help.

Marian – NC State

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kris June 24, 2013 at 8:52 am

Get an attorney to re-negotiate the loan. we are doing that , and using reserve funds from the account, and have 25 TIC’S owners. Good luck.

Karen Rittenhouse June 24, 2013 at 8:57 am

Hi Marian:

I believe you will need to find another IRA owner or a private money lender to refinance this loan.

Check with your IRA broker.

Jeff Brown June 24, 2013 at 9:56 am

Hey Marian — I’m pretty much with Karen on this one. If you haven’t tried NASB, North American Savings Bank, they might do it.

Leon Yang February 17, 2013 at 8:39 am

Thanks Karen! Yes I think many people naturally tend to see debt as something to avoid when in fact it can do a lot of good. It takes a bit of time to get over that hump!

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Greg February 16, 2013 at 11:48 am

Leon,

You knocked it out of the park. It has taken me a couple years to drop my hate of all debt. I had a couple chances where I could have blown a lot capital in the name of mortgage elimination. But it didn’t work out, only in my favor to buy top notch real estate last year.

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Leon Yang February 17, 2013 at 8:40 am

Thanks Greg! I am glad to hear that you were able to get some great real estate deals instead! Keep it up!

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kris February 16, 2013 at 7:46 pm

Agree 100% with you. Debt is good as long as $ comes to you after mortgage payments.

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Leon Yang February 17, 2013 at 8:41 am

Thanks Kris! Just remember, the more you have, the more you have to be careful, even if money seems to come consistently every month after mortgage payments.

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jerome February 17, 2013 at 7:14 am

This is the perfect description of what I want to say to my friends when they ask about why would want to get into real estate if I am going to be paying a mortgage? Me being new to the field I sometimes just can’t relay properly what’s inside my head. By the way, I am very interested in the las vegas market, would you have any time to give me a little insight?

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Karen Rittenhouse February 17, 2013 at 7:32 am

Jerome:
Be sure to tell them, you won’t be paying the mortgage, your tenant will.

Sweet!

And welcome to real estate investing.

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Leon Yang February 17, 2013 at 8:43 am

Sure Jerome! I would say the Vegas market has been a bit challenging as of late. The AB284 legislation has really shut down the availability of inventories so it becomes more challenging to buy properties. It is not impossible, but it gets harder and you have to be more imaginative. I would always recommend looking at your local market first as managing locally is always a lot easier!

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Brian Levredge February 17, 2013 at 12:22 pm

I think having non recourse debt, as Jeff touched on, is the real key. I see a lot of talk from RE investors about inflation, but hardly any about deflation, which are really both two sides of the same coin. How many RE investors can stay liquid if there is a 30-40% drop in market rents, which already happened recently in some markets? Even if you stay full, one could very easily be cash flow negative for years in that type of environment.

Even a highly inflationary environment is no guarantee that your “good” debt will be eliminated or paid off with worthless dollars. When Argentina devalued its currency by 75% or so awhile back, one of the only things that wasn’t devalued were mortgage contracts. If we have a big breakdown in the currency here, I would not expect the rule of law to hold up either. Caveat emptor.

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Leon Yang February 18, 2013 at 6:04 pm

Brian you definitely have some good points. I do have a couple of questions. Where have you seen rents dropping 30-40%? I’d be quite intrigued as to why that is happening. And I’m definitely interested to learn more about what happened in Argentina.

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Brian Levredge February 18, 2013 at 6:17 pm

Over the course of about 18 months, starting 2009, we saw rents drop by about 30% on some properties in Long Beach, CA, and further inland. This wasn’t a market wide occurrence per se, but on a more of a building by building basis. It was especially prevalent in buildings that had units that were somewhat dated. In order to get rents back up, significant capital expenditures were required in order to be competitive. I’d also add vacancies on 2 beds shot up as people either downsized or moved back home. Some areas of Vegas were hit especially hard as I had buddies that were getting $1200/mth for condos that now rent for less than half that price. Suffice it to say, my friends don’t own those condos anymore.

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chris February 17, 2013 at 3:13 pm

This is a good article helps to explain what Karen was talking about in the second podcast. Hers is one of my favorite ones. Very basic and informative.

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Karen Rittenhouse February 17, 2013 at 4:17 pm

Thanks, Chris!

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Mitch Mauer February 17, 2013 at 4:54 pm

Thanks for the article. Debt in Real Estate is a topic I have mixed emotions on. I understand the math and theories behind using leverage to gain wealth, but it’s hard for me to ignore the risks involved with borrowing money, and the possibilities of accumulating wealth when you have no payments!

My wife and I are in our mid-twenties and have high aspirations of becoming successful real estate investors. After we landed our full-time jobs fresh out of college, we decided to work our butts off to get rid of the tens of thousands of dollars we had in student loan debt and a car payment (“bad debt”). After being debt-free for almost a year, I can honestly say we are wealthier and sleep better at night because we have no debt.

On the other hand, I realize it would take too long to get our real estate investing started if we want to do it all in cash. Our plan is to buy or first property (most likely a live-in flip) with 20% down and a 15-year fixed. Although we plan to use leverage on our first couple properties, we hope to eventually own our primary residence out right and continue our investments in cash. To have absolutely no payments and save/invest all the money we earn seems to be the ultimate way to build wealth.

One concern I have with our plan, is the FICO score. Most traditional lenders require a high credit score to get a mortgage. When you have no debt (never had a credit card and never will) you eventually have a “zero” credit score. I’m hoping to find a lender who practices manual underwriting and will take other important factors (salary, cash reserves, rent history, etc.) into consideration during the loan application.

Has anyone been able to obtain a mortgage at a fair rate with no credit score? What are your thoughts on this conservative approach to real estate investing?

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Jordan Amarant February 18, 2013 at 9:22 am

With no credit score no traditional bank will lend to you.. You will have to find the money elsewhere, private lenders etc..Unfortunately you have to play the game as it designed and part of that is having great credit… If you had student loans and other bad debt then u for sure have some type of a credit score and as long as you weren’t late in any of those payments your score is probably decent. A few things my wife and I did to boost out scores over 750 was finance new furniture at 0% for 2 years and pay it off in 1 year or we also put all of our gas purchases on a cash back rewards Amex card and then pay it off every month religiously. It costs us zero dollars in interest, we get a check back for over $500 every year, we can see exactly what we spend on gas, and it dramatically boosts your credit score! As long as you can be disciplined you can learn to make credit cards work to your advantage. Also when flipping homes we only use credit at Home Depot and lowes to pay for materials and again stay disciplined with timely payments. For me the main benefit to this is all my purchases are tracked and categorized for me online as well as earn me extra discounts at the stores. Right now it sounds as if you are operating out of fear, change your mind frame and understand that credit can be a great tool especially to get low interest rate loans.

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Greg February 18, 2013 at 8:54 pm

Don’t credit card balance charged typical incur s percentage fee? I don’t though moving balances around is free.

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Leon Yang February 18, 2013 at 6:07 pm

Thanks Mitch! I think how leveraged you are depends on your comfort level. It all depends. And yes it is possible to borrow money with no credit… It is just not with banks. I have borrowed quite a few homes from sellers who have never checked my credit.

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kyle hipp February 18, 2013 at 8:04 pm

Mitch, yes you can purchase an owner occupy home without a credit score. If I were you I would contact ChurchHill mortgage. They do manual underwriting and you would be able to qualify with good income, steady payments on utilites or other monthly expenses, as well as a steady job.

However if you are going to finance you investment properties you might as well start utilizing credit once you purchase your home with manual underwriting. This is because once you obtain a mortgage you will have a credit score and then in order to get more credit you will need to maintain a strong score. I would wait until you purchase your first home with manual underwriting until you apply for otger credit in an attempt to build your score. Good luck.

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rj February 17, 2013 at 9:46 pm

Thanks for the article.
I have 3 houses and a duplex since 2003.
$380,000 in debt and a combined monthly mortgage payment of $2,800.
You mentioned vacancies as a risk.
Very real as a unit can go empty for 6 months under conditions.
But was also needs to be emphasized is expenses.
You can get hit with a $10,000 sewage line repair, a $6,000 roof repair, a $1,600 appliances replacement, anytime, over time…
If you want to own income property, you better have a savings account…

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Leon Yang February 18, 2013 at 6:08 pm

Thanks rj! You have a great point I missed. Maintenance can be quite a nightmare as well and I do hope as people manage their monthly cash flow they have set aside some money for maintenance. The higher reserve helps a lot.

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John February 18, 2013 at 9:37 am

Leverage and debt is key to building wealth faster. Most of my mortgage debt is “recourse,” but I don’t care, every deal is used debt to buy is cash-flowing, and this debt/leverage is working in my favor. And, sorry Brian, deflation is pretty unlikely, and would be hard to protect against in any event. Plus, if deflation did ever reappear long-term, we’d have bigger problems to worry about. It would mean that capitalists no longer can control capitalism, which would be the end of much of life as we know it.

One thing I still use as working capital is credit card advances. I still owe $200k or so on them. I only use the 0 or low % ones (when rates go up after a year or so, I pay it off and/or shuffle the balances to the next 0% offer), and never take more than 50% of available balance on a personal card (can hurt credit scores) or 90% on a business card. Be careful of Capital One’s “business” cards, they all report to personal credit, and are really personal cards with a business name on them.

Using CC debt this way sounds risky but carefully managed, it can provide a bit of working capital and rehab $, and it’s way easier to get than bank loans. Just be sure you have a plan in place to pay it back from cash flow!

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Brian Levredge February 18, 2013 at 12:10 pm

John, deflation is not something that should be simply ignored as it is something that can be planned for. A property with no encumbrances is much better prepared for deflation than one without and has the ability to lower its rents even more while still cash flowing, albeit at a lower rate. I would also add that deflation in and of itself is not a bad thing either. It is a normal part of the cycle whereby malinvestments can be cleared out at lower prices. What the Fed is doing right now is blowing another bubble, which doesn’t really give the market a real chance to clear out all the prior bad debts from the earlier bubble.

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Brian Levredge February 18, 2013 at 12:12 pm

Meant to say “than one with them.”

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Leon Yang February 18, 2013 at 6:10 pm

Smart move John! That’s a great tip and can be quite useful as an additional reserve against vacancies and maintenance expenditures.

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John February 18, 2013 at 12:46 pm

“Deflation” is an economy-wide phenomenon that doesn’t happen often. If you mean drops in real estate values, as happened recently, I agree with you, don’t OVER-leverage. That’s true in any business, or any investment. Always leave yourself some wiggle room, then add some more.

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kyle hipp February 18, 2013 at 8:22 pm

When we really study monetary policy, it is evident that the US as much of the developed economies have been fighting “deflation” with inflation not being an immediate risk. If you look at the makeup of US inflation numbers you will see that roughly 40% is made up of rental rates of all properties. This large metric in the inflation formula is on rental rates of each properties regardless if it is owner occupied or even paid off. Thus if housing demand increases with the policies and interest rates in place, rental prices will feel large downward pressure as more will own. If this doesn’t translate into increased consumer spending to counteract it will lead quickly to a disinflationary envirionment with the disticnt possibility of a deflationary trend.

Also many government actions could lead us down this path especially with many folks believing that the federal government could possibly go bankrupt or run out of money. At the end of the day, Deflationary forces must be understood and properly accounted for as in all reality that is a much greater risk than inflation using all the data that is available…. Good topic.

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John McCombs February 20, 2013 at 10:44 pm

Responsibility, yes, responsibility does go hand in hand with debt. Thank you for your emphasis on this. There is a risk in real estate investment. And responsibility.

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