Real Estate Debt – The Debt Worth Having
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.
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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.