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Real Estate Debt: A Useful Tool or the Devil’s Pitchfork?

Jeff Brown
5 min read
Real Estate Debt: A Useful Tool or the Devil’s Pitchfork?

Earlier this week I was invited to view an ongoing forum discussion concerning debt. In a nutshell, there seemed to be the completely AntiDebt group on one side, the Other People’s Money group on the other, and the majority of America in the middle. 🙂

Those against borrowing seemed to equate debt to signing up for Satan’s latest seminar. Those on the other end seemed to think it was downright sinful to ever use/risk one’s own cash. It was an interesting discussion to say the least. Here’s what I said in the thread:

I’m sorry, and don’t mean to sound harsh or unkind, but this discussion is a whole bunch about not much. Free enterprise capitalism is just that, the freedom to make wise choices in the marketplace. The acquisition of real estate using debt can be done wisely, with solid timing, using fundamental principles. It can also be abused by the DIY crowd who’ve provided comic/tragic relief for generations.

The opposite extremes in this debate are 1) Never buy real estate using debt. 2) Buy all your real estate with none of your own money. They’re both relatively ineffective when compared to investors applying known principles, with wisdom.

I’ll end with this observation. Those buying with all their own cash as the sole method of acquisition will do fine. Those using 100% financing will, for the most part, be financially demolished, with few, albeit loud and visible exceptions. However, those using all the basic fundamentals properly, including reasonable debt, will slaughter both of these approaches every time out.

That last sentence shoulda read, virtually every time out. Also, keep in mind that the context is long term.

Speaking only for myself, in the last four decades I’ve either personally met or spoken with 4-5 investors who’ve made a long term career of real estate investing, using the 100% financing model consistently. To say they’re the exception to the rule is to invoke British understatement. Every single exception I’ve verified myself was, at the very least, brilliant. They spent countless hours pouring over every possible detail you can imagine. They turned down dozens of potential transactions in order to find what they tend to call the perfect deal. It takes tenacity, an attention to detail, and Job-like patience. It also takes massive multiple skill sets, including solidly superior analytical talent. Remember, I’m talking about long term investing, not wholesaling, or flipping and the like. This is buy and hold stuff. It’s their future.

Debt is a Tool. 

Using debt as part of your long term investment strategies, model if you will, allows the investor to make use of leverage. However, before we all start singing the LeverageClub fight song, I’m not referring to down payment size. I’m referring to the primary definition.

Leverage: The ability to acquire an asset, using borrowed funds, where the asset’s return is greater than the interest cost of the borrowed funds. 

Put as an illustration, let’s look at two real estate investors buying the same type of property.

1. Mary puts nothing down on a rental property, borrowing the entire purchase price at 10% interest. Her investment yielded 14% during the 10 years she held it.

2. John put 50% down on a similar type rental property at 6% interest for the borrowed money. His yield was 3% for the time he owned it. 

Who had better ‘leverage’?

The obvious answer is Mary. She used borrowed money at 10% in order to acquire an asset yielding 14%, a clear win. John, on the other hand, did the opposite. Nobody borrows money at X% interest for the pleasure of a yield lower than X%, right? Notice how down payment had zip, zero, nada, bupkis to do with anything.

And there it is.

That very little illustration shows that borrowed money is nothing if not just another tool in the real estate investor’s toolbox. Debt, as a generic topic in the arena of real estate investing is a non-issue. That is, ’til it’s treated as if it’s God sent or the Devil’s revenge in and of itself. I’d put it in the same category of the debate about whether or not single family homes are better or worse than 2-4 unit properties. In what setting? Where in the country? Old or new? One bedrooms or family size? See? Almost every factor involved in long term real estate investing must be considered in the full context in which it’s being implemented — or avoided.

Down Payment vs. Cash

Let’s look at how ‘down payment’ leverage works vs buying for cash.

Again, I realize this is elementary, but so many go outa there way to ignore this elephant, it’s worth the short discussion. Don’t EVER assume appreciation in either value or income. But if we’re lucky enough to benefit from appreciation in value, those utilizing debt with care and prudence will outperform the debt free investors anywhere from 2-1 to 5-1 in both net worth AND cash flow at retirement.

No need to dwell on it. Pay cash for a $100k property. It goes up 10% and you just made 10% on your capital. Put 20-25% down on it, and with the same 10% value increase your capital grows by 40-50%. Fifth grade math, right?

But let’s talk about capital growth and cash flow with debt and NO appreciation.

Let’s take the same $100k and compare John and Mary again. John buys a rental for $100k cash. Mary takes the same $100k and buys four of the same rentals with 25% down on each of ’em. They never go up a dime in value. However, Mary takes her cash flow, along with any other available expendable income and begins to pay down her four loans like a possessed banshee. (Like a Possessed Banshee — the name of my new band.)  Meanwhile, John begins saving his cash flow along with his ordinary savings so he can buy another one for cash.

Question for John: If it takes him roughly eight years to save up another $100k, how much real estate will that get him? Don’t answer, cuz it’s a trick question. Nobody knows the answer to that. ‘Course, that’s assuming John can save $12k a year for eight years. Some can, some can’t.

Meanwhile, back at SatanicDebt Ranch (Now THAT’s the name of my new band. 🙂 ), Mary has paid off all of her loans in about a decade. It might take longer, but even at 15 years she’s ahead. The net worth of her real estate investment portfolio is $400k. Her cash flow and net worth is 2-4 times John’s, depending on whether or not John managed to buy another property or not. Since she’s not debt averse, and now just 45 years old or so, she has multiple options to increase her future net worth and cash flow.

She can exchange or simply sell her debt free portfolio, acquiring roughly $1.6 million in property. She then has one to two decades to retire those loans using the same pay down methods as before. Let’s assume the longer chronology. She arrives at retirement owning roughly 4-8 times the debt free property John does. The same relationship applies to their relative cash flows and net worth.

The real question might be, ‘Would you rather be John or Mary?’

This is not in any way an indictment of the financial ideology of debt avoidance. If John was able to save and acquire four homes for $100k apiece in say 35 years, heck, even half a dozen, he’d be doin’ fine. Using the 50% rule at $1k/mo. rent, he’d have a tidy $3k/mo in supplemental income at retirement.

But if I were John, I’d consider dating Mary in their latter years. Using the same formula, she’d be retired on an income of roughly $8k monthly. That’s not what most folks consider ‘supplemental’. She used prudent leverage in the truest sense of the principle. She had skin in the game at every turn. She took what the market gave her, when it gave it to her, without forcing anything. She wasn’t greedy. She was in fact very careful.

Debt is much akin to gravity. It is what it is and will do what it does regardless of what we’d prefer. We can use it to our benefit, or challenge it to our ruin.

What do you think?

Photo: Sam Jones

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.