A Controversial Look at Debt, Risk, and My Quest to Make $100,000 Through Leverage

In this article

BiggerPockets is many things to many people.  For instance, for Josh Dorkin it is an obsession (if asked he would tell you that at times – an unhealthy one, but that comes with the role of a CEO); for Brandon Turner it is fertile ground upon which to experiment the witchcraft of inbound marketing (think Dumbledor only the beard is not long and white – not yet).  And for someone who likes to educate (someone like me), BP is a source of never-ending topics to write about…

I noticed lately that one of the subjects that move people is Debt, more specifically “How Much Debt is Too Much” – ooooo…leverage…ooooo.  The following is an excerpt of an e-mail I received in response to the article I wrote for the BiggerPockets blog a few weeks ago entitled How I Bought a 10-Plex with 1.5% Down – Case Study:

That was a really good article. You placed a bet on the water, on the increase in rent, and on decrease in taxes. That’s risky, but the odds were/are in your favor.  Hope it turns out even better than you expected.One question I have is about accumulated debt.  How much is too much? What if things crumble?  What if there’s mass exodus and none are left to rent your units?Not sure you have the answer, but still figured I’d throw it out there…

WOW – does this give me good material to write about or what?!  Let’s take this one thing at a time…

Disclaimer:          I do not deal in the single-family market.  I buy exclusively apartment buildings because they provide much more diversification of income and expandability opportunities, included in which are options for forcing appreciation.  Also, since the value-setting mechanism in the commercial space is Capitalization as opposed to CMA which is used in SFR space, apartment buildings represent a much more stable and controllable value.

I generally don’t like to speak in hypothetical terms, so let me begin by giving you a status report on that 10-Plex that I originally wrote about.

Status Report on the 10 Plex

As of this writing, I’ve turned over 4 units out of 10.  Let’s look at the results:

Unit 1:   Before

• Rent was $575/month.
• Rent included water service, and since water runs about $15/month the true rent was $560/month.

Unit 1:   After

• Rent went to $685/month.
• Tenant pays me $20/month to keep the water service in my name, and since water runs $15/month, not only did I rid myself of the expense but I am making $5/month for the trouble.

Unit 1:   Net Positive

• $130/month – that’s $130/month of NOI that flows directly to the Cash Flow.

Unit 2: Before

• Rent was $575/month
• Same as in Unit 1, the rent included water service, and since water runs about $15/month the true rent was $560/month.

Unit 2:   After

• Rent went to $625/month.
• Tenant pays me $20/month to keep the water service in my name

Unit 2:   Net Positive

• $70/month

Unit 3: Before

• Rent was $595/month
• Rent also included water service, and since water runs about $15/month the true rent was $580/month.

Unit 3:   After

• Rent went to $625/month.
• Tenant pays me $20/month to keep the water service in my name.

Unit 3:   Net Positive

• $50/month

Unit 4: Before

• Rent was $595/month
• Rent also included water service, and since water runs about $15/month the true rent was $580/month.

Unit 4:   After

• Rent went to $675/month. (I replaced flooring)
• Tenant pays me $20/month to keep the water service in my name.

Unit 4:   Net Positive

• $100/month

Also, I did apply to lower the property taxes and succeeded.  Property taxes were lowered by about $1,425/year, which was slightly more than what I requested.  So, let’s tally these numbers up:

Gross Income Increase:                                                   $350

Operating Costs Savings (taxes):                                    $118

NOI Increase:                                                              $468

Cash Flow Increase:                                                  $468

Worth Mentioning…

As you can see, the smallest net rent increase including assignment of water expense has been $50/month.  Even if this bare minimum is all that I manage to achieve with the remaining 6 units, I will have surpassed my stated objective of $700/month of Expandability on this deal.  Quite likely, I will do better than that 🙂 .

What Does This Mean?

This increase in Gross Income, since it’s not accompanied by any increases in Operating Costs, will flow through directly to the NOI and Cash Flow.  Thus, having purchased a building with $1,000/month of Cash Flow ($100/door), I will be looking at $1,700+ of monthly CF ($170+/door)…I’ll take it!

Also, the additional Annual NOI of $8,400+ will justify an increase in value of $84,000 at 10% CAP, which happens to be the going rate for a building like this one in my town…I’ll take that too!  In fact, at the time of acquisition the NOI of the building stood at $3,406/moth, or $40,874 annually.  Having pushed that to $4,100/month, or $49,200 annually, I will have improved the valuation of the building to $492,000 at 10% CAP Rate.

I bought the thing for $373,500.  So, in another year and a half, I’ll be able to stick about $120,000 on my balance sheet, and $1,700+/month into my Income Statement…I WILL TAKE ALL OF THAT!!!

What About the “Risky Bets”

With all due respect – I fail to see the risk in the bets I placed.  I know my marketplace.  I know what things should rent for and I know what they should cost – don’t you?  I spotted an undermanaged asset and immediately knew that there was no legal, moral, or otherwise reason why the owner should continue to pay for the water service and why the apartments should continue to rent under market rent.

In principal there certainly is risk in trying to hike rents – all of the tenants could leave!  And some have…do you see me crying?  The essence of living life on our terms is positioning ourselves to only deal with those people whom we want to deal with.  Some have decided that my expectations for how this building should run are not to their taste – so?  It’s like I wrote in the article entitled Should You Tell the tenants you are the owner? – I am the owner – things will run a certain way – if you don’t like it, someone else would be happy to take your place…and they have.  Furthermore, I am not asking anyone to pay above that which is fare in my marketplace.  And the tenants have spoken…

Food for thought:               All of this is predicated on one simple fact – I know my marketplace, and I know the landlord/tenant law.  I know what things should rent for, and I know what the units have to look and feel like in order to deserve those rents.  I know what I am allowed to do, and what would be wrong to do.  Do you?

What is RISKY, is buying units without knowing EVERYTHING that there is to know about the marketplace and relying on a management company or a real estate agent to do it for you – NO! 

To mitigate risk you have to understand the demographics, the social trends, and the employment picture of a town, not just the numbers relative to the specific building.  It just kills me that people buy buildings half-way across the country having been there once – that’s stupid!

This particular 10-plex happens to be situated 10 minutes away from my house.  If it was 3 hours away, or in another state, I would not be buying it – it is not big enough to warrant me coming out every month…oh yeah – I will be THERE if I own a building either personally or as part of a conglomerate.  I will be there to study trends, to make contact with the political establishment, to introduce myself to tenants as THE OWNER, and to train managers…I WILL BE THERE!

It is my retirement!  If I wanted to outsource my retirement, I’d find a stock broker!

Am I Worried About the Debt?

There are a couple of different points to make here.  First of all, yes – of course I am worried, which is why I MANAGE THE ASSET MYSELF and I pick my deals very carefully to ensure strength from both the Cash Flow and Equity stand points.  Throughout the process that I just described, I am able to add to both substantially.

What this means is that if times turn very rough, I will bee able to come down on my rent very significantly and still break even long enough to hopefully ride out the storm.  Furthermore, having seasoned it for a bit, and having further improved the operations, I should have no trouble selling the building if need be at a very substantial discount to the capitalized value.

Look – it would be nice to own this thing free and clear yesterday.  Unfortunately for me, I wasn’t born with a silver spoon in my mouth and I have to leverage debt, and as long as I do, I have to protect myself with knowledge.  It’s not full-proof, but what is?

Final Point

I am of the opinion that if you must have debt, which is the case for most of us who did not inherit either money or business, that it is better to have $10 million than $100,000.  $100,000 of debt makes you a slave to the lender; $10 million makes you a partner.  If you loose the $10 million, the lender will also loose…

Now you tell me, would the lender be more willing to work with you over $100k or $10 mil?  I know this is a bit counterintuitive, but think about this…By the way, in case you are wondering, I’ve never been late on a mortgage payment in my life!

So – is what I am doing risky?

Leave your comments below!

Photo: Dan Simpson

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