What Investors Should Consider Before Using Leverage to Build Their Real Estate Business
I have a lot of my customers ask me about leverage. Should they use it? How much should they use? My answer is always, "It depends." As a matter of fact, I think that is my answer to more than half the questions that are posed to me. I can't answer that question in a vacuum. There are too many variables to be able to answer that with any certainty. What I can do is tell you my position on having debt and the questions that you need to answer to be able to figure that out for yourself.
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I personally hate debt, which is ironic considering how much debt capital I use. I have both private money loans and bank loans. I find it a necessary evil at this point of my career. Maybe I rationalize it to myself, but to be a full time investor requires me to have a substantial amount of working capital to be at a scale that makes what I do possible.
Funding My Real Estate Projects
My current amount of cash on hand does not allow me to move at my current pace or allow me to keep up with the demand I have selling properties to other investors. So, I borrow short term private money to fill that gap, but my whole intention is to get to the point of self-funding.
I am a little bit more flexible in my view of certain bank debt. There is only one reason I have flexibility in taking on bank debt (and this certainly isn’t all bank debt)? The term. I have less issues with fixed rate fully amortizing debt on cash flowing properties. The only problem is, as a full time investor, it is very difficult to find, if you can at all.
Using Debt Wisely
So why do I hate debt? I hate it because you are a slave to it. No matter what happens, you need to make that payment. Rents didn’t come in? Too bad, you need to make that payment. You lost your job? Too bad, you need to make that payment. The more debt you take on, the bigger the burden of that payment. The bigger that burden, the greater the risk that everything you’ve built comes crashing down.
So, when I talk to an investor and they ask about debt, I ask them, “Why are you buying the property?” If you are buying the property because you want to be a full time real estate investor, that is different than if you want passive income. After knowing that answer, I ask them what their cash position is.
Finally, I ask what their experience level is. Typically, what I have found is that 40-50% of the people I talk to have no cash and want to be in real estate and have no experience. I find this to be the scary group. If you are comfortable risking mom or dad or sister or aunt or grandma’s money on something you have no clue about, that is a problem.
This means you’ll risk anyone’s money and you are a poor fiduciary. This is what I say to them: If you are looking to be in the real estate business, you may need to take on debt. It is ok, but always understand what your out is. Don’t get caught standing if the music stops. You may not be able to expand as quickly as you’d like, but you won’t have to worry as much about going broke.
If you don’t want to be in real estate and you are just looking for cash flow, take on as little debt as possible. Sure, it reduces your returns. But the reason you get greater returns is because you are taking more risk. You have to be selective on where you take your risk financially. Don’t open up yourself to unnecessary risks if you don’t have to.
Debt is just a tool. Overusing it can create big problems and big headaches for you. If you are going to use it, make sure you have cash on the sidelines to be able to afford debt payments if the unexpected happens. As for me, I can’t wait until the day that I don’t need to take on debt.
Investors: How much debt are YOU willing to take on?
Let’s talk in the comments section below.