Why real estate investors use debt!

Question

👉 Debt to buy assets is completely different from credit card debt (bad debt).

Leverage (when used correctly) is a powerful way to build wealth.

Here's how:

1. We buy an apartment complex.

2. The bank contributes 70%.

3. We keep 100% of the profits.

Sure, we still have to pay the mortgage and interest, but real estate investors don’t have to split the cash flow or profits with the bank.

This is the power of leverage.

We partner with the bank to buy a cash flowing business, and we get all of the upside.

Not a bad deal!

I'm taking on more debt in 2024! It sounds weird to say this, but it's true 😎

Are you using debt to build your real estate portfolio and create wealth?

Stuart Udis · Answer

Debt used to purchase real estate is a powerful tool. However, no differently than any other type of debt it must be used responsibly. There are a lot of investors who are bringing money to the table to refinance properties right now at rates that are 2 or 3 times the rates of the mortgages that are coming due. There are also plenty of investors who are getting crushed by pref equity which is effectively a form of debt given its senior position to the GP's equity that cannot be paid back due to the constrained financing market. It's important to point out the risks if not used responsibly.

Evan Polaski · Answer

@Justin G. and @V.G Jason

While I shouldn't enter this fray, what V.G Jason is saying is that in many deals in today's world they are in negative leverage.  If you bought a property in 2021 at a 4% cap using floating rate debt you are underwater today on leverage.

Fast forward to today's acquisitions: many truly class B institutional quality assets in good submarkets in major metros are still trading in the 5% range.  Interest rates are generally high 5s for strong borrowers and 7-8% for more entry syndicators.  In these deals you are going in with NEGATIVE LEVERAGE.  You may be cash flowing because you put 40% down, but you are diluting your equity returns in the short term HOPING to boost your property's unleveled yield above your interest rate to get into positive territory.

This is exactly what V.G Jason is saying.  There is a big difference between cash flow and positive leverage.  I can get cash flow by putting more money down, even if my interest rate is higher than my unleveled yield.

So again, you are both right.  Multifamily operators CAN make a profit.  But for many operators that bought on floating rate in 2020-2022, and even most buying today, they are HOPING to make a real profit, since they are buying at a 5% cap rate, borrowing at 6%, and relying on rent growth and/or appreciation to turn their unlevered yield above the interest cost.

This is the challenge with many syndicators: they never talk about unlevered yield.  I would bet many don't know what that is.  Most syndicators that is see on these forums and many that I see posting about financial independence on LinkedIn have no real real estate background.  I will put it another way: institutional capital spends more time focused on UNLEVERED returns versus leverage.  Why?  Because they know strong unlevered returns show strong management.  Levered returns can be easily manipulated and, while used, increase overall risk in the deal.

V.G Jason · Answer

3. After we collect revenue, we pay back the bank. Even if we don't collect revenue, we still pay back the bank.4. Because of #3 & other associated costs of managing the property, we don't really see profit but hope to soon.

That's how you meant to put it.

Alan F. · Answer

Shhhhh, careful that's not a popular strategy on BP. Lol

Carlos Ptriawan · Answer

With your post I would make sure I would never invest in you :-)

Bruce Woodruff · Answer

Thank you @Evan Polaski. Yes they are both correct....

Alan F. · Answer

Aww c'mon I want him to school you on debt lol.

Evan Polaski · Answer

@Justin G., debt makes sense when you have positive leverage.  Debt does NOT make sense when you don't.

Given many Class B multis are selling in the 5-6% cap rate range, and debt is often costing more than 5-6%, debt is hindering your results and you are relying entirely on appreciation to create a profit.  As we are seeing with many syndicators, this is a risk that might pay off and very well might not.

What would make a lot more sense, from a purely financial standpoint: buy ALL CASH, execute value add plan to drive unleveled yield over interest rate, then refi out as much as possible.  Now you are in a positive leverage play throughout deal.

But yes, leverage can be powerful when used appropriately, but leverage in any situation adds risk to a deal.  That is the ONLY reason it can boost returns.  Econ 101: there is no such thing as a free lunch.

Carlos Ptriawan · Answer

6 self owned mortgage with 30YFRM is extremely different with 6 syndication 70%LTV 5 years IO debt based on SOFR.Can't compare between the two. In fact I support fully very leveraged position in residential based mortgage because it's almost guaranteed winning.

Why real estate investors use debt!

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