How not to lose everything if using debt

4 Replies

You hear stories like Dave Ramsey’s, $4 million worth in real estate with only a net worth of $1 million. At 26 he had it all but then lost it all. Using other people’s money is obviously key when there is no capital at hand, but how much is too much debt? When do you have to worry that your whole life is resting in a banker’s hands (even if you have a really great relationship with them currently)? How do you avoid & make the shift into a more secure financial freedom through real estate investing?

Originally posted by @Noah Kellar :

You hear stories like Dave Ramsey’s, $4 million worth in real estate with only a net worth of $1 million. At 26 he had it all but then lost it all. Using other people’s money is obviously key when there is no capital at hand, but how much is too much debt? When do you have to worry that your whole life is resting in a banker’s hands (even if you have a really great relationship with them currently)? How do you avoid & make the shift into a more secure financial freedom through real estate investing?

It isn't the debt that got Ramsey, it was the lack of cash flow. He didn't have enough coming in to service the debt.

Live below your means - I think he says something like: "Live like nobody else now so you can Live like nobody else later". Pour your money into solid investments early in life so you can live off the spread later.

 

There is smart investment leverage and dumb debt. You know the difference. Ramsey is good for those with no financial acumen.  He has a schtick to maintain to keep his followers. 

@Noah Kellar I’ve done a lot of research on Dave Ramsey’s downfall because I had the same questions about the risk of debt. If he lost everything using debt, I could loose everything using debt! But that’s just not the case. First of all he was flipping houses using short term debt (like a few months) kind of like bridge loans or hard money, which need to be paid off quickly or refinanced after (or during) the flipping process. He got this debt through a local bank, which was acquired by a larger bank, which wanted to reduce their exposure to these types of loans. As a result they wouldn’t continue to extend his terms/refinance his loans even though he was in the middle of multiple projects. My understanding is he was actually current on all his payments, they just turned off the faucet and called the notes due all at once.

The risk of debt is determined by the terms. Given the right terms I’d borrow $100’s of millions with no down payment if I could! What if it was interest free? What if payments were deferred for 100 years? I’d have zero risk.

Anyway the type of debt I get is long term (30 years) with a fixed interest rate on rental property that not only pays the mortgage, but provides healthy cashflow (double digit cash on cash return). I also have 6+ months of reserves so I can make the payment on the loans for a long time. If you have fixed interest, long term debt, on cash flowing property that has homeowners insurance, AND have reserves to pay it on your own, there’s (almost) no risk. What else could go wrong?

@Kade Lucero - hit it out of the park with his reply. 

I have the opportunity to look at commercial deals from time to time. Debt Service Coverage Ratios (DSCR) are closely watched. If for example a property generates $50,000/month of net cash flow and the debt service (loan payments) total $25,000 then the DSCR is 2.0. Generally, 2.0 or above is considered a conservatively safe place to be.

Loan to Value (LTV) is another component. Some conservative investors I know will not invest capital into a deal with a LTV ratio higher than 65%. Faced with a greater chance of a market downturn or other risk factors in play, that number may go down.