Debt should be secondary

Hello everyone, so let me ask you this: What kind of investments do you make in the current real estate market?  I am sure that most of you will tell me that your current investments are diversified and include things like single family homes (fix and flips or buy and holds) and multifamily buildings.  Well, this post is to show you how these types of investments (although a healthy portion of anyone's portfolio) are not as safe as you might think.

Let's begin by breaking down what a debt investment is.  First, you find an asset such as an apartment building.  You put in a portion of your own money (principal) and then you get a loan for the remainder (debt).  Let's say you have 80% financing and you put in 20% on a $1,000,000 building (to make it simple).  Your principal investment would be $200,000 right?  You are planning on making some cash flow and you are hoping that your building will appreciate so that you can sell it and make a big profit at the end while floating the loan using the cash flow for between 1-5 years.  Great, except for one problem, you are investing in a 2007 market.  We all remember 2007 and what happened shortly after.  Let's see if we can break this down even more.

In 2008 the market crashed and many people went under.  We all know what happened to the fix and flipper, but what happened to the apartment buyer?  Surely apartments were secure during the downturn; I mean, people have to live somewhere right?  Wrong! Although apartment buildings are secure and provide cheap and affordable housing, it is important to understand that even a secure asset like this can go under.  What happens when you go under? You lose your money.  Let's go back to our 2007 apartment building.

So you have put in $200,000 in 2007, purchased a building and now its 2008.  You are desperately trying to refinance the loan, but there is no way to do it.  Although you could probably try to pump more money into the asset, it just doesn't make sense because you are no longer cash flowing the way you used to.  Rent prices have decreased and you are upside-down on your loan.  The bank forecloses on your asset and your once sweet investment has turned bitter.  You lost your $200,000 and are now cursing certain real estate gurus for telling you that you were safe and sound.

Ok, so now we know what is dangerous about apartment buildings.  Does that mean that you shouldn't invest in apartment buildings?  No! It means that a truly diverse portfolio is about having some debt and some equity.  Debt should always be secondary and should be used sparingly.  If someone tells you that you should use debt as often as possible to build a huge portfolio then that person most likely stands in some way to gain from telling you those lies.

I hope that this short post was informative and please read more of my future posts to learn about different types of investments both on the debt and equity side of finance.  I am a major proponent of free and clear investing, but I also have experience in debt investments.  If you have any questions feel free to ask me via [email protected].

Dmitriy Chebotarev