Real Estate Debt: A Useful Tool or the Devil’s Pitchfork?

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Earlier this week I was invited to view an ongoing forum discussion concerning debt. In a nutshell, there seemed to be the completely AntiDebt group on one side, the Other People’s Money group on the other, and the majority of America in the middle. πŸ™‚

Those against borrowing seemed to equate debt to signing up for Satan’s latest seminar. Those on the other end seemed to think it was downright sinful to ever use/risk one’s own cash. It was an interesting discussion to say the least. Here’s what I said in the thread:

I’m sorry, and don’t mean to sound harsh or unkind, but this discussion is a whole bunch about not much. Free enterprise capitalism is just that, the freedom to make wise choices in the marketplace. The acquisition of real estate using debt can be done wisely, with solid timing, using fundamental principles. It can also be abused by the DIY crowd who’ve provided comic/tragic relief for generations.

The opposite extremes in this debate are 1) Never buy real estate using debt. 2) Buy all your real estate with none of your own money. They’re both relatively ineffective when compared to investors applying known principles, with wisdom.

I’ll end with this observation. Those buying with all their own cash as the sole method of acquisition will do fine. Those using 100% financing will, for the most part, be financially demolished, with few, albeit loud and visible exceptions. However, those using all the basic fundamentals properly, including reasonable debt, will slaughter both of these approaches every time out.

That last sentence shoulda read, virtually every time out. Also, keep in mind that the context is long term.

Speaking only for myself, in the last four decades I’ve either personally met or spoken with 4-5 investors who’ve made a long term career of real estate investing, using the 100% financing model consistently. To say they’re the exception to the rule is to invoke British understatement. Every single exception I’ve verified myself was, at the very least, brilliant. They spent countless hours pouring over every possible detail you can imagine. They turned down dozens of potential transactions in order to find what they tend to call the perfect deal. It takes tenacity, an attention to detail, and Job-like patience. It also takes massive multiple skill sets, including solidly superior analytical talent. Remember, I’m talking about long term investing, not wholesaling, or flipping and the like. This is buy and hold stuff. It’s their future.

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Debt is a Tool.Β 

Using debt as part of your long term investment strategies, model if you will, allows the investor to make use of leverage. However, before we all start singing the LeverageClub fight song, I’m not referring to down payment size. I’m referring to the primary definition.

Leverage: The ability to acquire an asset, using borrowed funds, where the asset’s return is greater than the interest cost of the borrowed funds.Β 

Put as an illustration, let’s look at two real estate investors buying the same type of property.

1. Mary puts nothing down on a rental property, borrowing the entire purchase price at 10% interest. Her investment yielded 14% during the 10 years she held it.

2. John put 50% down on a similar type rental property at 6% interest for the borrowed money. His yield was 3% for the time he owned it.Β 

Who had better ‘leverage’?

The obvious answer is Mary. She used borrowed money at 10% in order to acquire an asset yielding 14%, a clear win. John, on the other hand, did the opposite. Nobody borrows money at X% interest for the pleasure of a yield lower than X%, right? Notice how down payment had zip, zero, nada, bupkis to do with anything.

And there it is.

That very little illustration shows that borrowed money is nothing if not just another tool in the real estate investor’s toolbox. Debt, as a generic topic in the arena of real estate investing is a non-issue. That is, ’til it’s treated as if it’s God sent or the Devil’s revenge in and of itself. I’d put it in the same category of the debate about whether or not single family homes are better or worse than 2-4 unit properties. In what setting? Where in the country? Old or new? One bedrooms or family size? See? Almost every factor involved in long term real estate investing must be considered in the full context in which it’s being implemented β€” or avoided.

Down Payment vs. Cash

Let’s look at how ‘down payment’ leverage works vs buying for cash.

Again, I realize this is elementary, but so many go outa there way to ignore this elephant, it’s worth the short discussion. Don’t EVER assume appreciation in either value or income. But if we’re lucky enough to benefit from appreciation in value, those utilizing debt with care and prudence will outperform the debt free investors anywhere from 2-1 to 5-1 in both net worth AND cash flow at retirement.

No need to dwell on it. Pay cash for a $100k property. It goes up 10% and you just made 10% on your capital. Put 20-25% down on it, and with the same 10% value increase your capital grows by 40-50%. Fifth grade math, right?

But let’s talk about capital growth and cash flow with debt and NO appreciation.

Let’s take the same $100k and compare John and Mary again. John buys a rental for $100k cash. Mary takes the same $100k and buys four of the same rentals with 25% down on each of ’em. They never go up a dime in value. However, Mary takes her cash flow, along with any other available expendable income and begins to pay down her four loans like a possessed banshee. (Like a Possessed Banshee β€” the name of my new band.) Β Meanwhile, John begins saving his cash flow along with his ordinary savings so he can buy another one for cash.

Question for John: If it takes him roughly eight years to save up another $100k, how much real estate will that get him? Don’t answer, cuz it’s a trick question. Nobody knows the answer to that. ‘Course, that’s assuming John can save $12k a year for eight years. Some can, some can’t.

Meanwhile, back at SatanicDebt Ranch (Now THAT’s the name of my new band. πŸ™‚ ), Mary has paid off all of her loans in about a decade. It might take longer, but even at 15 years she’s ahead. The net worth of her real estate investment portfolio is $400k. Her cash flow and net worth is 2-4 times John’s, depending on whether or not John managed to buy another property or not. Since she’s not debt averse, and now just 45 years old or so, she has multiple options to increase her future net worth and cash flow.

She can exchange or simply sell her debt free portfolio, acquiring roughly $1.6 million in property. She then has one to two decades to retire those loans using the same pay down methods as before. Let’s assume the longer chronology. She arrives at retirement owning roughly 4-8 times the debt free property John does. The same relationship applies to their relative cash flows and net worth.

The real question might be, ‘Would you rather be John or Mary?’

This is not in any way an indictment of the financial ideology of debt avoidance. If John was able to save and acquire four homes for $100k apiece in say 35 years, heck, even half a dozen, he’d be doin’ fine. Using the 50% rule at $1k/mo. rent, he’d have a tidy $3k/mo in supplemental income at retirement.

But if I were John, I’d consider dating Mary in their latter years. Using the same formula, she’d be retired on an income of roughly $8k monthly. That’s not what most folks consider ‘supplemental’. She used prudent leverage in the truest sense of the principle. She had skin in the game at every turn. She took what the market gave her, when it gave it to her, without forcing anything. She wasn’t greedy. She was in fact very careful.

Debt is much akin to gravity. It is what it is and will do what it does regardless of what we’d prefer. We can use it to our benefit, or challenge it to our ruin.

What do you think?

Photo: Sam Jones

About Author

Jeff Brown

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.


  1. Good article Jeff!
    Now lets see if the back and forth bickering can be brought into the forum comments too. haha.

    My stance is clear. I love debt, it allows me to buy more properties and make more money. It is pretty simple to me. I don’t care where my debt comes from as long as my returns are higher than the interest rate I am paying.

    I also noticed something in your article that got me thinking. I am very analytical and I notice many people on the forums and even people who contact me want someone else to analyze their deals for them. Not just give a second opinion, but run the numbers and tell them if it is a good deal or not. In this business you have to be able to run the numbers to see if a deal makes sense. It doesn’t have to be a complicated fomula to get down tot he exact 1/10th of a percent, but investors need to know how to calculate ROI, cash on cash and other simple formulas.

  2. I can sum it up in by pointing to whoever invented the credit cards and mortgages. Aside from stretching the limits of capitalism (another discussion) without them and without all the debt big banks use and manipulate to their advantage, the banking industry would not be the leviathan it is today. Those who use debt and leverage strategically are fundamentally optimists, risk-takers, and/or are thinking large, Those who choose cash only are fundamentally pessimists, risk-averse, and/or are thinking small. There are virtues to both, obvously. But of the billionaires in this country, I would guess few if any (except those who inherited their money) made it to that list without the strategic use of leverage.

    • Since only 20% of millionaires inherited their wealth, I would consider that a majority.

      I kind of chuckle at certain radio hosts that decry all debt when it comes to real estate, instead suggesting we pour all our money into mutual funds. The people preaching this advice are NOT retiring on mutual funds but their own business equity.

  3. Cedric D'Hue on

    Thanks for the informative article Jeff,

    The downside risk is missing from the analysis of Mary. If anything like 2008 happens during the 10-15 years it will take Mary to pay off the four rental properties, Mary could end up with nothing, zip, zero, nada, no retirement income. John’s investment will pay off pretty much under any economic condition.

    I’m not risk adverse but risk cognizant. Budgets and plans rarely work out as smooth as this example.

  4. Jeff Brown

    Hey Cedric β€” Those real estate investors using the principles described in the post, including those implied, didn’t miss a beat in 2008. Did they experience delays in paying off their properties? Some did, some didn’t. I guess the ultimate reply to your comment about the downside of borrowing money is this. It’s called risk capital for a reason. The vast majority of RE investors choose to acquire reasonable debt as part of that risk.

    It’s almost always a matter of personal comfort zone, at least in my experience.

  5. Cedric D'Hue on

    Agreed. And you are a lot more experienced than I.

    Just keep in mind that a number of real estate investors lost everything in this last economic downturn and debt played a large role. To not factor in risk when assessing debt overinflates the benefits and minimizes the downside.

    • Jeff Brown

      Can’t say it any better than that, Cedric. Those folks were mostly the DIY crowd unaware of what they didn’t know. Those with skin in the game, well analyzed purchases, and either real expertise or access to it, came out just fine. All that said? Nobody with an IQ above room temperature would ever argue that paying all cash isn’t less risky than acquiring debt.

  6. Hi Jeff, very good article!

    One question, though, which has been bugging me for awhile. if someone were to follow what Mary is doing, when would you choose to get into “Banshee Mode” and start paying principal down?

    In the first example, Mary started after 4 units were purchased, but that’s not necessarily the best case. In the longer term, buying more leveraged rentals gives a better return, if all goes according to plan. So, blue-sky-case, you’d be purchasing places forever, accumulating umpteen mortgages in the process.

    But, after awhile, your debt-to-income goes up too and so does your risk. How do you determine the cutoff point, other than your friendly mortgage broker saying “No Money For You!”

    • I may not be Jeff, but in general, my approach is to:
      1) Buy what I can with the cash that I have, prudently leveraged. I own four units combined with two personal properties, putting me over the 4-loan limit, but not the 10-loan limit.
      2) Use the rents to payoff one loan at a time. If I run into extra money, throw it in there as well, unless it’s really enough to buy another unit
      3) When the market speaks, SELL! Then, releverage suitably. This is the time when I would debate pulling a little bit of cash out if I needed something, you know, like a new car debt free.
      4) Rinse and repeat until I’m approaching retirement. Then it’s time to shift to pure cash flow. Hopefully this combined with my EIUL and cash flowing stocks will be nicely lined up for a sweet retirement. I’ll send an invite to Jeff (who got me off the ground)!

      When it’s time to sell, I’ll pick up the phone to call Jeff and find out if a 1031 is the best approach, or if my CPA has banked me enough surplus depreciation to take the net proceeds tax free. But it sounds pretty simple, ehh?

    • Jeff Brown

      Hey Jason β€” Greg has the main points. Here’s the deal. Since we almost always know when we’d like to retire (sometimes different than when we’re able), and our own ability, along with property cash flow to pay off our combined investment property debt, we’re ahead of the game.

      In other words, it almost always comes down to sixth grade math. Total debt, time available, plus discipline equals free ‘n clear portfolio on about the time planned.

      You also made an excellent point about whether or not to pay of existing loans, or buy more property. The same simple math almost always answers that question. There are more ways to skin a cat than most know exist. The investor can use their properties as ‘piggy banks’ given enough time and discipline.

      • Do we necessarily care if the entire portfolio is paid off?

        Maybe my ideas here are not correct. My strategy has been pretty simple, just acquire as many good rentals as possible and once a good cashflow is coming in, everything should fall into place. Let’s say, cash-on-cash return from a leveraged SFH rental is $300. (I’m estimating here). I need, say, $5k / month to live on, but let’s say 6k to have some reserve each month. That’s 20 rentals. For risk mitigation, maybe keep rolling the stress-related-illness dice and work the day job for another few years. During this time, either pay some off or start buying all-cash if the lenders balk. (Hey, I paid good money for those mortgages, why pay off early?) Is this type of “partial” scenario something that I should even consider?

        On the other hand (and not to open another can of worms) because all of my extra cash is being put into new rentals, I’ll still have a mortgage on my primary residence. Decisions, decisions…

        • Jeff Brown

          You’re askin’ solid questions, Jason. The answers however, are complex, and different for you than your neighbor. Send me an email and I’ll address them.

  7. Instead of a pitch fork, a double edged sword is a better description. Although debt on the surface is a good thing, because of leverage, the sword cuts the other way by inflating the prices across the board. Which in turn causes one to need to go further into debt. Great for lenders, and they know and like the way things are.

    As a high school (1970’s) project we were asked to interview our grandparents about how they were effected during the Great Depression. On both sides there was no effect, my grandfather from my mother’s side was in the food business people have to eat, on my father’s side he (deceased) was the chaffer of Edward Stotesbury.

    My report quickly changed to why everyone else was impoverished during those times, number one reason personal and mortgage debt.
    In my grandfather’s time buying a house required a 50% down payment, the longest mortgage was 5 years, the interest rate was 10%.

    His first and last house was bought for cash ($5000) as he was a conservative German who thought personal debt was reckless.

    His house is still owned by the fellow he sold it to, before going into the old folks mansion.
    Today that house because of easy credit inflation, now would sell for $300,000. Same house buy much older so why the price increase? How about 30 years and 3% interest?

    The moral of the story if the SHTF in our future, not only might we not be able to pay our personal mortgage debt, but our tenants will most likely be in the same boat. Having a few free and clear properties will be superior to having many encumbered properties.

    Personally the rent is so much more enjoyable to collect from my free and clear properties then my mortgaged ones.

    • Jeff Brown

      Hey Dennis β€” The first strategy I advise investors to execute one debt is incurred, is to pay off that debt ASAP. Their are rare exceptions to this policy. But in your case, it’s clearly a matter of comfort zone, and your view of the future. You’re doing the right thing, given those realities.

    • Jeff Brown

      Hey Sharon β€” It’s about prudence, understanding, and the ability to execute a well thought out plan. And if that plan includes a nice lady with more income, more power to him. πŸ™‚

      Hope you’re feeling better.

  8. Kerry Baird on

    I love the comparison between the two types of investors. I’ve been on both sides: bought 100% leveraged with sub2 deals and am now 20% leveraged on several rentals. Either way, I like cash flow, which will lead to sweet dreams in Retirement Land. On our current military salary, we’d never save up 100% funds, but we can acquire and pay down several leveraged properties while we’ve got W-2 income and can still get conventional loans. Your strategy combines the best of both worlds, at the times in our lives where it matters most: first the 20% down when we have income, gazelle-intense pay down during career mode, and the full cash-flow when we punch out.

      • Douglas Dowell on

        Great post Jeff!!

        I believe its definitely not a strategy for the faint of heart. I love creative financing very much but I have been addicted everything real estate for a long time.

        I think you summed it up nicely. If you don’t know how to truly measure your risk your margin of error is very narrow.

  9. My wife and I have used debt in the past, but the USA is in especially dangerous political and economic times, so are now (2011- 2013) only doing cash deals. We also have no personal debt. As I like to say, the lever in “leverage” pries both ways. Being debt free also provides the significant non-monetary benefits of less stress and worry. When we have better political and economic conditions, we may well use debt, but only with plenty of reserves, not leveraged up to our eyeballs.

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