Recently, I wrote about what I think is a common misconception, in that a long-term rental must meet the 2% rule to be a good investment. I think another misconception is that all debt is bad, and must be avoided at all costs. Many people will tell you stay away from debt at all costs, while others will say good debt is okay but stay away from bad debt. Most people define bad debt as debt that uses depreciating assets or no assets as collateral. Car loans, credit cards, student loans, retail goods like TVs, furniture, exercise equipment all would classify as bad debt. My personal philosophy; I don’t care what is used as collateral, if I can use debt to invest and make me a higher return than the debt costs me – I will.
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Words of Caution
Before I get too deep into my debt strategy, let me say this strategy is not right for everyone! Everyone has certain comfort levels with debt and risk. I happen to have a very high comfort level for debt and aggressive investing strategies. If the idea of debt makes you anxious, nauseous and break into a cold sweat, stop reading now! I don’t want people to think there is one right way to take out debt and invest in real estate. We all have different amounts of money, are at different points in our lives and have different needs and wants. This article simply describes how I invest and try to maximize my returns by using debt.
I am very fortunate in that I make a very good living as a Realtor and investor. When I talk about my strategy of using leverage, please consider that I am not spreading myself so thin that a slight market fluctuation will cause everything to crumble around me. Even with all the debt I accumulate, I have plenty of cash reserves, if I ever need to weather a storm. I keep those cash reserves liquid and continue to acquire more debt to keep those reserves and then some for investing.
ROI Versus Cost of Debt
I mentioned earlier that I will use debt to invest in properties that bring a higher rate of return than the debt costs me. Ben Stein actually speaks about this philosophy regarding paying off your mortgage quickly or using the extra money to invest with. He feels if you can get a higher rate of return on your money through investing than your interest rate on your mortgage, you should invest that money. I use the same philosophy, but not just with the mortgage on my personal residence. If my rate of return(ROI) is higher than the interest rate on my debt, then by all means I will take all the debt I can get as long as I can continue to invest it in investments with higher return rates.
Banks use this same strategy to operate and make money. They take in all the deposits they can get, they pay a minimal interest rate on those deposits and use them to loan out at a higher interest in the form of consumer loans. The banks will never stop taking deposits, because they know they can loan that money out at a higher rate of return and make money without using any of their own capital.
Returns with Long-Term Rental Properties
When I invest in rental properties, I typically make at least 20% cash on cash return. I am borrowing money at 3-5 percent depending on the loan and terms. I have no problem borrowing money over and over again at rates under 5% in order to get returns of per 20%. Those returns don’t even take into consideration possible appreciation, debt pay down through monthly payments and the tax advantages of rental properties. The biggest factor that is not taken into account, is the money I make when I buy a property. As most successful investors know, you make your money when you buy a home not when you sell it. If you buy cheap enough, it is tough to lose money on a deal. I typically buy my properties at about 80% of market value. I get them that cheap for a number of reasons.
1. I am a Realtor, which allows me to act more quickly then other investors when I find a deal. I can look at a house, write up an offer and submit it, before most investors can set up a showing or even call their agent. Here are many other advantages of being an agent.
2. I scan MLS multiple times a day, so I see the deals pop up on MLS more quickly than investors. Many times investors are looking at sites that are not updated as quickly as MLS or they have to rely on their agent to send them new listings. ( Another reason to be a Realtor.)
3. I buy homes that need repairs or that I can improve on. A house that needs repairs is usually sold for a discount.
4. I am very patient and I am willing to wait months for the right deals to come around. For whatever reason the good deals seem to come in bunches, I will go six months without buying anything and then buy three in three months.
5. I have a great reputation in my area. When I make an offer, other agents know I will close.
6. I finance my offers, but I include a letter explaining that my portfolio lender does not require repairs, or utilities on and they only require the appraisal to come in at value.
When you factor in all of the items. that make up the ROI, it makes perfect sense for me to keep putting myself in debt to buy more houses.
Type of Debt
Many people say good debt is fine to use for investments, but don’t use bad debt. I disagree completely. I don’t care what the debt is collateralized against, I care what the rate and terms are. Why should it matter if a 4% fixed rate loan is against my car or a house or a TV? I am going to own those items, whether I finance them or pay cash. I see no reason to finance one and pay cash for another, because of the type of asset it is. Now, if I could not afford an item unless I financed it, or I did not really need an item, but I was offered a great loan on it that is a different story. I am not suggesting taking out debt is a good idea to buy crap I don’t need or can’t afford.
I have never bought a new car, but I do buy cars a couple years old, that are rather expensive (I am a car lover and I believe in doing things that make me happy). I finance my cars with the longest term and the lowest interest rate possible. I don’t pay anything extra a month on my car loans either! My car loans are at 2.9 percent, why would I pay that incredible rate off any earlier than I have too?
My personal house is financed at under 4% as well. I don’t pay my personal house off any earlier than possible either. Again, I am make such a higher rate of return on my investments, that I think it’s silly for me I pay it off early. Again, I am saying it is silly for me, if you have a lower level of comfort with debt, than it may not be silly for you.
When I Do Pay Off Debt Early
For those that follow my blog, you may notice I pay off one rental property at a time using a snowball strategy. I use all the cash flow from my rental properties to pay off one mortgage at a time. This may seem contradictory to my strategy of using lower priced debt to buy properties with a higher rate of return. It is, but there are many reasons why I pay off one rental at a time early.
1. Many investors find out how hard it is to finance more than four properties and especially more than 10. I have a portfolio lender, whom will finance as many properties as I can qualify for, but I don’t know if that will last forever. If they change their policies, I may have a much tougher time finding financing for my rentals. The less mortgages I have, the better chance I have of financing more properties, if something were to change with my lender.
2. My portfolio lender offers 5 or 7 year ARMs and a 15 year fixed loan. I choose to use a 5 year ARM to increase my cash flow. Because my rates could go up significantly in five years, I pay those loans off early.
3. Having a house paid off, is a great way to get banks to like you a lot. If I have a house or two paid off completely, I can get a line of credit for a significant amount of money. I can use those lines to buy more properties, show sellers I have the cash to increase the solidity of my offers or use the money for fix and flips.
In a perfect world where I knew I could get as many 30 year, fixed rate loans as I wanted forever, I would not pay off my rentals early. Since we are in a time where bank guidelines and regulations change everyday, I can’t count on the current policies lasting forever and I have to use some caution.
What if the Market Tanks?
With so much debt, what if home prices decline significantly or rents drop? The first thing to remember is I still put 20% down on my purchases, I am not leveraging them to the hilt. I also buy them below market, so even though prices may drop, my typical property has a 60% loan to value ratio or less. I may see lower returns from decreased cash flow if rents go down, but it would take a massive drop in rents for me to start losing money. Like I mentioned earlier, I have reserves to last out a few hiccups down the road. My main goal when investing is cash flow, I have plenty of room for rents to decline and still make money.
If prices go down, it won’t bother me either, because I am not looking to sell anytime soon. I may not be able to refinance and take cash out (I do that as well to increase debt to buy more properties), but otherwise it won’t hurt me. It might actually help my cash flow, because my property taxes may go down!
Once again, I have to warn people not to stretch themselves so thin that you don’t have the reserves to weather a storm. If you have the reserves, are able to buy properties right, concentrate on cash flow, then why not use debt to increase your returns and wealth?