IC Elesson: In Defense of Debt
There’s been this thing going around the real estate investing world for the past few years about being “debt free”.
It echoes a movement in the larger culture that has been championed by Dave Ramsey and his ilk that is a probably much-needed reaction to the too-easy availability of consumer credit in this country since the 80s. It was during that period that credit cards became accessible to folks outside the upper class, and that banks discovered that they could market people into paying them endless amounts of interest to finance depreciating lifestyle choices. (Am I the only one who remembers when having a second mortgage was a really bad thing, and meant you were in serious financial trouble? Then banks renamed them “Lines of Credit” and convinced everyone to buy jetskis and vacations with them, and now there’s zero shame in having one.)
Debt has always been a tool that rich people used to get richer, but, thanks to the tidal wave of easy consumer debt that’s washed over us in the past 30 years, the concept of debt got seriously muddled in the American psyche. We forgot about using debt as a way of getting actually rich, and started using it as a way to own things we weren’t rich enough to afford.
This all led to the late 90’s and early ‘00s movement toward teasing out the difference between “good debt” (debt that makes you money) and “bad debt” (debt that costs you money). This was a concept that all real estate entrepreneurs already understood at a nearly instinctual level: that bad debt drains your earning power, but good debt, used intelligently, leverages it.
Unfortunately, in the years leading up to the Great Recession, even good debt got toxic. Banks were making loans on investment properties of 110% of an already-generous appraisal, and without much checking as to whether the property could “afford” the loan. Lots of investors, forgetting the part about “debt used intelligently” snatched up properties at the top of the market, then lost them—and their peace of mind and good credit—when the market crashed.
Which led us to this weird place we are today, where so many of our fellow investors seem absolutely allergic to the idea of debt in a business that requires debt in order to maximize the income potential of that business.
I’ll be the first to say that maximizing profit is not the only criteria under which a business decision should be evaluated, but it’s important to understand that if you choose to avoid most or all debt in the real estate business, you’re making an emotion decision, not a business-based one.
Yes, I understand more than most how strong the siren call of “debt free” really is. I have no consumer debt—not on my car, no credit cards, no HELOC. In fact, my primary residence will be paid off in about 3 years. That makes me feel good, and safe, and like a lot of bad stuff could happen in the world and I’d be financially OK.
And I did watch helplessly as my father’s entire $4 million real estate empire crumbled to nothing in less than 7 years thanks to a perfect storm of economic conditions, his health (and lack of willingness to give up control of his assets despite his inability to manage them) and, of course, the debt against those houses. I fully intend to have de-leveraged my rentals in the next 20-25 years as a result of watching that horrible thing happen.
But I think that the various teachings that are prominent in our industry right now that advocate no debt (Lifeonaire) or no personally-guaranteed institutional debt (Ron LeGrand) may have gone too far in convincing people, particularly those at the beginning of their real estate careers, to needlessly hobble their own ability to build a large portfolio of assets. And as much respect as I have for those instructors, I’d like to present you with some food for thought.
Let’s imagine that you are at the beginning stages of your real estate business. Let’s also assume that you, like most of us, are starting with limited capital. Perhaps you’ve saved up (or produced, by, let’s say, wholesaling), $50,000. And let’s say that your long term goal is to have $10,000 a month in net passive income, and that you’re buying mid-range rentals in a mid-range market like Cincinnati.
With a little marketing effort, you can easily use your $50k to buy a pretty decent $70,000 house in the Cincinnati area. That house will rent for roughly $900 a month right now, will have a $150/month tax bill, a $40/month insurance bill, and, because you’re smart, you’ll set aside 20% of the rents for maintenance, vacancy, and reserves.
I’ll assume that your little rental will increase in value, even in Cincinnati, at about the same rate as inflation; call it 5% this year.
As a devoted debt-free investor, you’ll use your $50k to buy a house with this result:
-$190 taxes and insurance
$530 monthly cash flow
$530 x 12 months = $6,360 annual cash flow
Add a 5% increase in value, and in year one, you will have made $3,500 (appreciation) + $6360 (rent), or $9,860
$9,860/50,000 invested = 19.72% return. And that’s WITHOUT counting the $20k in equity you grabbed by buying under market. Nice job.
The problem is, of course, that you have to wholesale 7 more deals, or own that rental for 7 years, or somehow save up $50,000 more dollars before you can do all that again. And that could take a year or a decade, during which time that $70,000 house has become a $90,000 house that you have to pay $70k for instead of $50k—and someone else has gotten to take advantage of that appreciation in the meantime, while your cash has gotten LESS valuable, thanks to inflati9on.
So let’s shake off your fear of debt for a minute and imagine that instead of buying ONE house, you buy FIVE of exactly the same house:
Each with $10,000 down
Each with 15 year, 6% interest loans
Now, of course, you’ve got debt to service, so your numbers look like this:
$900 rent (x5)
-$190 taxes and insurance (x5)
-$180 vacancy/maintenance/reserves (x5)
-$338 mortgage payment (x5)
$192 cash flow (x5)
Now your annual cash flow is only $2,304 per house…but there are 5 houses, so you’re actually making $11,520 total–$5,000 more than with your unleveraged property.
But that’s not the real power to the debt. The real power is that, despite the fact that you have 5 mortgages, the value of the properties still increases by $3,500 per year, each. That’s an additional $17,500 in appreciation in year one, making your total return ($17,500+$11,520)/50,000 or 58%!
And you STILL captured $20,000 in equity in each house, and you’re $100,000 richer thanks to your $50,000 investment.
And instead of waiting longer to save up the money to get house #2 and 3 and 4 and 5, you grabbed them at the non-inflated price, and you started the cash flow and appreciation immediately. In 15 years you’ll have 5 paid off houses instead of one. With appreciation, your net worth will be half a million just from those properties, and you’ll have nearly half of that $10,000 a month cash flow you wanted without buying another thing.
The only downside? You also took on $200,000 in mortgages that you must service for the next 15 years. But if you bought these in the way I just outlined, which is with debt of only $40,000 each on a $70,000 property, chances are you could sell for the mortgage balance or more in an emergency, right?
I’m certainly not telling you to take on financial obligations that you’re not comfortable with. I’m just telling you that, while completely debt-free might feel better than having good debt, it’s also not the quickest or easiest way to get where you want to be financially.
If you want to learn more about creative, safe, and smart use of debt, I strongly suggest that you take George Antone’s all-day workshop at the OREIA National Real Estate Summit. He’ll teach on November 9th, and his class opened my eyes about leverage in a way that no other has in over 25 years. You can register for the Summit (which is November 9-12 in Cincinnati) at a discounted price right now at www.OREIAConvention.com.
But whether you attend or not, I hope you do choose to study more about the power of leverage before you discard the whole notion.