Is Debt Really That Bad? Utilizing Debt vs. Equity
If you’ve already purchased investment property, you may already have some knowledge about the information presented in this article. Although I go fairly deep, you could skip this one if you like. If you have never owned investment property, this information will definitely add value to you.
“Debt is bad” or so we have been taught. Over and over again it has been pounded into our heads to reduce debt; get rid of credit cards, buy with cash, not credit and so on.
But is all debt really that bad? No!
Can debt actually build wealth? Yes!
First, let’s clarify that personal debt, such as credit card debt, or a home equity line of credit that is used to pay for personal expenses is almost always considered detrimental to your financial health. However, debt which follows the acquisition of an income producing property can actually help you build wealth.
Leverage, the term used for debt financing
Leverage, the term used for debt financing, is an important part of most real estate deals. Using leverage to purchase an income producing property can increase your Cash on Cash Returns. The key to understanding leverage is knowing how much to use and when.
Looking back on the 2008-2009 downturn, it is clear to see that there are times when too much leverage on an asset can create catastrophic losses. Thus it is key for us to understand leverage – to be familiar with the risks associated and know what level of leverage is prudent in a given situation.
Loan-to-value is another term used to describe the amount of debt (leverage) on a property in relation to its value. Just prior to the recession of 2008-2009 there were many five-year loans being issued with very high (85-90%) loan-to-value rates. Two key mistakes that we can see here – very high leverage (85-90% LTV) and loans based on peak property values. As we all know, when those notes came due and the property values had dropped, then the need to inject equity to keep those properties was impossible for many investors. A better strategy is to reduce leverage as the market gets “hotter” and to write longer terms loans (10-20 year balloons payments instead of 5 years) as prices become increasingly unsustainable. Thus when the inevitable correction comes, you are prepared to weather the storm, maintain your cash flow, and are at very little risk of ever losing the income generating asset you worked so hard to attain.
…compare two deals with different amounts of leverage…
As you look at deals, a great way to compare two deals with different amounts of leverage is to compare the Internal Rate of Return (IRR). For a little background, the internal rate of return (IRR) is a widely used investment performance measure in commercial real estate, yet it’s also widely misunderstood. Simply stated, the Internal rate of return (IRR) for an investment is the percentage rate earned on each dollar invested for each period it is invested. Ultimately, IRR gives an investor the means to compare alternative investments based on their yield.
For instance, if you have one deal that shows an IRR of 10% and has lower leverage while another shows a 14% IRR with higher leverage, you should ask yourself whether the additional risk (due to the higher leverage) is adequately compensated by the increased return. If not, the lower return may actually be the better return!
Use Debt to Increase Your Return on Investment
Let’s take a few moments to show you how using debt impacts return:
In this first example above, the investor spent $800,000 out-of-pocket to purchase this investment property (not including closing costs). He will receive a Net Operating Income (NOI) of $60,000 which results in a Cash on Cash Return of 7.5%.
Let’s now look at the return if he would have 25% equity in the property by utilizing debt:
In this example, the investor spent $200,000 out-of-pocket to purchase this investment property (not including closing costs). He financed the remaining $600,000. After paying the monthly mortgage payment, the investor will earn $17,826 annually. This creates a COC return of 8.9%. In addition to the higher return, when the investor used leverage or bank financing for the purchase, he still has $600,000 remaining to invest into additional income properties.
Imagine if he used the remaining $600,000 to invest into three additional income properties. Not only would his NOI probably be greater than the $60,000 in the previous example, but he would have four properties appreciating instead of just one.
Use Equity to Counterbalance Leverage
The strategic use of existing equity can also dramatically increase your return on your real estate investment. Over time, as the mortgage is paid down and market values increase, the equity in your investment properties will also increase. This equity can then be pulled out and used as the down payment on another investment. Once again you use leverage to increase your returns. As mentioned above it is prudent to maintain 25-30% equity in your property. Currently most lenders require this amount of equity as a precaution against repeating the harsh lessons of 2008-2009.
Remember, not all debt is bad. Stay away from personal debt but use investment debt to build your net worth, property portfolio, and increase your cash on cash returns. Then as retirement nears, focus on paying off all the debt and enjoy the multiple streams of Lifetime CashFlow!