The Liability of Equity: Why Debt-Free Isn’t Always the way to Be
You hear it all the time from financial gurus. Debt, they say, is like slavery. And the best thing you can do is break free of those chains as quick as humanly possible.
For the most part, they’re right. When it comes to consumer debt (credit cards, personal loans, etc.), owing money all over town can be disastrous for your financial well-being.
But does that mean we should avoid all debt? Even someone as hard-core as Dave Ramsey would make an exception for one specific kind of debt: real estate financing.
Why? Real estate is in a class of its own. Land is the only thing they’re not making more of and, on the whole, real estate is one of the safest assets to invest in. Given the relative safety of a real estate investment, it makes sense to leverage your assets through debt.
That said, most of the guru-types who make room for real estate debt will still tell you to get debt-free as quickly as possible: double the mortgage payment; throw all your extra cash at principle; do whatever it takes to get that lender off your back. Debt is a liability, they say, and it’s better to get it off your balance sheet as soon as you possibly can.
Maybe, but let’s see how ‘debt-free’ can introduce you to a whole new level of liability.
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The Danger of Owning Property Free and Clear
Imagine you’ve owned a property for about 10 years. You started out with a healthy chunk of equity, cash flow has been great, and you’ve been aggressive about paying down the loan. Today, the property is worth $450,000, and you own it free and clear.
Now, imagine one of your tenants slips on a set of broken stairs and severely injures her knee.
She’s going to need multiple surgeries, extensive physical therapy, and a few months off work. That all adds up to hundreds of thousands of dollars in costs to her.
You’ve decent insurance on the property, but you quickly learn just how fast medical bills and compensation losses can eat into a personal liability limit. Next stop: a lawsuit.
Thankfully, you’ve got the property in an LLC, so all your other assets are safe.
But what about that $450,000 in equity? It’s ripe for the picking.
Now, imagine the same scenario, but instead of owning the property outright, you’ve got it leveraged at an 80%. In other words, you’ve only got $90,000 worth of equity in the property, and the rest of that cash is leveraged against other investments.
For one thing, that makes you a much lower value target. $90,000 is nothing to sneeze at, but given the time and expense involved, your tenant may choose to forego the lawsuit altogether. Even if they do take you to court and win, that $90,000 hit won’t hurt nearly as bad as the full $450,000.
Using One Liability to Protect Against Another
The best way to protect yourself against scenarios like the one mentioned above—apart from fixing the stairs—is to structure your business appropriately.
First, that means holding each of your properties in its own LLC and meticulously keeping each one’s finances and operations separate from all the others. The last thing you want is for some lawyer to ‘pierce your corporate veil’ in court.
Next, you need a comprehensive insurance policy on each property, as well as an umbrella policy to protect you from any potential overages. Not only does this protect your assets, but it provides an added layer of protection for your tenants as well.
Note: Do not skimp on insurance.
Finally, you need to carry a healthy level of debt on the property.
The best way to protect yourself is by using non-recourse debt. Simply put, a non-recourse loan is one in which the property entirely secures the note, leaving the lender with no opportunity to come after you personally in the case of judgment or default.
Debt may read as a liability on your balance sheet. But, when used right, it’ll shield you from the much nastier liability of watching massive amounts of equity go up in smoke.
Is all debt bad? No! While much of the debt we bump into in our contemporary society is foolish, real estate financing is an entirely different animal.
In this post, we’ve looked at one narrow angle in which debt can be used as a tool to benefit and protect your business. But that’s only one aspect. In another post, I showed how you could use debt to increase returns safely and more efficiently put your money to work.
For more information on liability, business structuring, and multifamily real estate financing, check out my free book How to Create Lifetime Cashflow Through Multifamily Properties. As always, if you’ve got specific questions, join us on Facebook, where you’ll find nearly 20,000 investors eager to help you find answers.