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Let's talk about debt, also known as leverage. Debt can be good or bad. It's how you use it, and how responsible you are with taking on debt. I can tell you, without a doubt, I would not be where I am in life if it wasn't for using the power of debt. I bought my first house, rented out rooms, and cash-flowed it with a 0% down VA loan. That subsequently started my real estate investing career at 22 years of age which led to now owning over 400 units. I also borrowed $50,000 against one of my rental properties 12 years ago to to boot-strap my tech company that eventually grew to a $20M+ operation. When you start with nothing, leverage can be a powerful tool to build a life. But, it's risky if not respected!
Debt has received a bad rap because it's usually associated with irresponsible debt. What's irresponsible debt? Generally speaking, that includes credit card and revolving line debt. Or perhaps you borrowed money from cousin Vinny to bet at the horse race tracks? Yeah, most people agree that's bad debt.
What's good debt? Is there such a thing? Everybody has their own opinion. Dave Ramsey believes that any debt is bad debt. Robert Kiyosaki believes that any debt on depreciating assets (cars), unsecured debt (credit cards), and a mortgage on your personal residence is bad debt. Any debt used to purchase assets that generate cash flow is good debt. I generally fall into Robert's camp when it comes to my philosophy on debt. The gray area might come with debt on your personal residence. What if you're just starting out in real estate investing, can get cheap money with little down, buy a personal residence, and house-hack like I did? (House hacking = buying a house, renting rooms, and basically living for free while building equity). Better yet, what if you have a ton of equity in your house, can refinance cash out tax-free, at sub 3% interest rates, and then invest in a small apartment building and get 15% cash-on-cash returns (tax-free), forced appreciation, and debt balance pay-down? I think an argument could be made that, in those circumstances, having responsible debt on your "primary residence" could be a good thing. Especially if you're starting with little to nothing in the way of cash and use the leverage to grow to bigger and better things.
But none of these scenarios will be what I'm writing about in this article! I want to give you a very simplistic example on the power of leverage when it comes to multifamily real estate investing. I've been told that, if I have the cash, never use debt to purchase properties. Why take the risk? Wouldn't you sleep better at night without debt? Your personal tolerance for risk and the stress associated with it has to be a consideration when looking to take on debt to grow your net worth and cash flow. But let's take the emotions out of it and just look at the numbers.
You have $1M in cash to invest. Maybe you inherited it. Maybe you won the lottery. Or maybe you decided to cash out a portion of your beloved 401K to diversify outside of Wall Street and money managers. Let's say you have two choices. On one hand, you could go buy a $1M apartment building. On the other hand, you could put $250K down on (4) $1M apartment buildings and finance $750K on each property. For simplicity sake, let's say all apartment buildings are operating at a 10% capitalization rate. That means they each generate 10% of the purchase price, or $100,000 per year, in Net Operating Income (NOI), or profit before paying any debt service (mortgage). 10% caps are REALLY hard to find these days. But I can tell you, Mitch and I buy mobile / RV parks and get them operating at 10% cap rates within 6-12 months all the time. Let's also assume that you can force appreciate (through NOI improvements) 10% per year, which is very realistic with the right properties. We've force appreciated some properties 50% or even 100% in the first year with operational improvements. Let's say you hold each property for 5 years.
Scenario #1:
Pay $1M cash to buy 1 apartment building
Cash flow over 5 years: $100K per year (10% cash-on-cash at 10% cap rate and no debt) x 5 years = $500K
5-year appreciation gain @ 10% per year: $610,510
Debt principal pay-down: $0 (no mortgage)
Total Dollar Return: ($500K cash flow+$610,510 appreciation) = $1,110,510
That's pretty good! You more than doubled your money in 5 years. But check this out.
Scenario#2:
Put $250K down on four apartment buildings and finance the rest ($1M in total down payments and $3M in debt)
Cash-flow: $200K / year x 5 years = $1M (with 25% down, 4% interest rate, on 10% cap properties, expect about 20% cash-on-cash returns).
That's reason enough! That's double the cash flow and twice as fast to freedom as opposed to option #1! But wait, there's more!
5-year appreciation gain on four $1M apartment buildings: ($610,510 x 4) = $2,442,040
You now have $4M worth of properties, as opposed to $1M, to appreciate. This is the most powerful part of leverage. You can control 4 times the assets.
Debt principal balance pay-down over 5 years: $381,026
By the way, did you catch that? You have hundreds of tenants going to work every day to pay off your loan(s). That's a wonderful concept most people forget about.
Total Dollar Return: ($1M cash flow+$2,442,040 appreciation+$381,026 principal pay-down): $3,823,066!
You almost quadrupled your money!
This is why the richest people on earth, with droves of liquidity, use leverage to get richer. Mic dropped.
Have a great day!
