Advertisements

Debt Is Good When It Comes to Real Estate | RE Investing

Debt Is Good When It Comes to Real Estate | RE Investing


A new series of articles we’re calling “Point-Counterpoint” will focus on one real estate investing issue at a time from two different investors’ perspectives. The first topic we’ll address is debt. Is it good or is it bad?

Today, Andrew Syrios argues why it’s good. Stay tuned tomorrow to find out why Engelo Rumora thinks it’s bad. And weigh in with your opinion in the comment section following the article!

If you listen to the likes of Dave Ramsey, then you would probably believe that debt is something to be avoided like the plague.

And when looking over the wreckage that debt has created in certain instances, I am tempted to agree with them. After all, according to NerdWallet, the average American household carries $6,929 in credit card debt.

Data from CreditCards.com show that credit card debt today has an average interest rate of 17.67 percent. And those rates beat the snot out of payday loans, which when fees are included, come out to an absurdly usurious 400 percent interest, as reported by PaydayLoanInfo.org.

But this is what I call “bad debt.” By bad debt, I mean any debt on a depreciating item or consumer debt. It stands in stark contrast to “good debt.”

As I’ve noted on BiggerPockets before,

“Rent-to-own televisions, computers, and furniture—and even things like car loans—are simply transfers of wealth from the impatient to the patient. This is all bad debt… Bad debt simply means you are obligating yourself to work in the future to pay off whatever you’re buying today. You’re demanding your future self to work to pay off whatever pleasure you are enjoying in the here and now.”

Good debt does the opposite.

businessperson showing unbalance between stacked coins

Good Debt vs. Bad Debt

If it came down to never using debt or taking out consumer debt in virtually any quantity, I would absolutely recommend no debt. Fortunately, there is a good type of debt out there. And it is the key tool that makes real estate investment so powerful.

Good debt is the kind of debt that allows you to leverage an income-producing asset and increase your future wealth instead of taking out debits against it.

One of those income-producing investments is real estate, which I’ve referred to before as the I.D.E.A.L. investment (income, depreciation, equity buildup, appreciation, leverage). The leverage is, in my opinion, the most powerful part.

It’s what others like to call O.P.M. (or other people’s money). This allows you to make truly exponential returns with real estate.

So for example, let’s say you buy a $100,000 property for cash and the market goes up 3 percent each year. After the first year, your asset would have appreciated $3,000, or 3 percent.

On the other hand, if you bought such a property with an 80 percent loan, then your equity would increase $3,000 on your $20,000 investment, or 15 percent. And this appreciation continues to accelerate every single year.

There are very few investments that get anywhere near a 15 percent return. Yet when you take out the leverage component, this advantage is greatly diminished.

Indeed, historically speaking, real estate has appreciated just barely faster than the inflation rate. According to Yale economist Robert Shiller (whom the famous Case-Shiller index is named after), between 1890 and 1990, “real home prices rose only 0.2 percent a year, on average” over the rate of inflation.

Without debt, holding real estate pretty much just gives you the cash flow and tax benefits. Not that that’s bad, but it could be much better with some good debt thrown into the mix.

You will, of course, lose some cash flow from having to pay the mortgage. But the cash flow that remains (and you should only buy properties that will cash flow with debt on them) will be on a smaller cash investment. So the return is still much higher.

For example, let’s assume the following about the above property:

  • Value: $100,000
  • Rent: $1,000/month
  • Operating Expenses: $300/month
  • Loan: $80,000
  • Interest Rate: 5%
  • Amortization: 25 Years
  • Loan Payment: $468/month

Under this scenario, with no debt, the cash flow would be $700/month ($1,000 rent – $300 operating expenses) or $8,400/year. That would make for an 8.4 percent return on investment from cash flow if the property was bought for cash ($8,400 / $100,000 investment).

But with a loan, while the cash flow goes down to $232/month ($1,000 – $300 – $468), the return goes up to 11.6 percent from cash flow ($232 / $20,000 investment). The return can certainly be lower (or even negative) with debt, but if you focus on properties that cash flow well, the return will generally be stronger.

Furthermore, this doesn’t account for principal pay down. Right off the bat on an $80,000 loan with the above terms, you are paying off $134.34 of principal each month. And that amount goes up each month you hold the loan.

So your equity begins to grow exponentially, both from the accelerating principal pay down and the appreciation growing from a higher basis each and every year (3 percent of $103,000 is more than 3 percent of $100,000).

Displayed graphically, it looks like this:

If you add all of your returns together (including those that increase your equity, such as appreciation) on the above hypothetical deal, it isn’t even close.

All Cash

  • Appreciation: 3.0%
  • Cash Flow: 8.4%
  • Principal Pay Down: 0.0%
  • Total Return: 11.4%

80 Percent Loan

  • Appreciation: 15.0%
  • Cash Flow: 11.6%
  • Principal Pay Down: 6.7% ($134.34 / $20,000 investment)
  • Total Return: 33.3%

While there would be a few loan fees to consider, it should also be noted that this is just as of day one. The appreciation will go up faster and the principal pay down will go faster as the years go by.

Related: How to Start Investing In Real Estate at a Young Age (or a “Young at Heart” Age)

But Isn’t Debt Dangerous?

Of course, debt comes with a downside. If the property above lost 3 percent of its value, then you would lose 15 percent of your investment with an 80 percent loan.

As anyone who witnessed the Great Recession can tell you, plenty of people got in over their heads with mortgage debt. Reuters reported that 2.3 million properties had foreclosure filings against them in 2008 alone!

And even good debt can be used badly.

But then again, real estate investing can be done badly with or without debt. I’ve seen people lose enormous sums of money on properties they bought for cash because they bought in really bad areas without knowing it.

Bad debt is a vice. Good debt is a tool—but only if used wisely. (Every tool can be misused.)

Fortunately, real estate investing has two built-in advantages that mitigate risk for a careful investor.

The first is that you can rent out real estate so it provides cash flow. That means that even through bad times, the rental income can help tide you over. And in the long run, real estate will eventually go up in the large majority of markets if you can just hold on through any downturns.

The other advantage is that real estate is an “inefficient market.” As I’ve put it before in comparison to the relatively efficient stock market,

“The real estate market makes no bones about it; it is undeniably an inefficient market. There are no motivated stock sellers out there. If someone wants to sell their stock, they just sell it. Not so with real estate. Selling a house is much more difficult.”

This is what real estate investing is all about. Because it can be difficult to sell or an individual property may be dilapidated, there are all sorts of opportunities to find those motivated sellers and value-add properties. And therefore, real estate investors can buy with a built-in equity margin that is much more challenging to find with most other investments.

So if an investor buys with a 20 percent margin, and then the market goes down 10 percent, that investor could still sell it with relative ease and make a small profit. The inefficiency of the real estate market allows investors to insulate themselves from the risk of leverage while still taking full advantage of its very positive upsides.

Getting Your Foot in the Door

Real estate isn’t cheap unfortunately. But this fact makes it illiquid, and therefore it’s possible to get really good deals. However, it also makes it hard to get your foot in the door.

As of this writing, according to YCharts data, the average sales price for an existing house in the United States was $249,500. Of course, this varies by region, but even still, it leaves a large mountain to climb for someone to be able to get started with only cash.

In sharp contrast to home prices, MarketWatch recently reported the median net worth for an American citizen was $97,300. For those under the age of 35, the average net worth was only $11,100. And not all of this wealth is liquid.

FRED Economic Data has indicated the median income in the United States is $31,099. So even if a median person saved 10 percent of their income and married another median person who saved 10 percent of their income, they would only save $6,220 per year.

Mortgage loan agreement application with house shaped keyring

Related: FHA Guidelines: How to Qualify for a 3.5% Down Loan

Even if they were trying to buy a house that was only half the national average in price ($124,750), it would take them just over 20 years to do that. (While I’m not including any return on their savings, remember that real estate will appreciate in that 20 years, as well.)

On the other hand, John and Jane Doe could put just 3.5 percent down with an FHA loan to buy the same house (or maybe a fourplex!). That would require just $4,366 and a handful of out-of-pocket loan fees—or about nine months’ savings.

Given that this is the case, it shouldn’t be surprising that a “Profile of Home Buyers and Sellers” survey published by the National Association of Realtors found that 91 percent of homeowners financed their home. Investors were much more likely to use cash, but a lot of this certainly came from having built wealth in the past with debt-financed real estate.

While most of this post has been written from the perspective of a buy-and-hold investor, it could just as easily have been written for a flipper. After all, where is the money to buy a house and fix it up going to come from?

Returning to John and Jane Doe, using good debt would get them into the real estate investing world much quicker. And when it comes to any sort of compounding investment, the earlier you can get into the game, the better.

We therefore shouldn’t be surprised that Morgan Stanley found 77 percent of millionaire investors say they own real estate. Or that, according to The College Investor, perhaps as many as 90 percent of millionaires made their wealth at least partially in real estate. And much of that wouldn’t have been possible without debt financing.

Simply and plainly, good debt is a critical first step to getting on a path toward wealth.

Conclusion

If you choose not to use debt, I certainly don’t mean to dissuade you. If you have the ability to purchase properties for cash and want to avoid any of the risks that come with debt, by all means do so. It’s a very conservative approach for sure, but real estate is still a strong investment.

Real estate is most powerful when using leverage though. And for most people, leverage is a necessity to buy real estate within a reasonable timeframe. While bad debt (aka debt on depreciating items) is almost always bad, good debt can truly be a good thing—especially when it comes to real estate.

Do you agree with my assessment of good versus bad debt? Why or why not?

Comment below!

 





Source link

Advertisements

Leave a Comment

Your email address will not be published. Required fields are marked *

*
*