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Understanding how to utilize debt

Oct 29 2016

When it comes to the world of debt, finance and investing there are many different thoughts, strategies and feelings that are strong.  A lot of people shy away from debt either because they do not understand it or because they are still licking their wounds from the financial / real estate crash of 2008.  But for those that do understand how to properly use leverage in their investing strategy their returns can be increased several times over.

                Leverage is just a fancy word for debt, and it can move worlds of money if used properly.  Dictionary.com defines debt as “use of small initial investment or credit or borrowed funds to gain a very high return in relation to one’s investment, to control a much larger investment, or to reduce one’s liability or loss.  In other words, to put it in Laminin’s terms debt is borrowing money at a lower rate to invest it and earn a higher rate than what you borrower it at.  If the investment pays 10% return and you borrowed the money at 4% then you can do the math and see how the borrowed money is earning you more money, hence the power of leverage.

                The reason most people are afraid of debt is because they lump all debt in together and call it bad.  There are many financial guru’s out there that teach that no matter what type of debt you have it is bad and you need to do what you can to get out of it.  While I’ll agree that any type of debt if used improperly is bad there are good kinds of debt and there are bad.  Consumer debt is one type of debt that would be considered “bad debt.”  Consumer debt is best described as debts you would incur for goods and services on your credit card, department store cards etc.  Student loan debt can get outrageous and if not managed well can become a problem.  Most people rack up a lot of student loan debt and either never finish their degree, don’t use the degree they obtained for any purpose and or they keep deferring their loans to get out of the payments.  This is dangerous and you are playing with fire on multiple levels if you are playing with this kind of game with your debt.

                Debt leveraged on real estate investments is a debt that savvy and intelligent investors consider as “good debt.”  Now good debt can easily become bad debt real fast if it’s over leveraged (meaning you borrow too much on a property), not maintained (meaning you don’t make your payments etc.) and don’t fulfill your obligations such as refinancing or paying it out when the loan comes due.  But if you do pay attention to these things and you use this type of debt as a tool then your returns will go increase dramatically. 

                Now I know this seems like a lot and there are some of you that think this is “mumbo jumbo” and I’m full of it.  Well I want to show you first hand with the numbers on just how leverage and over double a rate of return on a real estate investment and I’m going to walk through it with a deal I recently completed in Covington Kentucky on a six-unit apartment building that cost $197,000.  First I’ll walk through the deal with you and show you the numbers on an unleveraged return, meaning no debt just a straight up cash investment then I’ll walk through it by adding the leverage component to the deal so you can see firsthand exactly what I’m talking about.

                The building I recently purchased in a historic part of Covington was purchased and renovated for a total investment of $197,000.   The income from the property was a gross (meaning before any expenses taken out) was $61,200 and after taking out all operating expenses, which includes utilities, taxes, insurance, maintenance, reserves for improvements, management fees etc.) the net operating income (often referred to as NOI) is $34,508 per year.  Now to determine the rate of return all you simply need to do is take the NOI and divide it by the total investment.  In this case the NOI is $34,508 and when you divide that by the investment of $197,000 you get a percentage of 17.5.  This means that the $197,000 investment is earning annually 17.5%, which isn’t a bad investment at all.   If you can make a double-digit return on any type of investment and it be secured by something tangible, in this case real estate, then you are doing far better than most people in any investment arena.   Now I will go into how leveraging this very same asset with these very same numbers makes it even better. 

                You take that same building that has a total investment in it of $197,000 with an NOI of $34,508 per year after expenses and add a basic commercial loan.  Typically, commercial loan rates are ½ - 1 full percent higher than a residential one.  Current rates today for a residential mortgage are at like 3.38% but for the sake of this illustration I am going use a loan of 5%.  Now most residential mortgages have an amortization of 30 years.  What that means is you have your payments based on a schedule of 30 years to fully pay back the loan; however, in commercial they are typically less so in this example I am going to use a term of 20 years on the amortization.  

                So now we have loan terms down we need to figure out the cash out of pocket.  Most commercial mortgages will require a down payment of 20 percent.  So, if the total project cost is $197,000 we will be putting down a down payment of $39,400, and borrowing from the bank on the above terms $157,600.  This means instead of coming out of pocket for the full $197,000 as we did before considering getting a loan we are now only out of pocket $39,400.  Now there are cost association with the loan and a typical loan of this size will have about $5,000 or so in cost, so to make our numbers even I rounded up and accounted for $5,600 in closing cost.  The closing cost of the loan are the appraisal, the bank fees they charge to do the loan (they must make money too), fees to record the deed and have someone facilitate the closing.  When we had in the down payment of $39,400 and the closing cost of $5,600 we have out of pocket roughly $45,000, which is still far less than the $197,000 we would have had out of pocket has we just purchased the building straight up with cash.

                Now that we have our out of pocket cash and loan terms figured out we will get into the new yearly cash flow.  The principal and interest payment on this loan example that we pay to the bank each month is $12,481.08 annually, or broken down monthly we are paying $1,040.09 per month mortgage payment.  Remember we had a NOI of $34,508 after we took out all the regular operating expenses.  We must now subtract the loan payment from that number and we get a new NOI, after debt services, of $22,002.92 annually.    Keep in mind we are only out of pocket $45,000 cash to get into this investment because of 20% down and loan closing cost so when you compute the return on investment, remember you divide the NOI ($22,002.92) by the cash investment ($45,000) you get a return of 48%, which is 2.8 times more than the straight up cash purchase!  

                By now it is my hope that you can see from an investment stand point that not all debt is bad and certainly not all debt is created equally.  If used intelligently and wisely you can see how leveraging investments can not only increase your return but it also allows you to reserve your cash and look for and make more investments.  Keep in mind every investment is different and you should look at it from multiple of angles when analyzing them and deciding if you should utilize debt or not. 

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