Today we’re going to discuss a hot button topic in the real estate community - debt financing. Debt is used by many real estate investors to build larger portfolios with less money down. Like anything else, debt can have positive or negative effects depending how you use it.
Before we go any further, I’d first like to make the distinction between secured debt and unsecured debt. Most real estate debt is secured debt meaning the note is secured by an asset that is put up as collateral. With secured debt, if a debtor defaults, the lending institution takes the asset in exchange for wiping the debt clean. Unsecured debt on the other hand is debt that is not secured by a particular asset, but rather is guaranteed by an individual. An example of this type of debt would be credit card debt. If a debtor defaults on an unsecured debt, the lending institution would need to go to court and obtain a judgement against the debtor. This could lead to bankruptcy, wage garnishment, or other similar methods of debt collection. Unsecured debt is seen as high risk, which is why the interest rate is typically higher than with secured debt.
Many people are highly debt averse and for the most part I agree. The debt markets have not been kind to the majority of participants. Between high credit card interest rates, the subprime mortgage crisis, the current student loan crisis and the current auto loan crisis, Americans everywhere are drowning in debt they can’t pay back. Personally I don’t believe you should use debt to purchase anything that isn’t going to provide income and for this reason, I’m in favor of using debt to buy income producing real estate. Buying income producing real estate is just about the only purchase I think debt should be used for. Why you might ask? The answer is simple - leverage.
Leverage is one of the most powerful tools out there for real estate. Leverage allows investors to purchase larger properties that produce more income, often much more income than the corresponding debt they take on. This increases your Return On Investment, or ROI.
Now i’ll be the first one to tell you that just because debt is available to buy a property, doesn’t mean you should use it. Before considering taking debt out on a property it’s important to rigorously stress test the asset to make sure the debt service can be covered even if occupancy were to drop or unexpected repairs came up. One should always have a healthy profit margin above their debt payments to help with unexpected circumstances and cash reserves in the bank. The current environment and the effects of COVID19 are the perfect example of why it’s essential to stress test your portfolio and make sure you have capital reserves.
Used wisely, debt on an income producing property can maximize your gains and allow you to scale your business. Proper precautions must be taken, but with a reasonable business plan, solid underwriting, and healthy reserves, debt can be a great tool in your tool belt.