Is Borrowed Money Good or Bad? Answer… Both
There are many issues to consider when investing in real estate and other hard assets. Often, people are conflicted as to where to invest and how to invest. Should you invest in single-family? Multifamily? Mobile Home Parks? Mineral Rights? The opportunities are both exciting and daunting.
Then, once you’ve figured out an investment path, the choice of how to fund it comes to the forefront. One of the most common internal conflicts that arise among new investors is their zeal to get out of debt (often after attending a Dave Ramsey Financial Peace University training) vs using leverage to their advantage.
I was taught at a young age that “all debt is bad” and to “get out of debt at all costs” so I definitely understand those who are conflicted about the subject. Hopefully, I can offer you some clarity.
Everything changed for me when I started thinking about borrowed money differently.
When Is It Leverage and When Is It Debt?
I will agree that all debt is bad, but how you define debt is where the nuance comes into this statement. In the most basic of definitions, debt is taking on a liability (ex. home mortgage) to pay for an expense (ex. your second home). This use of borrowed money with no return will drain your bank account very quickly and leave you in a situation where you have to continue to trade time for money.
Leverage is different. While it’s still borrowed money, it’s all about what you do with it that changes its meaning. Leverage is using a liability (ex. commercial loan) to pay for an asset (ex. Mobile Home Park) that will provide cash flow over and above paying off the liability. Not only that, you can drive appreciation, have others paying off your mortgage, and get amazing tax benefits.
One scenario has you personally paying off the debt with your income. The other scenario has your tenants paying off the leverage you have on your asset with their income while providing extra cash flow at the same time. Starting to see the difference?
How To Use Leverage
Just because you can borrow money, doesn’t mean you should. Leverage is a wonderful tool to use that can really ratchet up your returns, but it can also be a double edge sword that screeches your returns to a halt.
Currently, we are in a high-interest rate environment with a slowing economy. We would expect (and we are already seeing) cap rate decompression in these times. Leverage is still a powerful tool to use, but a more prudent deployment is definitely needed. With an economic downturn, it’s better to have lower leverage so you are able to weather events like vacancies and unforeseen CapEx costs better without having to stress the asset’s financial performance.
It’s also important to know the risk profile when considering how much leverage to use. Generally, the “safer” the asset, the more leverage I can deploy. For example, if I have an investment-grade single tenant with a 15-year absolute NNN lease like Dollar General, I feel much more comfortable placing higher amounts of leverage on that asset because I know they are backed by the full faith and worth of a BBB-rated national company. Even if they close the business, that lease will still be paid for 15 years.
Contrast that example with a fix-and-flip investment. There is nothing wrong with these investments at all, but you just need to understand the economic climate we are currently weathering. With days on the market increasing, home prices stagnating and even falling in some areas, and higher interest rates cutting into returns and your buyer pool, putting high leverage on a fix-and-flip just isn’t a good idea right now.
Wrapping Up
Leverage is an excellent tool to use to increase returns and decrease out-of-pocket expenses when purchasing and operating assets. Like any tool though, if it’s in the hands of an untrained operator it’s useless at best or downright dangerous at worst. I’ve learned over the years how and where to deploy leverage to maximize my returns while minimizing the risk. Don’t let fear or lack of knowledge keep you from utilizing leverage to your advantage. If this is something you’d like to learn more about, feel free to reach out to me here and we can have a discussion.
Here’s to winning your time back!
Danny