Wrapping Your Brain Around Debt Versus No-Debt

1. Debt is a good thing and should be used in buckets for leverage, especially in the realm of real estate.

Two primary reasons exist for the advocacy of investment debt:

a) The use of Other People's Money or OPM and ...

b) The benefits of leverage.

As an investor, it is not necessary to start with a million dollars if you use other people's money which in most cases, is the bank's money. The bank of course does not freely hand out money. They want to see that you can in fact repay the loan through the cash flow of the investment and other sources of income.

The second, important factor is leverage:

If you put $20,000 down on a $100,000 property and it generates $3,000 a year in cash flow, what is your rate of return? It is $3,000/$20,000 or 15%.

If the property increases in value by 6%, how much have you gained?

Answer: $100,000 x 6% = $6,000.

How much of a rate of return is this over your initial investment?

Answer: $6,000/$20,000 = 30%

When you add this to your $3,000 of cash flow, your true rate of return is $9,000/$20,000 or 45%.

If you took that money instead and invested it in a stock mutual fund, how much rate of return would you expect? Answer: 10% over the long haul.

Stocks 10%

Real Estate 45%

‘Nuff said.

A major principle of leverage is that you are doing more with less and less creating the potential for a high return on equity. If instead of $20,000, the investor puts down the full $100,000, the return on equity in the property will be 9%, ($9,000/$100,000) versus 45%. Of course the individual in scenario one is saddled with $80,000 worth of debt. So why is this so bad ...

2. The presence of any amount of personal debt is equivalent to standing next to the gates of hell.

Two reasons to hate debt:

a) The reverse effects of leverage.

b) The confusion between bad debt and good debt.

This is a Two-Way Street - The Reverse Effect of Leverage

Just as leverage can magnify returns as values increase, it can also magnify losses as values drop. In our cash flowing rental property example, let us pretend that instead of increasing in value, the property decreases by 10%. Real estate is seen as a "steady," non-volatile asset class, unlike the stock market, that over the long term, consistently increases in value by 4% to 6% a year. But, there are occasions, (think 2007) when real estate values drop.

Instead of increasing in value by 6%, let us analyze the investment with a 10% drop in value.

If the property drops in value by 10%, how much have you lost?

Answer: $100,000 x 10% = -$10,000.

Based on the initial investment, what is the percentage loss?

Answer: $10,000/$20,000 = 50%

In the world of stocks however, a 10% loss will only equate to a $2,000 loss. (10% x $20,000).

Additionally, if your rental property asset has dropped in value, it is safe to assume that not all is well with the economy and rents will suffer. Let us assume that rents drop from $3,000 to $2,000 in the rental scenario. The total return during the downturn will be -40%, (-$8,000/$20,000).

Most real estate investors only pay attention to the cash flow. In the long haul, is it safe to

say that real estate will continue to increase in value. I believe the answer is yes .... as long as inflation exists, real estate values will increase. In the real estate world, economic downturns are truly detrimental when cash flow turns negative and the investor is unable to pay the bills. As long as the upfront cash flow analysis is through, the financing terms are favorable and quality property management is in place, the risk should be mitigated.

My Poor, Poor Income Statement. Damn You Debt!

Debt becomes a huge anchor weight when an investment or business can no longer cash flow through the debt payment. For example: Let us say in the rental property scenario that cash flow is slim due to the amount of debt taken on to finance the property. What happens during a rental downturn ...

You can see that before the downturn, cash flow is at $61 a month or 4% on the initial investment providing small wiggle room. When rents decrease, cash flow turns negative and the property owner may now have trouble paying the bills.

The same income statement scenario applies to small business as well. You would just supplement cost of goods sold for vacancy loss, supplies instead of yard work, so on and so forth.

More to follow ...

The Confusion of Good Debt Versus Bad Debt

Warren Buffett, Your Small Business and Debt

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