Leveraging Debt in Real Estate Investing

There is a different between bad debt and good debt. Bad debt includes things like credit card debt, student loans or any other type of consumer loan. Even your car note should be paid off as soon as possible. Good debt is real estate debt. That’s where you leverage a dollar 4-5 times to control more real estate. The more real estate you control the more rental income you generate.

Currently I have mortgages one all my properties. But I don’t mind it at all because they are cash flowing beautifully. Had I paid cash for my properties, I wouldn’t be able to own as much real estate as I do, which would mean less rental income.

Now the question is should you take an ARM (adjustable rate mortgage) or a fixed rate loan. I prefer ARM because over the course of the whole term it turns out to be a cheaper option. A lot also depends on the economic condition. During the housing bubble a lot of people abused the system to buy houses they couldn’t afford. They took adjustable rate mortgages to buy the most house for their dollar. These notes often had teaser rates with appealing payments for the first 6 months to 1 year. However, things turned sour as those introductory rates expired and people were no longer able to afford the payments. It’s for this reason that ARM gets a bad name. Again, if you are knowledgeable about what you are doing, you can avoid the common pitfalls that ignorant people would make. Don’t be that person!

Another important issue to discuss is making the lowest possible monthly debt service payments. Why do we invest in real estate? For the most part, the monthly cash flow. Therefore, your goal should be to reduce the expenses and debt service as much as you can. So when you apply for a loan, you need to go over the amortization schedule to see what the monthly payments will be. You should shop around for the best terms (interest rate, amortization, closing costs and term). All of these will ultimately impact your returns.

Should you apply for a commercial loan or a residential loan? It depends on the type of property you are purchasing. If it’s less than 5 units and owner occupied, you will get a residential loan. If it’s 5 units or more, it’s a commercial real estate loan. Commercial real estate loans are very different from residential loans. There are a lot of details one needs to consider which will be discussed another time. For this, you need to understand real estate finance. It’s not as simple as saying “here’s my down payment and this is my mortgage”. There are a lot of terms and conditions one has to deal with. My partners own two buildings each with 1,094 units and 288 units. They have commercial loans on the those properties. It’s a different mechanism to finance a commercial building than a small multifamily building. But even in that case, the goal is to reduce the monthly payments because we are in this business for the cash flow.

In conclusion, there are lot of things that go into financing a property. It’s crucial to get properly educated to avoid making mistakes that may bankrupt you or provide low quality returns that discourage you from further real estate deals.


Risks of Investing in Real Estate

One of the best ways to reduce risk is to always try to buy below market value. You want to be able to build in equity immediately. This is why you buy properties that need work and look ugly. I typically like to build 20-25% instant equity. But these deals are hard.

When you acquire your new building, you need to factor in rehab costs, closing costs and have a buffer of about 10% (depending on the type of deal) for what may go wrong (time and cost wise). You need to remember that you may not be able to rent the house out immediately. These are all things you need to be aware of before you jump in. You need to be aware of market rents and the costs you will face in running the property. At the end of it, if it’s cash flowing positively, it’s a win-win. I will cover cash flow another time.

Another thing to keep in mind is the age of the property. The older the property, the more the risk it has and it will naturally require more capital for repairs. Now age depends on what part of the country you look at. For example, if you want to invest in the Northeast, buildings will generally be 75-100 years old or more. But if you invest in Texas, as my partners do, you don’t want to go older than 50 years or so.

Some of the other more common risks with rental properties are having bad tenants who damage and vacate your property in the middle of the night. But this type of risk can easily be mitigated by investing in generally decent areas and screening for tenants. Don’t let your friends or family who have never invested scare you by saying that bad tenants are a reason to never invest and are not worth the headache. Those are pains any landlord can face. It’s all about knowing your options and dealing with those problems. Just know what you are getting yourself into, be knowledgeable and have a plan.