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Not All Debt Is Created Equal. To Leverage Or Not To Leverage?

July 13, 2022

chrisseveney

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CWS 2 | Debt

 

Not all debt is created equal. There is good debt and there is bad debt. Being in credit card debt, that’s bad debt. Taking out a loan to buy real estate, that’s good debt. It’s all about knowing your risk tolerance and your criteria. Knowing your threshold and the value of the property. Join Lauren Wells and Christopher Seveney as they talk about all things debt. They go into risk management and leverage. Know what to do if you are in debt. Learn how you can play the real estate game with leverage. Understand debt today so you can enhance your returns.

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Not All Debt Is Created Equal. To Leverage Or Not To Leverage?

Welcome to the show, where each week, we are going to bring you education and information that will help you take your next step when it comes to building wealth through real estate. In this episode, we want to talk about debt, good debt, bad debt, myths surrounding debt, and everything when it comes to debt. This came up on a call I had. It got me thinking about how not everyone sees debt as a good thing, especially even in real estate. Chris, what are your thoughts when it comes to debt? 

It’s very interesting because it’s almost like political beliefs. People have such strong opinions one way or the other as it relates to debt. There are varying different types of debt. For real estate, I’m a proponent that debt is a good thing, like anything used in moderation. Understanding the use behind debt is very important. Debt on the type of investment property also plays into account.

I look at debt as a type of risk, and I’m very big at measuring risk. I understand what can go wrong in every situation. I like to map out every situation to see what can and can’t happen. That’s an area that we’re going to talk more about in this episode with the different types of debt, the risks involved, and why, in real estate, contrary to popular belief of certain individuals, debt is not a bad thing.

I don’t remember where I read this analogy. I probably read it years ago. I never was like, “All debt is bad,” but I wanted to make sure I had any monthly payments that were coming out of my pocket. When we first bought our house, it was like, “We want to pay off our mortgage.” I laugh at myself now because we can pull cash out and invest in other places. It’s all about your comfort level and risk.

I read this analogy. It is a good debt versus bad debt analogy where you can buy a car that you only drive in the summer months because it’s a cool car, but you’re taking out debt on that car. That is a very different type of debt than buying a car that’s a work truck that’s going to help you do more business and help you generate more income.

I thought that was a very simple way of explaining how one is a debt that works for you and one that works against you. I wasn’t raised with the strong view that all debt is bad, but for some reason, in my mind, I was still hesitant to take out any loans, no matter what kind of loan that was. It was about getting comfortable with what my parameters were around risk. How would you describe good debt versus bad debt to people?

You described it very well where you mentioned debt that works for you and debt that works against you. Everyone could agree. Credit card debt is a very bad thing unless you’ve got a 0% interest for a short period of time and you use that money for something that is an asset. It goes back to asset versus liability.

Did you know that millennials are much more debt-averse than their older counterparts? Click To Tweet

Back up a second for people who might not know because we’re speaking to a wider audience here. Can you explain what you mean by asset versus liability in terms of debt?

I view an asset as something that has value or can generate income. For example, rental property is an asset. If you bought a fancy vacuum for your house and you use that on a credit card, it’s an asset for time, but from a liability perspective, if you don’t have the cash and it’s breaking 18% interest, you’re constantly continuing to pay for that. We can go down the rabbit hole of whether your primary residence is an asset or a liability. A lot of people have that argument, but we’re not going to go there in this episode.

If you’re borrowing money, for example, to buy a rental property and it generates cashflow that is paying that mortgage and also potentially putting money in your pocket, that is an asset. It’s generating some type of income. The work truck that you said is considered an asset because you bought it and it’s being used to work to generate types of income. Things that aren’t an asset if, for example, you go out and buy a TV on Black Friday and rack it up on a credit card. It’s great for entertainment purposes, but that’s not benefiting you or helping you in any way, shape, or form.

I find that when a lot of people get into debt, they’re spending it on consumer goods. They’re holding up the new iPhone. When a new one comes out, they’re like, “I’m going to go get a new iPhone,” and rack up a $1,000 bill and put on a credit card at 18%. That is bad debt. That’s my definition, which could have been said in about three words.

I’m not saying this as a dig, but we are different generations. I was reading an article about how they did a survey on Millennials. This shocked me because I’m a Millennial. We are painted as people who swipe our credit cards all the time. While that might be true, the study showed that Millennials are very debt-averse. We’ve been priced out of the home market in most cases, but even when buying a home, Millennials were much more debt-averse than our older counterparts.

I’m a Gen X-er. Growing up, when I was in my twenties, it was very similar where we were ringing up credit cards in a lot of things at that point in time because that’s when a lot of new technology was coming out. HD TVs were coming out. The internet was coming out. I remember my first HD TV. It was 65 inches. I was living in Framingham. It was probably in 1999 or 2000. There’s a lot of new technology coming out, so people were like, “This is cool. I want to get it.”

CWS 2 | Debt

Debt: An asset is something that has value or can generate income. If you’re borrowing money to buy a rental property and it generates cash flow, that is an asset. It’s generating some type of income.

 

In the last couple of years, electric cars emerged. People were like, “I want an electric car because it’s something new. It’s fancy. It’s hot.” A lot of people are ringing up a lot of credit card debt. What was happening during that time was a lot of products that were being made went from being made for long periods of time to being consumables in the last couple of years. When you look at appliances, everyone’s replacing their washing machine every five years, whereas my mother still has the same one from 1978 because it was built differently.

Financial literacy has improved over time. As people are getting older, they are sharing a lot more of that knowledge. With the internet, there’s a lot more out there that people can learn about. Before the internet, when you were getting a mortgage, you didn’t know what mortgage rates were. You go to two banks in your town and would have to walk in to figure out what it was or look in a newspaper. You couldn’t go online to compare rates.

Maybe more people were more okay with taking on debt and then the Great Recession happened. For my generation, most of us are trying to buy homes or have purchased homes. We have that thought, “What if that happens again?” Since I’m in this industry, I know that that’s not necessarily the case, but those were because people were overleveraging themselves. You personally evaluate what your risk tolerance is. When you’re going to evaluate a deal, what makes sense to you? What are your criteria?

I’d break it into two buckets. For example, when you’re going to buy a house, don’t stretch it to your max or your limit for what they tell you.

Are you talking about a home that you’re purchasing to live in or a rental?

Yeah. There are different risks involved. I would always say, “Never get the max that you can get,” but I would probably borrow more on my primary residence, knowing that I’m secured in my job and that I’m going to have a job. If houses go up or down in price, I don’t care because I’m not moving and I’m not controlled, whereas, on a rental property, it’s very different.

If you've got poor credit, it's going to be difficult for you to get leverage down the line to try to grow your investment portfolio. Click To Tweet

Let’s say I’m buying a $200,000 rental and I had to put 20% down. I’m putting $40,000 down, so I’m financing $160,000. From a leverage standpoint, a lot of people will try and max out how much they borrow because the monthly payment doesn’t go up a lot based on every $10,000.

Explain the concept of leverage.

Leverage is what you borrow and is usually based on a percentage. If I’m buying something for $100,000 and I borrowed $90,000, I’m at 90% leverage. That’s a lot. If I looked at a 5% mortgage payment on $90,000 versus $75,000, the payments over 30 years are probably not a lot of money. Pick a number. It’s not a lot, but $15,000 is a lot of money for people. A lot of people will look at it and be like, “I can get away with only putting a little bit down. My mortgage payment isn’t changing much. If I need to make the pay an extra hundred bucks, I can afford $100 more. I can’t afford $15,000 now.” That’s leverage. I can go into the next part of why that can be problematic.

I know where you’re going with this. Please continue.

Where that can be problematic is there are two areas of risk on that. One is making sure that the person borrowing the money has the reserves to make payment in case a renter misses the payment. Let’s say your mortgage is $750 a month and the rent is $1,000 a month. You got some money coming in, but you have other expenses. If they all of a sudden stop paying or they move out and it takes you two months to rent that property, do you have the money to continue to pay that mortgage? That is one type of area for reserves that you have.

Where people also sometimes forget about leverage is, let’s say the property was $100,000 and we have a slowdown in the economy. Look out your window. With what’s going on with interest and everything going on in the world, everyone would predict that housing is probably not going to go up in price in 2023. If that $100,000 house is all of a sudden worth $80,000, you’re what’s called upside down.

CWS 2 | Debt

Debt: Leverage is basically the money that you borrow and it’s usually based on a percentage. So if you’re buying something for 100,000 and you borrow 90,000. You’re at 90% leverage, which is a lot.

 

What that means is you owe $90,000 and it’s only worth $80,000. You can’t sell it. You can’t do anything. If you don’t have a tenant in there paying for something that’s worth less than it is, that’s where a lot of people can get themselves in trouble. They have no safety net or no way out if market prices decrease and they have to sell.

What I’m hearing you say is that when you’re looking at taking out a mortgage or a debt against the property, due diligence is key. You need to know what your criteria are, and those criteria are knowing your threshold, whether you have the reserves, and also the value of the property. For me, personally, and how I was trained, that value is everything. The loan-to-value is everything and having that buffer in case the economy slows down. If it goes the other way, that’s great, but if the economy slows down, you know that you won’t be underwater.

Let’s talk about worst-case scenarios. Not in terms of something you can’t control, like the economy, but let’s talk about how if you purchase a rental property and then you have your primary residence, you lose your job. You’re not able to keep that rental property for whatever reason, so what are your options? We know there are many options. However, there’s a misconception about, “If I can’t pay the mortgage on this rental property, I’m going to have to file for bankruptcy. I’m going to get the house taken away.” There are more options than that. Let’s talk about worst-case scenarios and what you would do.

One thing I want to mention why it’s important for people to understand about leverage is if you’re upside down and you start missing payments, we’ll talk about the options that can happen. A lot of people think there’s foreclosure. The first thing that happens before anything is your credit gets destroyed.

Let’s say you’re at 800. It could go down 550 at the drop of a dime, but to get it back up to 800 again, it’s going to take you 5, 6, or 7-plus years. Think about that. The impact that can have on you to grow your business is significant because if you’ve got poor credit, it’s going to be very difficult for you to get additional leverage later on down the line to try and continue to grow your investment portfolio.

If something were to occur, a lot of people think, “I’m going to go into foreclosure.” One of the things I would tell somebody is, “Do not ignore your lender.” Get on the phone with them, see if there are modification or forbearance options, and speak to them about, “Can I get a forbearance,” which has reduced payments for several months, and then you’ll start paying again.

When you're in debt, do not ignore your lender. Get on the phone and see if there are modifications or forbearance options. Click To Tweet

Many years ago, during the downturn, banks were like, “We’re foreclosing because we want to get this off our books. We’ll bite the losses.” Banks didn’t know how to work through that process. They had a lot of experience. Now, they’re more willing to work with borrowers. Plus, the government has a lot of intervention that forces them to try and work with a borrower who has gotten themselves in trouble. What that can do is that can also protect you from your primary residence.

If you were ever to get foreclosed upon and let’s say you were underwater by $50,000, that bank can still go after you for that $50,000 and also go to your primary residence. In most states, they could foreclose on your primary residence, too, if they wanted to. That’s the worst case, but there are a lot of options out there. There are modifications that the government has. You can get a modification of 2% called HAMP loans. Some of these programs still exist. Some do not, but the key is to talk to whoever gave you the money to try and work something out.

If you can’t work something out, in most instances, foreclosure does not happen overnight. You typically have to be 3 to 4 months behind. If you’re in a judicial state where it has to go through the court processes, it’s probably going to take a year plus. If you’re in Georgia, Texas, or some of the Southeast states, it can go pretty quickly. In Florida, it would take about a year. Understand the rules of the game as well.

For people who might not know your background and my background, the reason that you’re saying this is because this is the asset class that you invest in, which is mortgage notes.

We’re on the opposite end. We’re on the lender side.

We’re saying, “Talk to the lender,” because we are the lender. It makes it a lot easier for everyone. Most of the time, the lender is willing to work with you. How does this tie into debt? When it comes to investing in real estate, people are very fear-based around, “What’s the worst thing that can happen? What if I lose the house? What if I lose my job? What’s the effect of everything if everything were to go sideways?” You have more options. Speak to the lender. Don’t ignore and write it off. We’ve talked about myths around debt, good debt, and bad debt. What makes debt a superpower when it comes to real estate?

CWS 2 | Debt

Debt: When you’re looking at taking out a mortgage or a debt against the property that you have, due diligence is key. You need to know your threshold and the value of the property.

 

That is similar to steroids because it can either significantly enhance your returns, or if it goes bad, it can explode and be very bad.

Nothing’s for certain, but how do you avoid the explosion?

Avoid it by not being overleveraged. Let me give you an example. We’ll go back to that $100,000 property at $1,000 per month in rental income. If you pay $100,000 worth of cash with cash and you get $1,000 a month, that’s $12,000 a year, which $12,000 divided by $100,000 would be a 12% return on your investment. That is a financial term of, “How much money am I getting on the money I’ve put in?” You’re getting 12%.

Let’s say you took that $100,000. You borrowed $75,000 and you’re in it for 25,000. You would also have a mortgage payment, but your mortgage payment on that would probably be $400. $1,000 minus $400, you’re getting $600 a month. $600 times 12 is $7,200. $7,200 divided by $25,000 is a 28% return. You went from 12% and more than doubled your return over the course of the same property. Using leverage enhances your return because you are making a higher percentage than what you’re borrowing. Some people call that arbitraging in some terms, but by using leverage, you’re allowed to enhance.

If you look at most large multifamily transactions where somebody is buying a $75 million apartment building, rarely are they paying cash for that unless they’re Blackstone or BlackRock. Local developers are putting in a minimum amount of money and getting a loan. Previously, you were probably 4% or 5% on that money. You’re using that to have the cashflow, pay it, and then get the money on top of it with less money in. The name of the game in real estate is trying to make the most money with the least amount of money in the deal.

There are people who are considering taking out a loan and getting started in real estate, but there is one thing holding them back. They can get a loan to invest in a rental property. What would you say would be your top three things they should have done or prepared to do in order to take out that loan and get over that fear? Do you want me to go first?

Debt is like steroids. It can either significantly enhance your returns or it can explode and be very bad. Click To Tweet

Yeah. I want you to go first.

If you’re looking, for example, at short-term rentals, do your research and know what market is your market and your criteria. We’ll probably talk about this a lot throughout the show, but one thing you mentioned in the first episode was no two people’s journey is the same. What worked for one person might not work for another. Know your criteria and know your risk tolerance. That’s part of knowing your criteria.

Your risk tolerance might be different than mine. Yours is very different from mine. Also, know your exit strategies. Plan out the worst case. If the worst case happens, what would you be able to do? How would you be able to keep moving forward? I’d say those are my top four things. Know your criteria, do your research, know your risk tolerance, and know your exit strategies.

I’ll throw in something a little bit different on top of that regarding the leverage. One way to determine whether you’re overleveraged or not is really understanding what you’re buying. Know the neighborhood. Know the real estate in that area as well as the property itself. How old is the equipment on the property? How old is the roof? That’s where people can get themselves in trouble when they take on debt, but then all of a sudden, they have to take on more debt to pay for expenses that they might not be able to cover.

There’s a term out there that is called the debt service coverage ratio. It’s a mathematical formula. It’s a percent of how much money is coming in versus how much debt you have on the property. Most financial analysts will say it’s a 1.25%. $125,000 would be a 1.25% to give you an idea of some of the things where it stands. That’s usually used for larger-scale projects, but it’s something to give you an idea of how much leverage you’re at.

If your income is only covering your debt amount, then you’re overleveraged. We didn’t even talk about this on this episode yet, so I’ll throw it at you. Some people forget that there’s a debt that covers their payments, but when property insurance, taxes, and everything starts going up and creeping up on people, all of a sudden, they don’t have enough money to cover their expenses. Mainly, your primary cost is your mortgage, but if you’re also paying utilities, that’s another one. Do you want to can you comment a little bit on that?

CWS 2 | Debt

Debt: Using leverage enhances your return because you are making a higher percentage than what you’re borrowing. Some people call that arbitrating.

 

Yeah. I would say that falls under doing your research and the due diligence process. For example, with notes, when we look at buying assets, we are always factoring in what the property taxes are and what’s insurance going to cost us. It’s a little bit different with this asset class, but there are all those additional external factors that are related that you’re going to end up having to pay, or maybe not if you haven’t rented.

We always work that into our threshold of what we’re willing to pay for a note, so for me, that falls under doing your due diligence. You’re not like, “I want to buy a rental property. This market looks hot. Let’s go buy there.” You want people to take action, but try to guide them in a way that makes sense where you still need to do your own research. You still need to find a realtor in the area. Talk to them. Have someone see the property if you’re not seeing it.

I apologize. I did misspeak about that service coverage ratio. It’s not the amount of the mortgage. It’s the amount of your mortgage payments. If your mortgage payments are $1,000 a month, you’re paying $12,000 a year. You’d want somewhere between a $15,000 and $18,000 income.

That’s your tip in summary. Have reserves. Do you have any final thoughts?

I have a question for you. On an investment property, would you get a 15-year loan at 4% or a 30-year loan at 5%?

I would do the 30-year loan at 5%. What would you do?

Typically, most people would tell you to do 30 years at 5%, but this goes back to that initial question of what your end goal is. Here’s an example. We have a rental that we bought. We have owned it for nine years already. We ended up getting a fifteen-year loan because the interest rate was only 2%. It’s going to be paid off by the time our son goes to college. We’re looking at that as, “It’s going to be paid off,” so if we needed to use that money for college, we could sell it or turn it around and refinance it at that point in time, knowing that we had that.

When taking out a loan, know your exit strategies. Know what to do if the worst case happens. Click To Tweet

If we took a 30-year loan, there would still be a lot left on the loan and then we’d have to refinance, or we might not be able to get as much cash out of it. That was from a risk perspective play for us, but typically, everything else we do is 30 years. Most people will tell you to always do the 30 years because your payments are lower during that time. The interest rate is also typically something that’s low where you could take that extra money, invest it, and make a better return than your mortgage rate.

I plan on being around in 30 years, so we’re good there. It also depends on what your income is at that point. Do you have any other final thoughts or questions?

No. We covered a lot about understanding leverage, the good, bad, indifferent, and everything between it. It’s scary. That’s what my final thought is. Anytime you’re taking on a loan, it is scary because typically, in real estate, it’s the largest commitment you’re ever going to make.

Think of it this way. I’m not 100% sure on this, but there’s no other asset class where you can walk into a bank and say, “I’d like a $400,000 loan to buy stock,” and they’re like, “That’s something we do. Let’s write the paperwork up.” In a weird way, it’s the one asset class that you can walk into most banks and finance right there. It’s a tool. I look at debt as a tool when it comes to investing in real estate. It’s how you’re going to use it.

The one pet peeve that I see people do that drives me nuts is when investors are very short on cash and then go buy a property. They’ll try and rehab it or do something and then they rack up everything on credit cards during that time.

It’s like co-mingling debt.

They’re also banking on being able to refinance. They are putting all their eggs in the basket of being able to refinance.

CWS 2 | Debt

Debt: One way to determine whether you’re over-leveraged or not is to really understand what you’re buying. Know the neighborhood or the real estate in that area. Do your own research.

 

They’re also trusting that the market won’t tank.

Who knows what can happen in the market? There’s also so much risk. If that one time goes wrong, you’re done for seven years unless you get creative and hustle doing alternative investment strategies. You put yourself behind the eight ball, insignificantly stunting your growth. Have the patience to save up the money or have some money, so you do not overleverage.

With that said, thank you guys so much for joining us on this episode of the show. If you enjoyed the show, share it with a friend, subscribe, or leave us a review. Until next time.

Thank you.

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