Bad Debt vs. Good Debt

Bob and Sally are neighbors. Both work hard at their jobs. Bob is a dentist and Sally is a College Professor. After they realized they wanted to diversify their investment portfolios and build other income streams, they discovered the power of real estate investing at a local diner where they overheard two older gentlemen talking about the deals they were buying. One man told them, “I always buy my rentals all cash, I do not want to owe any debt.” The other gentleman scoffed at him saying, “This isn’t a bad debt. On the other hand, this debt can be your friend.”

At this point, you may be thinking, “How could debt ever be my friend?”

After all, we have always been taught to pay down credit card debt, avoid taking high interest loans etc.  However, this “friendly debt” can help you scale your real estate portfolio to a much greater scale than you would if you just stashed cash each time you wanted to buy a property.

In this article, I hope to teach you about the power of Leverage. By utilizing good debt (responsibly), you can buy 3x-4x the amount of assets with the same amount of cash as your friend paying all cash.

Let’s go back to Bob and Sally:

Bob has $200,000 cash and decides he does not want to take on any debt and buys a 3-family house around the corner from his primary residence. He pays $200,000 and each unit’s cash flows (after all expenses) is $300/month. This equates to $900/month in cash flow for the entire building, and $10,800 in yearly cash flow.

Bob’s ROI (return on Investment) is $10,800 cash flow /$200,000 initial investment = 0.054 (5.4%)

Sally, on the other hand, likes the idea of not placing all of her money in one deal. Because she is a college professor, she uses her semester vacation to learn about analyzing deals more thoroughly, and because of this she is comfortable taking a loan from a bank and using debt to purchase her investment property.

Compared to Bob, Sally only has $150,000 in cash. Coincidentally, she finds out about four Single family homes down the road from her that are about to go for sale. She approached the owner and told him that she’d like to buy these homes from him. They negotiate a purchase price of $600,000 for the four homes total. Sally then goes to a bank, gets approved for a loan of 75% of the purchase price ($450,000 will come from the bank), meaning that Sally only needs to make a 25% down payment (using her $150,000) to purchase these homes. Sally and the bank agree on loan terms (interest rate, length of 30 years etc.) and close the deal.

Sally buys the homes and immediately finds great families who want to rent these homes. After all expenses (this includes a mortgage payment for each home. Bob did not have this expense because he paid all cash), each of the four homes cash flows $225/monthly or $900/monthly for a total portfolio of four homes. Yearly cash flow equates to $10,800.

Sally’s ROI is $10,800/$150,000 = 0.072 (7.2%)

Sally’s Investment of $150,000 bought her $600,000 worth of assets.

Bob’s Investment of $200,000 bought him $200,000 worth of assets

By using debt, Sally was able to acquire $400,000 more in assets with $50,000 less than Bob. In addition, because Sally has less of a cost basis (what money you have in the deal), she receives a greater return on her money.

To close, it is important to note that utilizing debt is not as simplified as I made it here. This is just a high-level view. Debt is a powerful tool that if used properly, can yield amazing results. (Just ask all the investors who use this leverage.) However, it is important you understand the risks and the potential pitfalls in using debt, and make sure you are analyzing investments with proper calculations and assumptions.