I feel like there is so much hate on debt these days.  Every guru out there is screaming “Payoff Debt” and then never go into debt again.  Even for investment purposes.  I could not disagree more with that logic, and I’m going to explain to you why I love debt.

Debt is the lever that makes average people grow massive amounts of wealth.  Debt allows me to take a deal that would return me 8% if I paid cash for it, and make 20% due to the fact that I put much less into the deal.

As much as I love debt, I have found that banks love giving me debt.  And why do banks love giving me debt?  Well its pretty simple.  Because at Towner Companies, we are proven operators of our business, and we always pay our mortgage payments on time.

But more important than our clean record on mortgage payments, is the fact that before we even get into a deal, we show the bank our worst case, conservative estimate of how ours deals will perform, so that they can feel confident that the revenue it will produce will be more than adequate to sustain and service the loan.

The only thing that matters on a real estate deal is the cashflow.  Therefor, the only metric I pay any attention to is the cash on cash cash return.  Quite simply, it is the amount of money you have at the end of the year, after you have paid all of your operating expenses and debt payments.  We do not do deals that return under a 10% cash on cash return.  Its not even an option.  And I’m fortunate to know tricks and formulas so that I can estimate any deals cash on cash return in less than 2 minutes, provided that I have some basic financial information on the property.

Lets dive into some numbers.

Lets say I have a million dollars that I want to invest.  (1 Million is very simple for calculating returns).  Since I buy deals typically at a 8% cap rate, I can expect to earn around $80,000 per year on this investment.  I own a 1 Million Dollar Asset as well, which provides me some decent depreciation each year, but not near enough to cover my income, which leaves me with a decent tax hit each year.

Now lets run the numbers utilizing debt.  I always put 20% down, so that means I can purchase $5,000,000 worth of real estate.  And since my deals always yield around a 15-20% cash on cash return, I can expect to earn around $150,000-$200,000 per year, just in cashflow.  I also get a phantom expense of depreciation each year, but instead of it being just on $1,000,000, I now get depreciation on $5,000,000.  In other words, I get 5X the amount of depreciation.

So what about appreciation?  Same rule applies.  5X more appreciation on your assets.  I know in Rochester, the prices have gone up by around 8% each of the last 3 years.  Without utilizing debt, my $1,000,000 all cash investment would have grown to $1,240,000 using a simple rate of return formula (8% at 3 years = 24%.)

$240,000 in appreciation is nothing to sneeze at.  To most that is pretty good, but I would be absolutely sick to my stomach with that, because I know if I had utilized debt on the deal, I could have been getting 24% appreciation on $5,000,000.  That would have turned my assets off of the same $1,000,000 investment into being worth $6,200,000!  That is $1.2M of appreciation in 3 years.  Add on the cashflow of $150,000-$200,000 per year, and then factor in the tax advantages that come with real estate to compound your returns even more, and its easy to see how these deals end up returning +30-40%, each and every year.

And what have we left out of the equation so far?  Yes, the debt reduction being paid down by your tenants.  It really is a beautiful thing.  It seems like not a lot of principal is being paid down at first, but it adds up over time.  For this example, we are utilizing 4.5% rate for financing on a 20 year amortization schedule (very common for commercial loans).  After 3 years, $396,431 has been paid down on your debt by your tenants, which converts dollar for dollar to instant equity.

See the following for charts and graphs for amore visual explanation of the difference between all cash deals versus leveraging with debt.

$1M Investment Example
All Cash DealUsing Leverage (4.5% 20 Yr AMM)
Cash Investment$1,000,000 $1,000,000
Debt$- $4,000,000
Asset Value$1,000,000 $5,000,000
Equity$1,000,000 $1,000,000
Cashflow/YR$80,000 $150,000
8% Appreciation$80,000 $400,000
Debt Paydown/YR$- $126,255
$1M Investment 3 Years Later (Appreciation at 8%/YR)
All Cash DealUsing Leverage (4.5% 20 Yr AMM)
Appreciation$240,000 $1,200,000
Debt Paydown$- $396,431
Asset Value$1,240,000 $6,596,431
Equity$1,240,000 $2,992,862
Cummulative Cashflow$240,000 $450,000
Cashflow plus equity gained$480,000 $2,442,862
Return on Investment48%244%

These life enhancing types of returns are not possible without debt.  

Now I know what a lot of people are thinking. Debt adds additional risk into the deal.  And while they are right by thinking that, what they don’t understand is that there is also a risk of not utilizing debt.  And that risk is the loss of all that income, appreciation, and depreciation.  You reduce your risk with the debt, by simply finding deals that can break even between 60-70% occupied.  That way, you can get through recessions, or other economic storms that you cannot foresee.  I will post another blog in the future on how to build a recession proof portfolio.

That takes me back to why banks like to work with Towner Companies.  They know that we are sophisticated investors who know how to put a business plan together to ensure that debt is serviced adequately, each and every month.  If you are able to stay with me with all of these numbers and formulas, then congratulations.  You will be able to utilize this powerful tool, and should have no issues “talking the talk” with your bankers when you are putting your deals together.

Next time you hear someone say that debt is the devil, or that you must get out of debt, make sure you don’t just take their word for it. You want to get out of “bad debt”, that is debt that leaves you with liabilities, and get into “good debt” when it rewards you with assets.

And an asset, be definition, is something that puts money into your pocket each and every month and year.  If it doesn’t do that for you, it is a liability, and it is probably best to not have debt for it.

I want to share one more brief story before I wrap this blog post up, and its in regards to Amy and how she views debt.  Amy is incredibly frugal with how she lives her life, and how she operates our business, and our own personal finances.  Most people think I handle our finances because I am the one who does the acquisitions and all that, but Amy takes the leadership role in that aspect of our lives.  She’s smart, savvy, and unemotional to money.  It doesn’t get her too high or too low.  That being said, anytime I want to buy a new gun or bow for deer hunting, a boat, some hunting land, or just a random purchase on Amazon or at Scheels, it causes her a bit of heartburn.  We usually talk about it, and I get out my best sales pitche and hopefully close on what I want to buy.

But whats funny is that its easier for me to tell her I want to take out a $500,000 loan on a new real estate deal, than it is to tell her I want to pay $99 for a new zip up hoodie.  Although she is very frugal and takes the lead on our personal finances, she knows that the $500,000 of debt is going to put bigger deposits of money back into our pockets on a consistent basis, but the $99 is going straight out the window and I will probably not wear the hoodie in 2 or 3 years from now.

In fact I have never once had her tell me that she didn’t wan’t to take a loan out on a property.  She only asks if I have ran all the numbers and if I am confident in the deal, which I always have because that is my specialty, so we agree as a team to pull the trigger, and we move on and never think twice about the decision.

That is when everything gets handed over to Amy, so that she can handle the operation of the asset.

Amy serves as Vice President, Secretary, and Property Manager

I hope you now can understand why I love banks, and what I love debt.  I also want to place a point of emphasis on the importance of having relations with banks and commercial bankers more specifically.  If you are able to show that you are a sophisticated investor, and that you fully understand how to operate whatever asset you are buying, they become your best friend and truly are a partner in all of your deals with you.  Utilizing debt is a powerful tool, that allows you to create money out of thin air.

I can remember my parents telling me when I was a kid that money doesn’t grow on trees, but it actually can when you are intentional with your investments and continue to increase your knowledge in the business of real estate.

But if you are not a sophisticated investor, then its important you either stay away from utilizing debt, or you hire a coach or mentor to teach you the basics (its really quite simple once you get over the hump) so that you can ensure you are only utilizing debt on winning deals.

Best Regards,

Greg

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