Why Debt is a Good Thing in Real Estate

I worked through high school and college at a local Boy Scout Camp every summer. For my efforts, I earned a great scholarship to the University of Colorado. The donor who established the scholarship fund had given the Boy Scouts $4 million. One night he hosted a dinner to celebrate the successes of the scholarship recipients.

I was asked to stand and say a few words about what the scholarship had meant to me, and I shared that I knew I was lucky to graduate from college debt free when many of my peers took on tens of thousands of dollars in debt for their education. The donor then stood and said, “You’re debt free? I owe $100 million and people say I’m rich!”

The Power of Leverage in Real Estate

There are a few places where people commonly take on debt no matter their background. Real estate, car buying, and college educations are often funded through loans. This article is not about debating the merits of car or student loans. We are going to focus on real estate debt.

In commercial real estate, banks generally require more than the 20% down payment standard in residential real estate. It is common to see requirements for 30% down or more for an investment property. 50% isn’t uncommon of depending on the project.

But with investment properties, we care more about the cash flow than the total amount of the debt. For easy math, you can generally get a loan for two to three times your down payment amount. If you have $100,000, you can get into a $200,000-$300,000 project. If you have $250,000, you can get into a $500,000-$750,000 project. With debt, your money can get you a lot more.

Focus on the Cash Flow Rather than the Price Tag

Assuming you can reach the price tag of a project with a loan, you have to look at the projected cash flow to determine if it is a good project. To project a project’s cash flow, you have to estimate both the revenues and expenses of the project.

To estimate the revenue, look at the number of units and projected rent. To do so, look at comparables in the local area for units of similar size and quality. For costs, consider owner paid utilities, upgrades and rehab, management fees, and costs to list and rent out the units. But don’t forget the loan payment! You can estimate that with a mortgage calculator.

Subtract your projected expense from the projected revenue to get your monthly cash flow. If the project would yield a profit that is reasonable when compared to the investment, it is a good project.

Do the Math to Understand Your Long-Term Forecast

While real estate investing requires some estimates, the decision to go forward on a project and take on debt should be based on good old fashioned math. Calculate several scenarios for a best case, most likely case, and worst case to get an idea of what’s possible. Try to be as realistic as possible when estimating to ensure you don’t get underwater on a bad project.

If you already own a property, you can use the same logic when looking at upgrades and other projects. If you are considering a major renovation financed with debt, you can look at the projected rent increase compared to the costs and projected loan costs to estimate the financial outcome in advance.

Debt Can Be Good, Sometimes

Debt in real estate can help your income grow to places you couldn’t have thought possible. Every year people use real estate to supplement and grow their income. Sometimes it goes so well that the investor can quit their day job thanks to passive real estate income.

But on the other side, debt can be crippling. Taking on too much debt or getting underwater on a project can leave you in financial ruin. It can drain your savings and leave you with nothing. Always do the math and take extreme care before signing on the dotted line.

But if the numbers check out, you could be sitting poised for a great new life thanks to real estate investing. If you are ready to go but not sure where to start, working with a real estate agent with a specialty in investment properties could be the best option for your needs. Before you start searching for the right property, you need the right agent. Start your search for the best agent at AgentHarvest.

If you are buying or selling a house and are looking to hire a successful real estate agent to help you through the process, take a look at AgentHarvest's list of top-ranking local Realtors in your area. We found these agents by examining their sales track records, awards, rankings, client testimonials and by conducting personal interviews.

Leave a Reply

Your email address will not be published. Required fields are marked *