Like a great spouse, the “good” kind of debt can be your best friend when it comes to investing. Debt can be used to increase your returns, and it can be the product itself for making money. Many people have become fabulously wealthy by successfully leveraging debt. But like a not-so-great spouse, debt can also be the friend you wish you had never met, as it has taken many investors all the way to bankruptcy.
Debt is one of the most powerful tools for wealth accumulation, and like any powerful tool, it must be respected, understood, and properly used for the benefit of your portfolio.
Two ways to use debt
There are two ways you can use debt for investing. The first way involves using debt as leverage to yield better returns, like when you purchase a piece of real estate and take a loan out on the property. The second way to use debt is by being the bank or lender, so you own the debt in the form of a first trust deed, a mortgage, or a note.
1. Debt as leverage
When you purchase an investment with debt (i.e., buying property and using a loan for a portion of it), you leverage your money. If you are doing it correctly, you will have a higher return.
Real estate is a perfect example. Let’s say you invest in a single-family home that costs $200,000 and you put 25% down ($50,000). Your investment is $50,000 cash out of pocket. If you are paying 5% on the debt service and your investment produces a greater-than-5% net return (if your rent money received is greater than the total of your mortgage payment and all your expenses), you have a winning formula.
Let’s look at two different scenarios to see how we can successfully leverage debt for a greater return on investment.
Going back to the single-family home, let’s say you have $200,000 in cash and you decide to use all of it to purchase the home. If the rental produces $20,000 a year in net operating income or NOI, which is what you’re left with after expenses, that would be a tidy 10% return on your investment of $200,000. Not bad, but it could look a lot better if you were to use debt to leverage your investment.
Let’s say you decided to invest only $50,000 cash out of pocket and were financed through a bank loan for the rest. You still have an NOI of $20,000, but now you’re paying $10,000 a year in debt service on your loan. Subtract the $10,000 debt payment from the $20,000 NOI, and your net cash flow decreases to $10,000. But, don’t despair. You only invested $50,000, not the full $200,000, so your return on investment INCREASES to 20%. Do you see what we’ve done here? Just like that, by using debt, we increased your return from 10% ($20,000 net income on a $200,000 investment) to 20% ($10,000 net income on a $50,000 investment).
But, wait a minute. Your return on investment has doubled, but your net income has been cut in half. How do you increase your return AND your cash flow? Well, you still have another $150,000 to work with, so rather than let it sit idle, let’s take your full $200,000 in cash and split it up into four $200,000 rentals with $50,000 down each. If each one produces $20,000 a year in NOI, your combined NOI would be $80,000 per year. Of course, there’s your debt service, so we’d have to subtract $40,000 in loan payments ($10,000 a year for each of the 4 homes). After accounting for the debt service, you’d be netting $40,000 a year on your $200,000 investment—again, a healthy 20% return on investment, but now, your entire $200,000 is working for you, leveraging your money for greater cash flow.
As with any investment, there’s always risk, so if your cash flow were to drop below $40,000, your investment would turn into an expense. I am not going to go into all the math, but you get the picture. Once again, debt can be a friend or a foe.
2. Being the bank
The second way to use debt, by being the bank or lender, makes you the note holder. (A note, or promissory note, is basically a promise to pay back borrowed money.) There are lots of options for being the bank—like purchasing performing and non-performing mortgage notes (non-performing being the trickier of the two), hard money lending (often used by developers or flippers looking for construction loans that corporate banks won’t provide), peer-to-peer lending, small business loans, and Treasury notes and bonds (IOUs from the U.S. government paid at a low interest rate with different maturity lengths).
Does this type of lending work the same as far as risk and reward? It certainly can, yet I think most investors who act as the bank downplay the overall risk. The problem is, when things go bad with the economy, they usually go really bad in many different ways, not just one.
This was a hard lesson my business partner, Steve, and I learned during the big recession before we started Hughes Capital. Steve and I (along with about a dozen or so other investors) were “the bank” on many different properties, but they were all vacant land. (When things go bad with vacant land, it just becomes an expense!) All the investors lost a lot of money on the deal, and while we were able to recoup some of the losses (Steve and I spearheaded the efforts for the group), it took a long time and a lot of energy to get to that point.
After having had this painful experience, we knew we never wanted our investors to go through the same thing. That is why we insist on stress-testing all our investments and funds to understand what they would look like in a serious downturn. Our buy and hold fund purchases single-family homes that can always be rented out and be income-producing. Not only do the homes produce consistent cash flow, but we’ve thoughtfully structured the assets to be recession resistant, continuing to generate investor returns, even in a bad downturn.
How we use debt
It’s also common for investment funds to use debt to leverage investor returns. In fact, our buy and hold fund has lenders who receive a fixed annual interest rate as debt payment. Just like buying a house with cash, if we used only equity (investor cash) to purchase homes, returns would be slightly lower. By having lenders—investors who act as our “bank” for let’s say 20% or so of our working capital—it leverages the whole investment, driving up investor returns. (Funds have to be careful not to use too much leverage, as it can be risky. Our fund keeps leverage on the lower side of what’s considered effective, which results in safer, more consistent returns overall.)
Offering debt and equity positions in an investment works well because it appeals to two different types of investors, and it even offers two options to the same investor, if they’d like to be involved in both the debt and equity sides. For investors who like the idea of earning higher potential returns with a slightly higher risk, you can be an investor on the equity side. (Hughes Capital investments fall very much in the conservative investment category, though there is always a measure of risk). For investors who prefer an even more conservative approach, you can be a lender at a lower, fixed interest rate. Another benefit to being a lender is that we must pay our loan debt to lenders before we pay returns to investors, so lenders are in what we call “first position,” making it a safer place to be.
I am always surprised at how few people truly understand that there are many types of investments out there that can produce consistent returns with very little risk, with our buy and hold fund being only one of them. Maybe I shouldn’t be all that surprised. We’re not taught about investing in school, most of our parents weren’t savvy investors, and for a lot of people, investing beyond putting money in a low-interest savings account or 401(k) is an intimidating concept. It’s unfortunate, because people who don’t take the time to understand the benefits of investing—particularly in non-traditional assets like real estate—are missing out on strategies that could help them build their wealth and investment portfolio.