Should You Use Debt to Invest in Commercial Real Estate?
“Debt is bad.”
Most of us grow up learning and believing that statement (or something close to it) to be true.
And, for the most part, it is. But like everything else in life, context is, well … everything.
For example, if you came to me and told me you were unemployed, going to max out four credit cards, and ask grandpa for a loan to buy a brand new F150, I’d tell you that’s a straight up bad idea.
And the “debt is bad” advice is mostly talking about just those sorts of transactions, consumer debt.
But what about using debt in a different context? What if you’ve spent hours and hours researching a particular investment, a proven investment that you thought had a reasonable chance of return? What if you came to me asking whether that might be a good use of debt?
Well, I always refrain from giving advice like that, but for the sake of this analogy, I might be convinced it’s a good idea.
Here’s the thing… debt isn’t always bad. You have to be smart and careful in your use of it, but it can be a powerful weapon when it comes to investing in commercial real estate.
What is Debt (in the Context of Investing)?
Simply put, debt is the borrowing of capital (money, or access to it) from a person or organization, in order to acquire something (investment) you can’t afford to acquire on your own.
Debt is leverage. Taking on smart debt gives you leverage you otherwise wouldn’t have to be able to make intelligent, well-informed investments.
As we’ve already touched on, there is such a thing as good debt and there is such a thing as bad debt.
Bad debt would include things like credit cards. And the use of those credit cards for purchasing consumer items that do not increase in value. Now, that doesn’t mean we can’t have nice things, only that -- in my opinion -- we shouldn’t be purchasing nice things if we don’t have the cash to pay for them.
Good debt would include things like a loan secured from family and friends, or a bank that allows you to purchase (or invest in) things that do increase in value, give you monthly cash flow, or give you a longer term return on the investment. I happen to call an item like that commercial real estate!
To illustrate the difference between good debt and bad debt, I’ve been using the acronym “BURL” for quite a while... it means Buy Utility, Rent Luxury.
That is, if you can’t buy a property for more than 100X the monthly rental cost of it, then rent it. That solves both overspending AND the problem of not being able to charge enough rent on that “super great deal” you just made on that duplex.
BURL can be adjusted for geographic location, but it holds true in almost any situation, and it will almost always keep you away from bad debt.
The Pros and Cons of Using Debt to Invest in Commercial Real Estate
Let’s take a look at the good and the bad of using debt to invest in my favorite play… commercial real estate.
Debt isn’t always the answer, but for most people, it might be the only way to have a shot at creating generational wealth.
A Few Pros of Using Debt to Invest
You have no cash.
This is likely the most obvious pro in the list. When you have no cash of your own, you’re extremely limited in the investment opportunities you can take advantage of. Don’t feel weird about this, most people have this problem, and most people can remedy it.
Other people’s money.
Why risk your own capital (if you have it) when you can risk money that’s not yours. Now, don’t get me wrong, I’m NOT advocating for the reckless acquisition and deployment of other people’s money, absolutely not. But any debt that is acquired in good faith comes with a knowledge of risk from both sides. Use other people’s money, then do everything you can to successfully invest it.
Return on investment.
The larger the investment, the larger potential return. Let me put it this way, if you only have a couple thousand dollars to invest in real estate, 1) you’re not going to get very far and 2) even if you do, the return on that amount is not going to be that great. On the other hand, if you have $100,000 to invest, well, you can see that it opens up an entirely new world.
Leverage.
Leverage allows you to place less money into a deal and yet still make more return on your dollar than you could on your own. This is, of course the central point of this article, the one that will enable many to get into the real estate game in the first place.
More.
With debt, you’re able to purchase more properties, which obviously allows you an even greater opportunity for return on investment. But it will also allow you to spread the risk over those multiple properties and enjoy even greater tax and appreciation benefits!
A Few Cons of Using Debt to Invest
Risk.
First things first, when engaging in the use of debt for the purpose of investing, you can lose big. I mean, you can lose it all. That has to be said very clearly in this conversation. Even with top level due diligence, the element of risk exists in every investment situation. If you’re not able to recover and carry on from a particular leveraged deal, take a hard pass. Never bet the farm.
Accountability to a bank or investor.
As soon as you sign on the line that is dotted (hat tip to David Mamet), there exists a very real shift of power. You go from completely independent to, at least, somewhat shackled to a creditor. Now, if you know what you’re doing, this won’t likely be a huge problem. But if you don’t, you might be unwittingly entering into a world of hurt. Either way, when you take on debt, you’re no longer 100% in control of your destiny.
You’re not worthy?
When looking for financial leverage, you need to have your ship in order. This is good advice generally, who doesn’t want to move through life with everything in its right place? But in the pursuit of good debt, this principle arrives on steroids. You need to prove, sometimes in minute detail, that you can handle the debt you’re seeking and that you can pay it back, on time and in full.
Penalties.
Along the same lines as the last “con,” if you don’t play by the exact rules laid out in your loan deal, there will be penalties. From late fees all the way up to the bank calling in the loan, things can go wrong. Sometimes, by no fault of your own (crazy weather, downturns in the economy, etc.), but you need to be prepared, not only to keep your word to your creditor, but to pay the price if you don’t.
Paperwork!
Yep, this one’s a killer. If you’re going to get into the debt game, prepare yourself to do a lot of reading, a lot of signing, and likely a lot of lawyering. In the acquisition of leverage, paperwork is endless. It’s just how it is, best thing to do is accept it and get your pen ready.
Wait, There Are Different Types of Debt?
There are many different types of debt you can look into for your deal, from bank loans, to private lenders, to friends and family.
Most commercial real estate loans originate in banks, but that doesn’t mean that yours has to. You might have family and/or friends who are looking to hold or grow their money outside the conventional means.
That said, here are five common types of loans you’ll see out there…
Conventional Loans: The most common by far, conventional loans are used mainly in the purchase of homes by consumers (you and me), but can be leveraged for commercial real estate deals.
“Hard Money” Loans: If you’re looking into a commercial property that needs a little tender loving care, this might be the way to go. Usually backed by private lenders outside the traditional banking system, Hard Money usually moves things along faster than any other form of debt.
Blanket Loans: These are used mainly by developers to purchase large amounts of land or several properties at one time, not likely where a beginner is starting, but something to keep in mind, depending on the type of deal you’re doing.
Portfolio Loans: These are for folks who may have had a few financial bumps and bruises along the way, or are looking to purchase a “weird” property. This type of loan may be generally easier to obtain, but may come at the cost of higher interest rates.
One last thing… whichever way you go, do not overlook how your debt is structured. This can make a lot of difference in your cash flow from month to month, and even your ultimate return on your investment.
Look seriously into concepts like interest rates, loan to cost vs. loan to value, amortization rates, and balloon payments, to name just a few.
Debt vs. Cash: Which Way Should You Go?
The answer to this question is intensely personal. Your experience and resources in the world differ vastly from the next person.
But the shortcut to an answer of some kind lies in the “Pros vs. Cons” section of this article.
Do you have zero cash? Leverage might be your only option.
Do you hate the idea of answering to a bank or other creditor? You’re in the all cash game.
Do you want to purchase more commercial properties than you can afford, spreading out your risk? Again, smart debt can remedy that issue.
Are you a risk averse person who hates paperwork? Cash is likely your way forward.
Re-read that section above, think deeply about both sides of this coin and how each way may or may not lead to the kind of life you want to live, to the kind of business and investments you want to build.
Let me finish this question with this…
Debt is like an axe. If you know how to use it, you can chop down a tree very quickly. If you don't know how to use it, it could hurt you, sometimes badly.
So, Should You Use Debt to Invest in Commercial Real Estate?
I obviously can’t answer that question for you, but I'm very much on the side of utilizing good debt in order to grow your portfolio... as long as you are intentional and wise about it.
The proper use of debt within a smart investment strategy can get you 4 to 5 times the amount of properties you could secure otherwise, which can increase your returns significantly over time.
Since we were children, we’ve been taught that all debt is bad and that only irresponsible, reckless, and poor people are in debt. Again, context. This is certainly true in many cases, but it might surprise you to learn how the wealthy actually use debt -- they need debt -- but to get wealthier and wealthier.
But that’s a story for another time.
In the meantime, If you’ve got access to $100,000 or more that you’re looking to invest in commercial real estate, I’d love to chat with you.
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