Debt increases risk. Why use it?

Question

Debt increases riskSo why do investors love using it?👇Debt, when used correctly, is one of the most powerful benefits with real estate investing.We can take $3.5M of investor equity↓And purchase a $10M apartment community.↓The bank receives a fixed rate return↓And the investors keep all the upside!Because of this, debt will always multiply returns 📈We don't follow Dave Ramsey's advice on this topic.

What are your thoughts about using debt to buy real estate?

Stuart Udis · Answer

@Justin Goodin thanks! Perhaps I will send over the loan agreements for the nearly $13M in real estate debt I originated in the last 90 days as the sole gaurantor so you can point out where I tripped up and perhaps you can even explain to me what I signed :)

Melanie P. · Answer

To be clear: you've never actually taken $3.5 million of investor equity and purchased a $10 million apartment building, correct?

Unfortunately there is no such thing as a "lifetime" interest rate on commercial real estate loans. They are typically due in full 3-5 years after being written. Using your example there is no way for a $10 million apartment complex to pay back $6.5 million in debt in 5 years. So there has to be another plan. What many investors are learning is that this leads to terrible outcomes including paused distributions and loss of principal invested.

You are technically correct that debt will always multiply returns. But you are implying this is always positive when in fact debt is just as likely to multiply negative returns as positive ones. Especially in a declining market.

Your statements should give serious pause to anyone considering a syndicated real estate investment. Because this is the attitude, but not the reality, of the industry.

Stuart Udis · Answer

@Justin Goodin   This is honestly the most reckless apporach to real estate debt I've heard in some time. This is how bank originated debt works in the apartment scenario you describe: The lender collects their origination fees and debt service payments are then collected priorty every month until the loan is paid off.  If there's a correction in the market, guess what? The loan you originated still must be paid in full. If rates unexpectedly increase and the loan term is coming due, guess what? You are showing up with a check to refinance the loan. If you experience vacancies, guess what? That monthly payment is still due. If expenses  increase, guess what? That monthly payment is still due. You clearly don't protect the downside with your approach to originating debt. This is the recklessness that's getting a ton of apartment syndicators in trouble right now. Debt if used responsibly is a valuable tool but to say debt will always multiply returns is the wrong message to spread in these forums where there's a ton of readers who are inexperienced investors and will fall for the trap of following your flawed approach to originating debt.

Chris Seveney · Answer

Ask all the syndicators right now how debt is working out for them? In can multiply returns but what everyone also fails to mention is it can also multiply losses.

Now I am not opposed to debt but there is smart debt and bad debt.

This is also my issue recently on BP. People forget to mention risk in every conversation. If you ask any HNW individual they are never about multiplying returns - they are concerned with preservation of capital first and foremost.

This is also why many investors never achieve HNW, they want to get rich quick and get as much money as fast as possible and they never get close because they do not know what they do not know, which involves the risk in real estate and especially syndications.

ok I will step off my fake podium and go back to work.

Robert Rixer · Answer

Debt has no feelings, it's just an amplifier. If you do a good deal it can turn it into a great deal, if you do a bad deal it will turn it into a terrible deal. Of course no one goes into a deal expecting it to be bad so many investors unfortunately only calculate one side of the debt equation.

George Voutsinos · Answer

Some operators are in trouble now because of how they bought years ago utilizing bridge debt, variable debt, etc.  That's why it's so important to buy right & finance right.  Not many buildings being bought in cash and not sure how many are traded but it's safe to say using debt is inevitable. Best thing to do is get fixed rate financing if you can.

Alan F. · Answer

I think you're 100% correct, that being said since Dodd Frank debt is not a tool for the self employed pr very small businesses. I have to rely on liquidity.

Justin Goodin · Answer

If you need additional help understanding how debt works in real estate, please send me a DM and I would be happy to help you out. It’s clear that you completely do not understand the point of my post. Best of luck to you!

Justin Goodin · Answer

I knew there would be at least 1 person who would bring up the current events 😅

Too much of anything is bad. Too much vitamin C is bad.

Of course there’s risk with debt. There’s risk with buying properties in cash too. Debt is a powerful tool. But I agree with your post overall.

Debt increases risk. Why use it?

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