As our property rehab business model utilizes debt, we are often asked by clients about the rationale behind leveraging the business to create what is viewed by many as a liability. The answer lies in the distinction between “good debt” and “bad debt”. To many, any debt is often viewed as “bad debt”, but our perspective on this is different, as it is with many like minded real estate investors.

Bad debt can be defined as any debt which creates a liability that one personally has to pay back out of pocket. This could be credit card debt, an auto loan, student debt, and as some would argue, the mortgage on a primary residence. This kind of debt takes money out of one’s pocket every month without providing any additional benefits. If one is not careful, it is easy to get carried away with this kind of bad debt and find oneself in a hole that is tough to get out of.

Good debt, on the other hand, can be used to acquire assets that create additional streams of cash flow that will, when used correctly, cover all of the loan principal and interest, create additional monthly cashflow, and create the build up of equity in the asset. The best example of good debt is debt used to acquire cash flowing rental properties. With the tenant essentially paying down the debt on the property, this is a powerful tool to more quickly build up wealth through a portfolio of cash flowing real estate assets. Let’s use some real numbers to further analyze the benefits of using good debt in a real estate investment versus using all cash.

Say, for example, a $100,000 rental property is acquired using all cash, and the tenant in that property pays $1,000 a month. What would the return on investment look like after one year, assuming 2% appreciation?

$100,000 INVESTED
INCOME	$12,000
EXPENSES
Taxes	$1,800
Insurance	$800
Property Management	$1,200
Repairs	$600
Capex	$300
TOTAL EXPENSES	$4,700
NET INCOME	$7,300
PLUS APPRECIATION	$2,000
TOTAL ROI	$9,300
	9%

A 9% return isn’t bad, but what would that return look like on the same property if debt at 75% loan-to-value, at 6% fixed interest amortized over 30 years, was used to acquire it?

$25,000 INVESTED
INCOME	$12,000
EXPENSES
Mortgage	$5,395
Taxes	$1,800
Insurance	$800
Property Management	$1,200
Repairs	$600
Capex	$300
TOTAL EXPENSES	$10,095
NET INCOME	$1,905
PLUS APPRECIATION	$2,000
PLUS PRINCIPAL PAYDOWN	$930
TOTAL ROI	$4,835
	19%

As shown above, the leveraged investment of $25,000 yielded a 19% return as opposed to the unleveraged investment of $100,000 which only yielded a 9% return. Even with the added mortgage expense, the power of debt helped this investor more than double their returns!

But what about the LIABILITY?

Even after understanding the power of debt to increase returns, many clients still are worried about their personal liability in assuming this kind of debt. Again, this goes back to the confusion between good debt vs bad debt. If the debt assumed were bad debt, then the liability should be a real legitimate concern. However, when assuming good debt, the liability is just not a legitimate concern, especially when assuming the debt through a limited liability company (LLC), which adds an extra layer of protection between the debt and the personal guarantor.

When a bank makes a loan to an LLC to acquire a rental property, the bank’s main concern is the value of the property. In a worst case scenario in which the bank has to foreclose on the loan, 99 times out of 100 they will simply force the sale of the property. That is why the bank will usually only loan in an amount of 75% of the value of the property. This means that even if the value of the property were to decrease by 25%, AND the property lost the tenant and was unable to replace with another tenant (a very unlikely scenario), then the bank would still be able to recoup their loan amount by forcing a sale of the property. A 25% decrease in the property value would very dramatic, especially in the markets that Paraprin operates in. To put that in perspective, during the last financial crisis of 2008 – 2010, arguably the most catastrophic housing market crash of our time, property value in Memphis decreased by 15% and Houston by just 5%. To imagine a scenario in which an even more catastrophic housing crisis hit, causing property value to decrease by 25%, AND at the same time not being able to fill a tenant in the property, even at a reduced rent, seems very far-fetched. Even if that scenario did occur, then bank would still be able to recoup their loan by foreclosing on property.  

If we take it to an even further extreme, say if the value of the property decreased by 35% and there was no tenant in place, then, taking the example of the $100,000 property above, the bank would still be able to recoup $65,000 of the $75,000 loan. If the foreclosure happened 5 years after the initial closing of the loan, then the loan principal balance will have been reduced to about $69,000, so the bank will only be short $4,000. The bank will then go after the assets of the LLC to recoup the remaining $4,000. If the LLC owns many other properties, as is the case with Paragon’s business model, then there will be ample cash reserves in the LLC to cover this shortfall.

It is only in an absolute worst-case scenario that the bank would still not be able to recoup the shortfall from the LLC and have to go after the personal assets of the loan guarantor. And even in that scenario, we are only talking about the shortfall between the loan balance and the amount the bank was able to recoup from the sale of the property and from the assets of the LLC, which is likely to be a small amount.

From a risk-reward perspective, the benefits of using leverage to quickly build up a real estate portfolio and increase returns dramatically outweighs the potential liabilities. That is precisely the reason why banks are so willing to lend against real estate. Try going to a bank to get a loan for another type of operating business. The bank will require a detailed business plan, thorough review from a loan committee, and ultimately some kind of personal guarantee secured by hard, tangible assets (most likely real estate). When going to a bank to ask for a loan for the acquisition of real estate, they will really only be concerned with the market value of the property and the rental income. As long as they can check those two boxes, the bank will be eager to lend because they know the chances of recouping their loan are very high, even in a significant downside scenario.

So don’t be afraid of good debt – embrace it! Use it to create cash flow and build long term wealth with the most historically proven asset class.