Good Debt vs Bad Debt

Good debt vs bad debt. It’s a topic that often sparks debate and confusion, and while some people believe that all debt is bad, the reality is that not all debt is created equal. In fact, when used wisely, the right kind of debt can be a powerful tool to build generational wealth.

3 Unbreakable Rules

As a mentor, I have the privilege of helping investors buy commercial real estate across the country. To invest, they must use debt to build wealth based on our advice. It’s a huge responsibility, and I would never have them do something that I wouldn’t do myself. So, when it comes to using debt, especially in real estate, there are three fundamental rules you should never break:

1. Never Borrow Against Depreciating Assets: Never borrow against things that lose value over time. Cars and poorly chosen real estate investments with declining value are prime examples of depreciating assets. However, debt is your friend when you borrow against appreciating assets.
2. Have a Well-Designed and Realistic Exit Strategy: Your exit strategy, essentially your plan to repay the debt, should be rock solid. Ensure that this plan is realistic and well thought out and agreed upon by you and a knowledgeable mentor.
3. Acknowledge the Power of Debt: Never underestimate the impact debt can have on your future. While it can help build wealth, if misused, it can quickly become a trap. Use debt with caution, purpose, and responsibility, always bearing in mind its potential to shape your financial future.

What is Good Debt?

What is the difference between good debt and bad debt? Good debt can be defined as money borrowed to acquire assets that appreciate or generate income. This type of debt, when used with caution, purpose and responsibility can contribute to wealth creation over time. On the other hand, bad debt refers to borrowing money for items that depreciate and provide no long-term benefit.

One of the most effective ways to use debt to build wealth is by investing in income-producing commercial real estate in stable and growing markets. Instead of buying single-family homes, which often don’t yield substantial long-term benefits, commercial real estate such as multifamily, self-storage, mobile home parks, flex space, and retail spaces can generate ongoing income and appreciate over time. In other words, good debt is debt that is leveraged wisely to invest in commercial real estate and build wealth that you can transfer to future generations.

Leveraging Debt to Build Wealth

Take the case of our students, a father and son, Phillip and Andrew. They recently purchased a 12-unit multifamily for $1,015,000. Here’s why their debt can be considered “good debt”:

Strategic and Purposeful: They secured an 80% loan-to-value mortgage, putting down 20%, with an interest rate of 7.1%, 30-year amortization, fixed for 10 years which allows Philip and Andrew to ride out any market volatility.

Appreciating Asset: The property will increase in value because it’s an income-producing asset. Every month the tenants are paying rent, and Phillip is paying down his mortgage. So, month by month, his mortgage is reduced, and his equity grows. The second way we will appreciate this asset is through forced appreciation. With forced appreciation (e.g., through renovating and raising rents to meet the market rate), their investment’s value will grow over time. By simply raising the rents, we can force the appreciation from $1,000,015 to $1,400,000.

Debt Coverage Ratio: The property has a debt coverage ratio (DCR) of 1.6, meaning their net operating income is 1.6 times higher than their debt payments. This ratio is well above the usual lender requirement of 1.2, ensuring they have a cash flowing asset and added financial security.

Long-term Value: This 12 unit property has a 3000 square foot basement with incredible potential. Philip and Andrew have a 5-year plan that includes two basement units that are currently offline. Once they are renovated and occupied, the value of the property will increase to $1,700,000. This is a perfect example of strategically using debt to acquire an income-generating property that appreciates in value and can transfer wealth from Phillip to Andrew.

7 Attributes of Good Debt

These are the seven attributes of what well managed debt looks like:

1. Strategic and Purposeful: Debt should be well-planned, with strategic goals and based on expert advice.
2. Buy Appreciating Assets: Focus on purchasing income-producing assets that will yield benefits over time.
3. Debt Coverage Ratio: Ensure your income significantly exceeds your debt payments for consistent cash flow. Phillip and Andrew’s property had a DCR of 1.6, meaning their net operating income was 1.6 times higher than their debt payments.
4. Fixed Interest Rates: Secure long-term, fixed interest rates to protect against market volatility. Unlike residential real estate, which are fixed for 25-30 years, most commercial loans are only fixed for 5-10 years. So, a 10-year fixed loan is considered long-term in commercial real estate.
5. Tax Deductibility: The interest on the debt is tax deductible. So, every year Philp and Andrew can write off what they paid in interest on this property.
6. Long-Term Value: To build wealth with commercial real estate, you need to think long-term. Aim for long-term investments, with an outlook of ten years.
7. Wealth Transfer Potential: Good debt can facilitate the transfer of wealth to future generations.

Debt Management 101

To protect yourself when using debt, implement these 3 risk management strategies:

Maintain a Healthy Debt Coverage Ratio (DCR)

The Debt Coverage Ratio (DCR) determines the property’s ability to pay (or cover) the property’s loan payments out its Net Operating Income (NOI) and is calculated by dividing the NOI by the annual debt payments. You want the NOI to cover the debt by at least 1.2 times because most lenders require the DCR to be at least 1.2. If the DCR is 1.0, your debt and your NOI are the same and therefore you are just breaking even. Even worse, if your DCR is less than 1.0, then you have negative cash flow and are losing money each month. Therefore, a healthy Debt Coverage Ratio is crucial to managing your borrowing risk. Ensure your net operating income is at least 1.2 times your debt payments (or higher) to maintain cash flow and reduce the risk of overleveraging.

Build Cash Reserves

Having a rainy-day fund is just common sense, but where do you start? We instruct our students to have at least 5% of their property’s gross annual income set aside as cash reserves to manage unexpected expenses or financial downturns. These are your initial cash reserves, and the goal is to build them up over time. To manage your debt risk, do not spend any of the cash flow from your property until you have your cash reserves in place as a safety net for lean periods.

Effective Asset Management

The third strategy to managing debt is effective asset management. And it’s key to understand the difference between asset management and property management. As the asset manager, you are responsible for overseeing the property manager (management) and ensuring the financial health of your investments. We train our students how to effectively manage their asset by focusing on the 4 Ms: management, money, marketing, and maintenance. Imagine the 4Ms as a four-legged stool, if one falls away, the chair will collapse. So, you need to have a system in place for the 4Ms to ensure optimal property operation and debt repayment.

By following these guidelines and implementing smart strategies, you can leverage borrowing to build substantial wealth while minimizing risks. Questions or Comments? Text PETER to 833-942-4516.

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