First, let me say that I am a real estate investor with 20 years of experience, own a decent-sized (~1500 unit) property management company, and have an MBA with numerous graduate-level finance classes under my belt. That said, here is my take on debt, as it relates to real estate investments.

Any capital investment, whether a small rental property or a billion dollar factory requires capital. That capital can only come from two places: equity and/or debt (or put another way, your money or someone else’s money). The mix of equity and debt is what is known as the “capital structure” of the investment.

Capital comes at a cost. With debt, the cost is interest. With equity, the cost is whatever else you could have done with the money (opportunity cost). Typically people demand a higher return on their equity than the bank does for debt. The bank might be willing to give you a 5% mortgage, but you expect a 10% return on your investment. The difference is known as an equity-risk premium. The reason this can happen is because, legally, debt gets paid off first so it is less risky to the lender — the bank gets paid first and you get what is left over.

Ultimately, an investor needs to decide on the best capital structure for their properties. This is not a one-size-fits-all decision, because it depends on what you are trying to accomplish. If you are looking for secure income, such as in retirement, then free and clear properties are a good way to go. However, if you are looking to maximize your return on investment, then you must introduce debt into your capital structure (I’ll spare you the math, but it is true).

If you are going to use debt, there are a few things you need to understand. First, is that you have to make sure that the rent from your properties can service that debt with a comfortable margin of safety. If you have 10 units, make sure that you can pay your bills if only 7 of them are rented. Also, have a healthy cash reserve in case something goes wrong. Second, there is a trade-off between debt and cash flow. It is very unlikely that you will find a highly-leveraged property that has a large positive cash flow. If you find one, you are probably making poor assumptions about the operating expenses.

Where the “no money down” crowd goes wrong is that they assume that property values will always rise, and that they can use 100% of someone else’s money to capitalize the investment and service the debt, while accruing 100% of the appreciation to themselves. This is great, until it isn’t (as we’ve seen in recent years).

The bottom line is that some debt — particularly fixed-rate debt — can be a healthy thing to add to your investment portfolio as long as you don’t overdo it. Being over-leveraged can take you down. But being under-leveraged can lead to mediocre returns.

…jp