It’s funny. Two years ago, I had exactly zero idea how to invest in real estate. If you would have told me then that Selenid and I would be real estate investors with going-on 5-6 rental properties, I’m sure I would not have believed you. But sure enough, fast forward two years and we love real estate investing. Mostly because we learned the right way to do it and, in turn, have seen it have a major positive impact on our financial health, well-being, and net worth. It’s accelerated our path to financial freedom. The key though, was our education. We learned a ton of key concepts. But one concept that was hands-down the most difficult to understand was how to use debt to buy real estate.
And a lot of potential physician real estate investors struggle with this exact concept. I go on and on in this blog about the importance of getting out of debt. And yet here I am saying that you need to learn how to use debt to buy real estate?
It just doesn’t jive…at first.
And that is because you need to learn the important difference between good debt and bad debt.
Good debt and bad debt
I’ve gone in depth about good and bad debt before here.
But I want to provide a refresher because this concept is key to understand how and why to use debt to buy real estate.
So, what is good debt?
I’ll borrow my definition from Robert Kiyosaki in his book, Cashflow Quadrant.
Debt is good if you are compensated or paid for taking it on.
You may be screaming at the computer or phone screen right now saying that this is not possible. When we borrow money, we have to pay interest on top of the principle. So, how the heck would we get compensated for the debts that we take on?
I’m getting to this point. Stay with me.
What is bad debt?
Well, it’s the inverse of good debt.
Therefore, it’s debt that you are not compensated or paid to take on. I would venture to guess that most of the debt that most physicians think of fall into this category.
Now that we have these definitions in mind, let’s jump back to focus on real estate investments bought using debt.
Investment properties purchased with debt are examples of good debt
Let’s start with an example from my life. My wife and I bought a duplex with a purchase price of $174,500 using a 25% down payment and a mortgage. Thus, we owed about $130,000 on the mortgage when we closed. We increased our debt by six figures! Our mortgage payments added about $800 to our monthly payments toward debt service. (At least thankfully by this time we had paid off all our credit cards! But we still had six figures in student debt.)
But…that’s not where the story ends.
Every month, the tenants in our rental property pay rent. This rental income covers our mortgage. It also covers all other expenses like taxes, insurance, and maintenance. There is also extra that we put (usually tax-free) into our pockets.
There is no better example of getting paid to take out debt than investing in cash-flowing real estate. In fact, it is the best way!
I don’t think anyone can argue that this is bad debt.
So, this example I think does a great job of illustrating the why of buying real estate with debt. It is obviously a great way to use leverage to your advantage. You are using other people’s money (like the banks) to buy somethings that pays you money. This is the huge benefit of being an investment property owner.
But, what if you don’t use debt to buy real estate?
Of course, you don’t have to use it, even if you do know how to use debt to buy real estate. You can always buy a property in all cash. And there may be a variety of reasons for wanting to do this – landing from religious to risk tolerance.
If you fall into this category, this post will teach you 3 ways to buy real estate without debt.
However, this is the bottom line: Making a property investment using debt with give you higher returns compared to buying without debt.
For instance, using the same duplex I referenced above as an example, our expected cash-on-cash return (check out here for a refresher on how to calculate cash-on-cash return) using a mortgage with 25% down payment was 17.2%. This expected return drops to 10.3% if we had planned to buy using 100% cash.
Now, those are both good deals with excellent potential return. So, in all, both ways serve as a fine investment strategy. But the trade off with using all cash is a much higher initial investment required. In exchange for this, your monthly income from rent increases. But overall, the investment return, measured using cash-on-cash return, is less compared to a strategy with use of debt.
Let’s break down the pros and cons then…
Using debt to buy real estate holds the following advantages:
- Higher return
- Less initial investment required
So, what are the disadvantages? In my mind, there is one big one that ultimately is on every potential investor’s mind:
- Risk associated with holding debt
Or, in layman’s terms…
“What happens if I can’t get enough rent to cover the mortgage?”
Well, in this case. You went from making much money to making little money to eventually having to come out of pocket on this so-called “investment.” Basically, your good debt just turned into bad debt.
That is what everyone worries about!
But, we can combat this in a multitude of ways that allow us to harness the power of leverage (increased returns, less initial investment needed) while minimizing this risk in our real estate portfolio.
There are two main ways to do this:
- Become a limited partner in real estate debt funds or syndications or real estate investment trusts
- Bake away this risk in your due diligence when actively investing in real estate
How to minimize risk to use debt to buy real estate
This then becomes the real question and focus of this post. How to can use debt to buy real estate that maximizing its advantages and minimizes its risk? Based on the two concepts that I just presented above, I’m going to lay out a menu of real estate investing options that allow you to do just this!
(I also will note that now is a good time to consider your risk tolerance. Some of you will be find using an investment property loan to carry your real estate investment and some will not. If you are in the latter group, no problem! Keep reading and just choose from the below menu of options on the lower risk side.)
Your “how to use debt to buy real estate” menu of options
(Remember, higher up on this list means higher relative risk. Lower means lower relative risk.)
1. Use conservative due diligence in direct real estate investing
I’ve said this before but what I love about direct or active real estate investing is that its a numbers game. You set your criteria, run your numbers on a property, and if the property meets your numerical criteria, you buy it. If not, you move on to another property.
The catch though is that you have to have the right criteria and use the right numbers. Using the wrong numbers or criteria can give you a false “green light to buy a bad property. If you continually do this, you will find yourself in too much debt and big trouble.
So, what are the right numbers?
The way that I figure this out is using the cash-on-cash return metric. Cash-on-cash return (CoC) is the percentage of annual cash flow that a property puts in your pocket divided by the amount that you paid out-of-pocket for that property.
I pursue properties that reach an expected CoC return of 10% or greater. If it meets that mark, I am going to make an offer. If not, I’ll pass.
As an example, suppose that you buy a $150,000 property using a mortgage with 25% down. You also pay $5000 in closing costs and put another $5000 into renovating the property before renting it out.
So, you put $47,500 out of your pocket into the property ($37,500 for down payment + $5000 closing costs + $5000 renovation = $47,500).
Now, let’s say that after paying the principal and interest on the mortgage, maintenance, taxes, insurance, and all other expenses, you make $400/month from the property. That equals $4800 annually.
Therefore, your CoC is 10.1% ($4800/$47,500). Again, if you are looking for a more in-depth explanation of this criteria, take a moment to review here.
Boom…you should lock up this property! These are there right numbers and the right criteria telling you this is a property with a very high upside and low risk.
How can you reduce risk even more?
It’s actually pretty simple. Just be even more conservative in your estimates that lead to your cash-on-cash return.
Conservatively estimated your monthly cash flow by:
- Overestimating expenses like repairs, monthly maintenance, and vacancy, and
- Underestimating income, namely expected monthly rents based on local rental market conditions
When Selenid and I analyze a property, we always put in purposefully low rents and overestimate expenses as a “worst case scenario.” If it still cash flows well in this worst case scenario, we know that we have very low risk of going underwater and turning our good debt into bad debt. It’s never zero risk, but it’s very low.
2. Vary your debt strategy in active real estate investing
There are a ton of different types of loans and loan strategies available for investors.
Some of these strategies, like hard money loans with higher interest rates or loans with future balloon payments, increase risk. And some strategies will decrease risk, such as increasing your down payment,ents above the minimum 25%. Some strategies, like sell financing, are relatively risk neutral. And others, like using a home equity lone of credit from your primary home, depend on your mindset but are usually considered higher on the risk-reward spectrum.
Others have minimized risk in a unique way by using a second primary residence as a short term rental. This strategy is dependent on a mindset where you don’t really plan to make huge cash flow from the property but just to help cover costs by occasionally renting the place out. I would argue this is not really an investment strategy but rather just a slick way to have use people’s money to finance your vacation home. But, I’ll leave that for you to decide…
3. Invest in real estate debt funds or syndications
Real estate syndications and funds are more passive and less risky options on the “how to use debt to buy real estate” menu.
Basically, when you invest in these options, you are contributing only your money to the real estate investment at hand as a limited partner. To be sure, the general partners AKA sponsors of the deal of fund are using debt. But you as a limited partner will generally have less at risk since you are only contributing to a part of the initial investment cost.
However, there is still risk involved. That is why real due diligence is required on your part prior to investing. Look for deal sponsors that have been successful in the past (although this doesn’t guarantee future success, it’s nice to know they have done it before), that are education forward, and that are conservative (see point #1 on the menu above!)
More on these deals can be found here.
4. Use real estate investment trusts
REITs are huge funds that invest in usually class A range properties with thousands of properties in their portfolio. They still use debt and leverage to be sure. But they are really conservative and chase less return in exchange for this stability. Plus, you can buy REITs without really needing to do much due diligence and can use any brokerage.
REITs however are not the final and lowest risk rung of this ladder…
Watch Jordan’s Masterclass Webinar on The 12 Steps to Financial Freedom for Physicians here!
5. Just don’t invest in real estate!
You may be a bit surprised to see this here. Especially given that I just spent the previous 2000 words of this post talking about how great I think rREI is and teaching you how to use debt to buy real estate.
If real estate is above your risk tolerance, don’t worry.
Save 20% of your gross income. Invest in broadly diversified low cost index mutual funds. Rebalance yearly based on your asset allocation. Let compound interest work over a long period of time. Spend intentionally. (Maybe even make passive income from a physician side gig…) Then, when you reach your goal nest egg, retire on your own terms.
What do you think? Do you think we should use debt to invest in real estate? What debt strategies have you used in real estate investing? Do you agree or disagree that real estate debt is good debt? Let me know in the comments below!