A question I get all the time is, “Should I buy rental real estate with debt?” And here’s a simple, I’m just a tax attorney, but I look at returns all day long of successful investors, and I see a lot of failures as well. And invariably, those failures have to do with something called over leverage.
So from a real simple standpoint, and there’s studies that back this up, if you as an investor can get to about seven properties that you own outright, it’s more than likely, more likely than not, that you will never have to work again. In other words, you’ll have enough income coming in off of those, if they’re just average, that you will be replacing your income, and have enough money put aside to handle any repairs or any expenses that are associated with those properties.
In order to get there, sometimes you’re using debt, but you have to run your numbers right. So I’m going to give you some real easy rules of thumb.
Number one, there’s something called a cap rate where you’re figuring out what you’re actually getting on a property. So if I buy a piece of property at $200,000, and it’s netting me, what I’m actually putting in my bank account at the end of the day is $10,000. Then I would take that 10,000 and I would divide it by the 200,000, and what I’m going to get is a five cap.
What that means is that would just be termed a five cap; you’re getting 5%. And the easiest way to figure it out, is you take your gross rent, the total amount of rent that you’ll be getting for the entire year, and just cut it in half. Because you’re going to have something called a CapEx. You’re going to need to put money aside for repairs. You’re going to have insurance. You’re going to have property managers. You’re going to have repairs. You’re gonna have all those things that come up that you’re going to have to pay expenses on. You’re gonna have vacancies. You’re gonna have all sorts of stuff that you can’t control.
And what it means is that if I have $2,000, a month of rent coming in, I’m probably seeing 1000 of it come into my pocket. And this is the most important part is that out of that $1,000, I need to be able to pay my debt service.
So again, $200,000 property, if it’s mortgaged, and I’m at a 6%, or something like that I am paying $12,000 a year just in mortgage payments. I am now going to be in negative territory, if I’m bringing in that 2000. Remember I’m bringing in one, I am now breakeven or negative, which scares me, because I don’t have any wiggle room.
Now, if you have a bunch of cash set aside, ignore me a little bit and say I can cover it. Everybody else, I’m going to say this is what destroys real estate investors. So be very, very careful with that. I’m just going to say, if it’s me, my first few properties, I’m going to try to buy with cash, or I’m going to lever myself to the tune of maybe 60% to get more properties. Sell ones that go up, maybe I’m flipping a property to pay off the others or I’m going to use the extra amount of money that I’m bringing in to pay down that debt as quickly as possible and get out of debt so that I have properties outright.
Again, there’s been studies and I remember watching a podcast that was so interesting, was internet I call it podcast but it was a video, I guess is the easier way, of Dave Ramsey when he was talking to somebody about whether he should be levering up the existing real estate he had. And the numbers that were used was, hey, seven properties outright is better than 15 to 16 properties with 60% leverage. Like you’re going to be much better off.
So I’m going to say your goal is to own a bunch of properties and own them outright. So I hope that helps. I’m just trying to give you the best advice possible. That doesn’t mean you don’t use debt, but you treat it like fire. Controlled fire is okay. Out of control fire eats you up. And so we want to make sure that we are always in a position to control it, and extinguishes it so it doesn’t burn us.
So click on the link to get more information, or to talk to us so we can determine and help you determine whether or not it makes sense for you to use debt on a property.
Transcribed by https://otter.ai