Isn’t it great that there are so many ways to get financing for real estate investment projects today? This is important as sellers somehow want to get paid for their homes when they sell them… Right?? Well, just because there seems to be an endless number of sources of money doesn’t mean that those funds are easy to come by… or if you can get them… easily afforded. In many cases, the borrower has to “jump through hoops” in order to end up with the required funds. Credit approval, ratings, LTV/ARV… and even then, they usually don’t get it. All they need is “skin in the game”.
Good Debt vs. Bad Debt
Most real estate investors are familiar with the expression “good debt vs. bad debt.” The problem is that most don’t fully understand the difference. My daughter knew the difference when she was 8 years old. I remember when we went to lunch and she went from asking me if I should do “plus and minus” to story issues. So, in the interest of “training her early in life,” I gave her business problems. she would inadvertently Learn everything from expenses to profits… including the differences between good and bad debt. Her understanding was so thorough that she could recite the definition and, more importantly, explain it when asked.
Unfortunately, we are no longer taught that in school. We are taught to be financiers/savers instead of being investors/entrepreneurs. In other words, we are never taught how “money works,” but we are certainly taught how to “work for money.” Knowing the difference between good and bad debt isn’t brain surgery, but the ill effects of ignorance can be enormous. The difference is very simple. Bad debt costs money, good debt makes money. Yes, it’s that simple.
What the banks know that we don’t know
The banks are aware of the difference. Just look at the difference between what they “pay” you for your deposits (and I use the word “pay” very loosely) and what they “charge” you when they “sell” you credit. Understand that banks’ business is to sell loans. You also know and understand the saying “own nothing but control everything”. They live on it. What’s fun is that using non-attachable debt, the real estate investor can do the same. You can almost become your own bank.
Bad debts cost you money because you end up with less than you started with. Good debt turns you into money because you end up with more than you started with. In business, one compares profit vs. expense. In our personal lives, we compare income to “income replacement”…sometimes referred to as credit cards.
The obvious examples of good debt would be things like SF rentals, multifamily rentals, commercial real estate, and other cash flow assets of note. Examples of bad debts would be the previously mentioned credit cards, boats, RVs, etc. The equity in our own home is not an investment. It doesn’t make us money, it costs us money to build it. Now if we take them in the form of a loan, they become debt… what kind of debt depends on what it is used for. Note that I’m not saying that we should all go out and refinance our homes, cash out the equity and invest. If you decide to do this, you do not have my blessing. You are endangering your home. Not smart. Especially since there are so many other safer ways to get funds to invest with.
The power of compounding… duplication on steroids
Banks understand all this. You convert your assets/deposits into loans/debts. That means credit from them and debt to you. They don’t own anything and can actually use credit, but actually sell you “virtual money” that is many times the “face value” of your asset on deposit with them. This topic is for another time. For the sake of this discussion, understand that the bank is exploiting the power of duplication. In fact, they harness what Albert Einstein called “the greatest invention of the 20th century”… Compound interest. He went even further, explaining that those who got it (banks) thrive on those who don’t get it (the rest of us).
You want a very strong example? Start with a penny… only 1 cent. Then double it for the next 30 days. So day 1 would be 2 cents, day 3 would be 4 cents, day 4 would be 8 cents and so on. do it on paper It will have a much greater impact on you. What’s the answer? Try it. You will be amazed. What you will see is an example of this Compounding at its finest.
How do we as real estate investors do the same? Can we do the same? The answer to the second question is a resounding one Yes indeed! The answer to the first question is, you guessed it, with the use of non-attachable debt.
The Power of Unforeclosure Debt…Compounding on Steroids
how do you ask Easy. First, remember that the typical financing used in real estate investments is mortgageable debt. There’s a lien on the asset… the property we’re buying. When we use unpledged debt, there is no lien on the property. In fact, there is no attachment to ownership at all. This is critical. That’s what makes this work. That makes us our own bank. As?
What happens first at closing after the mountain of paperwork has been signed? The answer is that the seller’s original lender is paid off. In other words, the lien will be paid. The seller doesn’t even see the money. Wouldn’t you like to at least touch it when selling it… even for a minute? How about doing more? How about reuse it, over and over again? Yes you can. This answer was for all those reading this who are saying, “You know, you can’t”. Here’s why… and how.
Let’s look at a typical real estate financing. First a loan is taken out and we buy and renovate the property. We flip the house and in selling we do two things: 1) we pay back the original financing (lien); 2) We (hopefully) make a profit. In order to move forward, we now need to get new funding and deal with the “app triplets” again. You know, new application, assessment and approval. All expensive, time-consuming and without guarantees.
Well, if this were a form of unpledged debt, we wouldn’t have to pay back the money we borrowed… at least not immediately. It also means that we don’t just walk away with our profits, we walk away with them all proceeds from the sale. Sell a $75,000 house with a $50,000 garnishee debt and we walk away with only $25,000…the profit. Sell the same house with unpledged debt, and we walk away with the entire $75,000… minus closing costs. What would you rather do?
Turn Bad Debt into Good Debt
OK, before I go any further, I have to answer all those readers who say, “I still have to pay off the debt”. In fact, there are monthly payments due, which due to the nature of the conditions in most NLDs, are usually very high. So what I do is I fund a cash reserve as part of the NLD. That cash reserve is your silent partner whose only role is to make the monthly payments until you can develop your system to become self-sufficient and self-sustaining. Combine the profits from the first few flips and buy/rehabilitate a second “Flip House” in which you will also use those funds over and over again as there would be no debt at all for that second house… you have it for bought all the money. The idea is to NEVER use the principle for anything other than the cost of the next flip house. You are now working with two “flip houses” after the second flip.
Flip these two houses, combine the two wins and buy/refurbish a third flip house. Again, you’ll reuse the cost of all 3 houses to buy/refurbish the next 3 Flip houses in the row. You now have three rows of Flip Houses. No matter how often you To attempt spend the principle… they keep giving it back to you. Well, this is where the real fun begins.
As you develop your system, your cash reserve dwindles to zero. So it’s time you refunded it, don’t you think, and “buy” yourself more time. Remember, those payments you’re making from the cash reserve are actually paying off the debt… or it won’t work. So when you’re calculating how much to put into the cash reserve, keep that in mind. Now for the real fun.
As said, the cash reserve is “no more” so refund it… with one of the winnings from any of the three flip houses. What do you do with the other two wins? Buy/rehabilitate a “home hold” for cash flow…with all the cash. Then just flip the three Flip houses over and over again, use the “winnings” to buy more “cash flow” houses with all the cash, and occasionally pay back the cash reserve until the debt is paid off… and You are completely debt free.
The tape story… Einstein was a pretty smart guy
Question #1: How many times have we paid for these funds?
Answers: Once… we just didn’t pay it back all at once like we would have if it were an attachable debt.
Question #2: How many homes can we use these funds for (remember, we only pay for it once)?
Answer: I don’t know. I’ll let you know when I stop using them again.
We just became our own bank. We now use our own money for ourselves, at no extra cost. Every time we recycle those funds at no extra charge, we lower the cost of debt per home. This means that we only paid the acquisition costs for this type of financing insignificant.
Einstein was right. Compounding is a beautiful thing. Combined with non-attachable debt, this can be a “gold mine” for real estate investors.