The idea of using debt as a tool for wealth creation often sparks skepticism and caution. It seems counter intuitive. How can someone create wealth by going into debt?
Enact Partners works with many real estate investors and borrowers who know that debt, when wielded intelligently, can be a powerful asset for diversifying investments and maximizing returns. Borrowing “from Peter to pay Paul” can in fact open doors to lucrative opportunities and financial growth when done strategically.
Investor Scenario
Let’s imagine the husband-and-wife team of Sarah and Bill. They are savvy investors who’ve accumulated a substantial sum of savings. Instead of letting their savings sit idle, they decide to employ a strategic approach to leverage debt for wealth creation.
Sarah and Bill begin by allocating a portion of their available funds into high-yield savings accounts. Given the current market conditions where banks offer competitive interest rates to attract deposits, they earn a steady stream of passive income while retaining liquidity for other investment opportunities. This ensures that their money is not only working for them, but also easily accessible when needed.
Being savvy investors, Sarah and Bill don’t stop there. They recognize the potential to amplify their returns by borrowing against their assets, particularly a rental property Sarah owns with significant equity. By leveraging this equity through a short-term private loan, Sarah and Bill can access additional funds to invest in acquiring and renovating other commercial real estate ventures.
Loan-To-Value (LTV) Ratio
One of the key concepts to consider when leveraging debt is the loan-to-value (LTV) ratio. This ratio represents the amount of a loan compared to the appraised value of the asset securing it.
In Sarah and Bill’s case, they carefully evaluated the LTV ratio of her rental property to ensure they were not overleveraging their real estate investments. By maintaining a conservative LTV ratio, Sarah and Bill mitigated the risk of overexposure to debt while still unlocking the potential for higher returns.
Sarah and Bill’s decision to strategically borrow against her rental property gave them access to funds they could invest into alternative assets, in this case other commercial properties that generate lease and rental income. By focusing on investments with a high probability of generating returns in excess of interest due on the borrowed funds, Sarah and Bill were able to grow their wealth.
Not Without Risk
As with any investment, nothing is guaranteed. Real estate investors like Sarah and Bill understand the importance of managing risk in their investment strategy. While leveraging debt can enhance returns, it also introduces an element of risk.
To mitigate this risk, Sarah and Bill diversified their commercial real estate investments across different property types (office buildings, multi-family residences), and geographies (California, Arizona, and Texas). Such a balanced approach helps protect their portfolio from market fluctuations and unexpected downturns.
As their investments grow, Sarah and Bill diligently monitor their portfolio and adjust their strategy as needed. Working with a private lender like Enact Partners gives them the flexibility and quick access to lending decision makers they need to take advantage of additional opportunities as they arise. This helps ensure that their debt remains a valuable tool for wealth creation.
Snapshot: Pros & Cons of Utilizing Debt
Pros
- Increased purchasing power—By leveraging debt financing, borrowers can invest in one or more investment properties simultaneously that may otherwise have been beyond their immediate financial capacity.
- Potential for higher returns—If an investment property appreciates in value, the profit earned may exceed the cost of borrowing, leading to a higher overall return on investment.
- Diversification—Debt financing allows borrowers to spread investments across different properties, geographies, or asset classes, potentially reducing risk.
Cons
- Risk of default—If a property fails to generate sufficient rental income or experiences a decline in value, meeting debt obligations when relying heavily on borrowed funds can be a challenge.
- Cash flow challenges—Loan repayments, including interest and principal, must be factored into the sufficiency of the borrower’s cash flow necessary to cover debt obligations. Insufficient cash flow can strain borrower finances and limit their ability to reinvest or handle unexpected expenses.
Another Example of Utilizing Debt to Grow Wealth
Let’s explore how one experienced investor, Todd, used debt to grow his wealth. To appreciate his approach, it’s important to understand a metric known as cash-on-cash return.
Real estate investors generally aim for at least 10% to 15% annual cash-on-cash return from their investment properties. Cash-on-cash return calculates pre-tax cash flow relative to the amount of cash actually invested in a property in a given period. It’s typically used to evaluate annual performance, not long-term performance over the life of an investment.
In our example, Todd buys a $500,000 retail property with a mortgage that required him to put 20% down ($100,000). He also paid $8,000 in closing costs and invested another $15,000 in cash to make necessary improvements so he could rent the space to multiple tenants.
So far, Todd is out of pocket his $100,000 down payment + $8,000 closing costs + $15,000 for renovations, or $123,000.
After meeting his monthly mortgage repayment obligations, maintenance, taxes, insurance, and other expenses, Todd finds that he clears $1,200/month from renting the property, so he expects a profit of $14,400 annually.
So is this a good investment? Is it a good use of debt to grow wealth?
Calculating Todd’s cash-on-cash return for year one ($14,400/$128,000), we see he is at 11.7%, which is well within the 10% to 15% range that is usually indicative of a worthwhile investment.
Could Debt Work for You?
The concept of utilizing debt as a tool for wealth creation is not about reckless borrowing. It’s about employing a strategic approach to leveraging assets to maximize returns. By borrowing intelligently and diversifying investments, individuals like Sarah, Bill, and Todd can unlock new opportunities for financial growth and achieve long-term wealth goals. As with any investment strategy, though, careful planning, risk management, and ongoing monitoring are essential to success.
We invite you to contact Enact Partners today to explore how you can turn your idle cash or equity into the seeds of opportunity for your next investment or commercial real estate project.
(760) 516-7776 | [email protected] | www.enactpartners.com
