How to Invest in Commercial Real Estate

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Episode #048- How To Use DEBT To Produce CASH FLOW!

by Criterion, Braden Cheek, Brian Duck
February 7th 2022
00:00:00
Description

Today our hosts Brian Duck, Braden Cheek & Joel Thompson from The Criterion Fund talk about how to leverage your debt by buying assets that produce a positive cash flow.

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yeah that that's basically the definition of good debt right? Is is that that that you get and it's paying you an income or increasing your wealth? Bad debt is taking money out of your pocket like a car or something like that? So yeah the financial sophistication of most people is when it comes to debt is well I have my house values gone up and I have a little bit of equity in my home, which means that they haven't paid off their house, they still owe on their house. But you know they can go and get another loan and then they're gonna take that loan and then they're gonna go buy a freaking pool with it or a vacation with it. Something that that does not add any value. I mean adds value and the fact that they use it but it doesn't add uh you know to their balance sheet or their net worth. And so that's really the sophistication of it is that they use debt to get stuff or debt to get a car and that really is is the opposite direction. You're going in the wrong direction when you're getting debt to get stuff that should be a tool to use to buy assets that go up in value.

Welcome back to how to invest in commercial real estate and today is an exciting episode because it's kind of contrary to what a lot of people think and it's all about why we love debt. That is a powerful tool investing in commercial real estate and and a lot of things but specifically getting debt when investing in commercial real estate is rather easier than some of the other traditional investment classes. So Joel how how do we use debt? Why do we love it so much? I think it's important to, to think about what we are all taught about debt as kids. And for most of our lives we're all saddled with this idea that debt is bad and that if you get into debt or if you have debt, you're a loser, you can't manage money well. And so you have, there's several paradigm shifts that you need to make when you're getting into commercial real estate. And one of them is is you have to get comfortable with debt and you have to see debt as you said so eloquently as a tool to help you make more money. Uh, and so that's why we're gonna be talking about today because we want to change your thinking. If you're listening to this and you're saying, hey, you know, I don't want to get out of debt, I want to pay off my credit cards, I want to pay off my house, I want to pay off my card.

That actually is a good thing. But when it comes to business as you need to learn how to use debt in order to grow your business and make a bunch more money. And commercial real estate is an easy way to do that. Well, frankly we couldn't afford, it right, we can't go, by you can't go buy a $10 million or $15 million dollars Asset If you, unless you have $10 or $15 million. So you have to use debt. Yeah, but there's really no choice. So like Joel says, you've got to get comfortable with it. Yeah. And the traditional Dave Ramsey's of the world have just constantly taught us like Joel said is don't get into debt because it's, it's going and buying a car or a house or, or typically that's something that's not appreciating very well and it's definitely not paying you anything to service those debts. It's just, it's, it's a debt service payment you've got to deal with every month and they advise against that. But when you're using debt in commercial real estate, the property you're buying is covering the debt service and it still has excess cash flow. So you're able to not only service your debts, but pay a return on the money you did invest in commercial real estate. So it's, it's just a completely different way of looking at it, but you've, you've got to get comfortable with getting into that and you've got to understand why and, and the biggest reason is it's, it's cheap.

It's insanely cheap, putting debt on commercial real estate, right? So yeah, the interest rate you pay is going to be lower than the than the money that that percentage return that property makes you. Yeah. Which you know, to put it super super simply, it's like saying, Hey, can I borrow 3%. So I can go make 20 and the banks like, yeah, let's do it. They're excited that you're making that much money because that's a safer loan in their eyes, they're literally taking everyone else's money, you know, that's just in the savings account, right? And they're, they're loaning it out to us so we can place it in commercial real estate. Yeah, that that's basically the definition of good debt, right? Is is that that that you get and it's paying you an income or increasing your wealth. Bad debt is taking money out of your pocket like a car or something like that. So yeah, the financial sophistication of most people is when it comes to debt is, well I have my house values gone up and I have a little bit of equity in my home, which means that they haven't paid off their house, they still owe on their house.

But you know, they can go and get another loan and then they're gonna take that loan and then they're gonna go buy a freaking pool with it or a vacation with it. Something that, that does not add any value. I mean adds value and the fact that they use it but it doesn't add uh you know, to their balance sheet or their net worth. And so that's really the sophistication of it is that they use debt to get stuff or debt to get a car and that really is, is the opposite direction. You're going in the wrong direction when you're getting debt to get stuff, debt should be a tool to use to buy assets that go up in value. And when you do that and, and just think like you were saying they'll loan you on real estate, they'll loan you 80% of the value, 90% of the value. That means you're putting in, let's just take a 90% example, which is a little bit rare. But let's say you put 10% down now that appreciating asset only needs to go up 5% and you've made a 50% return on your money. I mean there's no other avenue that can do that. Maybe crypto, but crypto is not that safe. No one's gonna loan you 90% on crypto, they may loan you 50% maximum and when crypto dives 50% they're gonna call that note do and all your value is going to be gone.

And so that's why the debt is powerful is that you can lever up and it's safe enough. You can equate it to this. If someone's, The more someone is willing to loan on it, the safer the asset class is Okay. So you know, business businesses are safe, but sometimes you can't even get 80 90% on a business, but real estate consistently, 80%, you can get loaned and that's because it is safe and they do tend to go up in value. Yeah. And and you know, I get a lot of people that ask about signing the guarantee like who's guaranteeing these mortgages? That's a that's a scary one. It's like, do you think I would come to you and ask for your hard earned money as an investment if I was scared about defaulting on the loan? I mean the lone like you said is is maybe only 90% of of the value, you know, so you'd have to take a jump but in in reality, you know, sometimes that's 80%, is the loan. So you've got a lot of wiggle room there before you're you're defaulting alone. That and the property is kicking out cash flow. So I mean cash flow is another amazing reason to get into debt.

Yeah. Let me, let me ask you a question, Joel because how can you get comfortable with all the personal guarantees that you have, Right? So if you go out and you get debt for a business and something happens to the business, well, you can just have the business declare bankruptcy and everything is great, right? That was good debt. You tried to, you tried to build a business by going into debt, but then the debt can or the business can just declare bankruptcy. But on real estate don't you have to do a personal guarantee such that if something goes wrong that you, your your funds are at risk right? Not not the company's funds or not the LLC that you set up for that property, but your personal funds are at risk. Is that right? Yes. But it could also be that way with with the business uh depending on, you know, depending on the business, you could have a personal guarantee on the assets of the business or something. So you could be personally liable real estate though. It it just depends if you are going to sign your name, you you better know what you're doing because in the event that that property, for some reason you can't get tenants now the cash flow drops.

You can't make that mortgage payment. The bank will come and take that. Uh and then if you're personally liable, what will happen is the bank will then sell that property at a at a loss and whatever the differences between what they sell it for and what you owed them, they're gonna come after you for that difference. Okay. So people that are listening, what happens if they say, well, how am I gonna get debt? Because I don't have when they come to me for a personal guarantee? I don't have that much um assets or networks. So can these people get, get the debt or do they need to find someone who who can partner with them? That that does have some uh net worth, that they can sign a personal guarantee or how somebody gonna do that. I would say it this way if if you have an amazing deal and you're having problems getting the debt on it, bring it to me. If it's good enough deal, I'll get the debt for you and you should take that scenario and apply it to everything right? Because if the deal is good enough, you're gonna raise the money from your investors, you're going to be able to get the debt. If the deal sucks, you're probably not going to get the debt.

You're probably not gonna get a good deal. Is the bank gonna give you the money, even if you without personal guarantees, definitely, definitely. You need to find it. You need to find a partner for your first one. They want to see a track record of getting alone, completing alone, satisfying alone paying the interest, paying the money back, you know, because those are 57 year terms. So you've gotta have a track record. So going to a partner and saying, you know, hey, I've got this amazing deal. The bank isn't necessarily completely comfortable with me yet. But maybe, you know, given your track record, if I give you a piece of this deal, could you help me get this loan? And then it's kind of a win win. Yeah, I would agree with that in general. There there will be instances where depending on the size of the deal, The person may be able to get the debt. What the bank's gonna look at, They're gonna look at you, they're gonna look at your income from your day job. Uh If you didn't have it, let's say, let's say you're gonna buy a $3 million apartment building and the bank really likes it. Well, okay, if you don't have the benchmark is if you have a $3 million net worth and they're going to loan you the $3 million on your signature.

But let's say you don't have a $3 million net worth, They may still get comfortable if your net worth is 500,000. But you Are an attorney and you make, you know, $400,000 a year. And that they'll they'll kind of take that into consideration with the cash flow, the property. You might find a bank that alone you that money. Okay, what if you want to do another $3 million dollar deal interestingly enough is that they'll look at each one individually. So you're actually better off on the next one that you have the apartment complex and you you have your job now, you've got two sources of income. And so that'll that'll be better each deal. You do like with us. We've got 70 80 $90 million worth of loans. And they love it. Uh They don't look at us and say, well, he's already got 19 projects and so he's he's riskier on the next one. No, they think the opposite, they think, well, he's got, you know, 20 projects cash flowing, He's less of a risk, let's just keep giving him the money. Okay, But will the same bank do that or do banks reach a limit with you as well? Good question.

They do brian Brian bring the questions. So these local banks will have, yeah, we'll have limits and we, you know, if it's a smaller local bank, they may have a $10 million $20 million dollar lending lending limit per person. But if you're gonna do like uh you know, a non recourse, we've talked about it, Fannie Freddie loans, government backed loans through the agency's, well then it's unlimited. And those are mainly restricted apartments, Those are those are mainly restricted to apartments, but there's also for retail, there's there's live company loans and cmbs, commercial mortgage backed security loans. And those are once again unlimited. They're really only underwriting the real estate. Uh Now they and and so you you may not even have a signature on that, and you're you're not gonna be liable for that debt. So let me ask a crazy question. How how do banks make money, I mean, making, making these loans, how do they do that? How do they make money? Well, we should have a banker answer that, but how I think it happens is that they they borrow from the Federal reserve at at a lower rate and and loan at a higher rate.

And they use their deposits where they're giving virtually no uh you know, savings return. And then they're lending that that money out at a higher rate. So it's just it's just borrowing at a low rate and and lending at a high rate. So if a bank has, you know, $10 million $10 million. I mean, that's not that much. I think they can lend. No, I think they can lend a multiple over the deposits. I mean, 2, 2 times maybe. I think. I think it's more I don't know that that is we need a banker. I don't know. I've heard I've heard a lot more, a lot more. So it's the best kind of marketing scheme in existence because we were all taught to to do what with the money in the bank, the bank, the safest place you could possibly put your money is in the bank and they're lending it out And they're lending not only your money out, but 10, potentially, 10 times the amount of money you give them to make more money. That's insane. And we're basically doing the same thing in commercial real estate. They're borrowing the money cheap and they're they're getting a lending lending it out at a higher return.

We're borrowing money cheap, We're using it to buy property that pays us 234 times the return. That's all it is. It's a leverage game. And so you've got to get that in your mind. That debt is the tool to leverage your money to make and the bank's money to make big time returns. You get all their you say well you gotta have your money work for you. Yes but you've got to have the what if I could say oh you can get eight times your money working for you. It's get the bank's money working for you. And so then not only am I making money on my money, I'm making money on the bank's money because I'm paying 4% and I'm making you know 8%. So money To that point Brian said in the beginning you know we're not buying these properties in cash because you can't afford it and you could if you wanted to I mean there's people out there that have $10 million dollars in cash and they could go buy something In all cash. And if if you were buying it on a cap rate, you know cap rate is kind of your multiple value of of the profitability of that company. So if you're buying it on an eight cap and you bought it in all cash you're gonna make 8% that first year right?

But if I thought that Like Okay that's it's safe. I know it's going to do the 8%. If I really believed in the deal, I would go get a loan from a bank, you know, at like 4%. Let's be -4%. You can get that right now. Then then I could make instead of eight, I could make 24 or 25% on on the same deal. Not the same amount of money. Yeah, I'm putting in, you know, 20% of the money instead of 100%. So even though you may make more money buying in cash, the percentage on the return would would triple by getting alone. Well. And then the other, you know, you say you only invested 20% but the other 80% you can go buy another four deals with that. So in essence that's how you make 20% on your money is leverage through debt. So you want to make 8% great. But we did a whole show a whole podcast on how important the rate of return is over time. So 8%. Yeah, you'll get rich eventually making 8%. But you'll get really freaking rich if you can make 20% of your compounding in real estate gives you the opportunity to do that.

That's that's doubling your money. What every every five years, Every four years. 25% for five years. That's yeah, if it's compounding. Yeah, it's last because That's that's done. So you could take the exact same investment that's making 8% and you're wow, that's a lot. That's a lot, man. Well and another point I want to make about debt is always be willing to trade. Uh, today's cash flow uh for debt that you can go and use to grow your business. And what I mean by that is like we were talking about when we refinance the property for me, cash flow is king and cash flow is great. But that, but if it's, if it's properties cash flowing, well then I can go refinance that uh it may cost me some cash flow. But I'm gonna get, I'm gonna get, you know, maybe an extra million dollars in that refi and I can go multiply that that money. So I'm always willing to trade uh, you know, today's cash flow for a really good debt to go invest in more properties. So lessons to learn, stop putting your money in the bank.

You know, cash is trash. As a lot of people say you, I mean you can't, you can't, you can't just hold it, you can't just caches, can cash is trash. I mean if you've got a million dollars sitting in your bank account just doing nothing. It's not even in the market. You know, earning, earning 78% you've got to do it because they're they're making money on your money. So you might as well take the power back, invest your money with some debts and make some more money. Yeah debt is good if it's used to buy assets. Okay, not not liabilities, not cars, not not trips credit cards, not credit card. So debt is good for you. If you are buying assets simply stated, well, make sure to like and subscribe, share it with the buddy. Um, and if you've got a question, feel free to comment down below. We will catch you next time on how to invest in commercial real estate. Thanks.

Episode #048- How To Use DEBT To Produce CASH FLOW!
Episode #048- How To Use DEBT To Produce CASH FLOW!
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