Isn’t it great that there are so many ways to get financing for real estate investment projects today? That’s important since sellers want to get paid for their houses when they sell them… Right? Now, just because there are what seems like endless sources of funds doesn’t mean those funds are easy to get… or when you can get them… they’re easy to pay for. The borrower is required, in many cases, to “jump through hoops” to end up with the funds he needs. Credit Approval, Appraisals, LTV/ARV… and they still don’t usually 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 to do “more and less” to doing story problems. So, in the interest of “training her early in life,” I gave her story problems involving business. she would accidentally Learn about everything from expenses to earnings…including the differences between good and bad debt His understanding was so complete that he could recite the definition and, more importantly, explain it when asked.
Unfortunately, today we are not taught any of this in school. We are taught to be spenders/savers instead of 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 negative effects of ignorance can be enormous. The difference is very simple. Bad debt costs you money, good debt makes you money. Yes, it is that simple.
What the banks know that we don’t
Banks are well aware of the difference. Just look at the difference between what they “pay” you (and I use the word “pay” very loosely) for your deposits, and what they “charge” you when they “sell” your credits. Understand that the business of banks is to sell credit. They also know and understand the saying: “Own nothing, but control everything.” They live for it. The fun thing is that with the use of non-taxable debt, the real estate investor can do the same thing. They can almost become their own bank.
Bad debt costs you money, as the net result is that you end up with less than you started with. Good debt makes you money because the net result is that you end up with more than you started with. In business, you are comparing profits and expenses. In our personal lives, we’re comparing income to, well, “Income Substitute”…sometimes referred to as Credit Cards.
Obvious examples of Good Debt would be things like SF rentals, multi-family rentals, commercial properties, and other appreciable cash flow assets. Examples of bad debt would be the credit cards mentioned above, boats, RVs, etc. The value of our own house is not an investment. It does not generate money for us, it costs us money to build it. Now, if we take advantage of it as a loan, it becomes debt… what kind of debt depends on what it is used for. Keep in mind that I’m not saying we should all go out and refinance our homes, withdraw the equity and invest. If you decide to do that, you don’t have my blessing. You are putting your home at risk. Not intelligent. Particularly as there are many other safer ways to obtain funds to invest.
The Power of Compounding… Duplication on Steroids
Banks understand all this. They leverage their assets/deposits into credit/debt. That is, credit to them and debt to you. They own nothing and, in fact, can take advantage of credit, actually selling you “virtual money” at many times the “face value” of your asset on deposit with them. This topic is for another time. For this discussion, understand that the bank is exploiting the power of Duplication. In reality, they are taking advantage of what Albert Einstein called the “Greatest Invention of the 20th Century”… compound interest. He went further by stating that those who understood it (banks) live off those who don’t (the rest of us).
Do you want a very powerful example? start with a penny… only 1 cent. Then, for the next 30 days, double it. 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 bigger impact on you. Which is the answer? Try it. You’ll be surprised. What you will be seeing is an example of Composite at its finest.
So how do we as real estate investors do the same? Can we do the same? The answer to the second question is a resounding Yes! The answer to the first question is, you guessed it, with the use of non-taxable debt.
The Power of Debt with No Lien… Compounded on Steroids
How do you ask? Easy. First, remember that the typical financing used in real estate investing is encumbered debt. There’s a link of some sort on the asset… the property we’re buying. When we use non-taxable debt, there is no lien on the property. In fact, there is no link to the property. This is important. This is what makes this work. This is what makes us our own bank. How?
What’s the first thing that happens at closing, after the mountain of paperwork is signed? The answer is that the seller’s original lender is paid. In other words, the Link is paid. The seller doesn’t even see the money. Wouldn’t you like to at least touch it when selling… even for a minute? How about doing more? How about being able to re-use that over and over? If you can. That answer was for all those who read this and say “you know you can’t”. Here’s why… and how.
Let’s take a look at typical property financing. First, a loan is taken out and we purchase and rehab the property. We turn the house around, and when we sell it, we do two things: 1) We return the original financing (link); 2) We make a profit (hopefully). Now, to move forward, we need to get new funding and deal with the “App Triplets” again. You know, new Application, Appraisal and Approval. All expensive, slow and without guarantees.
Now, if it were a non-taxable form of debt, we wouldn’t need to pay back the money we borrowed… at least not right away. This also means that instead of just walking away with our profit to use, we walk away with all proceeds from the sale. Selling a house for $75,000 with $50,000 in taxable debt and walking away with only $25,000… profit. Sell that same house with unencumbered debt, and we’ll walk away with the full $75,000…less closing costs. What would you rather do?
Turn “bad debt” into “good debt”
Well, before I continue, I need to respond to all the readers who say “I still have to pay the debt”. In fact, I have upcoming monthly payments that are usually very high due to the nature of the terms in most NLDs. So what I do is fund a cash reserves as part of the NLD. Tea cash reserves is your silent partner whose sole role is to make the monthly payments until you can build your system to be self-supporting and self-sufficient. Combine the earnings from the first few flips and buy/rehab a second “Flip House” which will also reuse those funds over and over again as there would be no debt on that second house…you bought if for all the cash. The idea is to NEVER use the principle for anything other than the cost of the next Flip House. You are working with two “inverted houses” now after that second inverted.
Flip these two houses, combine the two winnings and buy/rehab a third Flip House. Again, you will reuse the costs of the three houses to buy/rehab the next 3 Flip Houses online. You now have three lines of Flip Houses. no matter how many times you try to spend the principle… they keep giving it back to you. Now, this is where the real fun begins.
While you have been developing your system, your cash reserve is shrinking to nothing. So, it’s about time you gave it back, don’t you think?, and “buy” more time. Keep in mind that these payments you’re making from the cash reserve are actually paying down debt…or it doesn’t work, so when you’re calculating how much to put in the cash reserve, keep that in mind. Now for the real fun.
As I said, the cash reserve is “no more”, so pay it back…with one of the winnings from one of the three flip houses. What do you do with the other two benefits? Purchase/rehab a “holding house” for cash flow…with all the cash. Then you just keep flipping the three Flip Houses, over and over again, using the “earnings only” to buy more houses with “Cash Flow”, all in cash, and occasionally repaying the cash reserve until the debt is paid off. …and you are completely debt free.
The story of the tape… Einstein was a pretty smart guy
Question #1: How many times do we pay for these funds?
Answer: Ounce… we just didn’t pay it all back at once, as we would have if it were bond-capable debt.
Question #2: How many homes can we use these funds for (remember, we’re only going to pay them once)?
Answer: I don’t know. I’ll let you know when I stop reusing them.
We become our own bank. We are now leveraging our own money for ourselves, at no additional cost. Every time we repurpose these funds, at no additional charge, we drive down the cost of debt per household. This means that we have also just calculated the initial cost of this type of financing. insignificant.
Einstein was right. Composing is a beautiful thing. When combined with non-taxable debt, it can be a “gold mine” for real estate investors.