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The Power of "Non-Lien-Able Debt" to a Real Estate Investor
Isn’t it wonderful that there are so many ways to raise funds for real estate investment projects today? This is important because sellers somehow want to get paid for their houses when they sell them… Right?? Just because there are what seems like an infinite number of sources for funds doesn’t mean that those funds are easy to get…or when you can get them…easy to afford. In many cases, the borrower has to “jump through hoops” to finally get the funds they need. Credit approval, appraisals, 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 term “good debt vs. bad debt.” The problem is that most people 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 “pluses and minuses” to solving story problems. So in the interest of “training her early in life”, I gave her story problems involving business. She would by chance learn everything from costs 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, none of this is taught to us in school today. They teach us how to be spenders/savers instead of how to be investors/entrepreneurs. In other words, we are never taught how “money works”, but we are definitely taught how to “work for money”. Knowing the difference between good and bad debt isn’t brain surgery, but the negative effects of not knowing can be huge. The difference is very simple. Bad debt costs you, good debt makes you money. Yes, it’s that simple.
What 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” you credit. Understand that the business of banks is the sale of credits. They also know and understand the saying: “Own nothing but control everything”. They live off it. Funnily enough, a real estate investor can do the same thing using unsecured debt. They can almost become their own bank.
Bad debt costs you money because you end up with less than you started with. Good debt makes you money because you end up with more than you started with. In business, you compare profit with costs. In our personal lives, we compare income to, well, “income substitutes”… sometimes called credit cards.
Obvious examples of good debt would be things like residential rents, multi-family rents, commercial real estate, and other substantial cash assets. Examples of bad debt would be the aforementioned credit cards, boats, RVs, etc. Equity in our home is not an investment. It doesn’t make us money, it costs us to build it. Now, if we take advantage of it in the form of a loan, it becomes a debt…what kind of debt depends on what it is used for. Note that I’m not saying everyone should go out and refinance their homes, cash out their equity and invest. If you choose to do that, you don’t have my blessing. You are endangering your home. It’s not smart. Especially since there are so many other safer ways to get funds to invest.
The power of compounding… Duplication on steroids
Banks understand all this. They turn your funds/deposits into credit/debt. It’s a credit from them and a debt to you. They don’t own anything and can actually get credit, they actually sell you “virtual money” at a multiple of the “face value” of your assets deposited with them. This topic is for another time. For this discussion, understand that the bank is leveraging the power of duplication. In fact, they take advantage of what Albert Einstein called “the greatest invention of the 20th century”… compound interest. He went further and claimed that those who get it (the banks) are outliving those who don’t (the rest of us).
Want a really strong case? Start for pennies… only 1 cent. Then double it over the next 30 days. So day 1 would be 2 cents, day 3 4 cents, day 4 8 cents and so on. Do it on paper. This will have a much greater impact on you. What is the answer? Try it. You will be surprised. What you are about to watch is an example mixing in the best way possible.
So how can we as real estate investors do the same? Can we do the same? The answer to the second question is resounding yes! The answer to the first question is, you guessed it, using unsecured debt.
The Power of Debt Not Lienable… Compounding on Steroids
How do you ask? Simple. First, remember that the typical financing used in real estate investment is mortgage debt. There is some sort of lien on the property… the property we are buying. When we use unsecured debt, there is no lien on the property. In fact, there is no connection with the property. This is critical. That’s what makes this work. This is what makes us our own bank. how
What’s the first thing that happens at closing after a mountain of paperwork is signed? The answer is that the seller’s original lender is paid off. In other words, lien it pays off. The seller doesn’t even see the money. Wouldn’t you like to at least touch it when selling…even for a minute? What more to do? What if you could reuse this, over and over again? Yes you can. This answer was for all those reading this saying “you know you can’t”. Here’s why… and how.
Let’s look at typical real estate financing. First, a loan is obtained and the property is bought and rehabilitated. We flip the house and do two things when we sell it: 1) we return the original financing (lien); 2) We make a profit (hopefully). Now, in order to move forward, we need to get new funding and deal with the “triplets of applications” again. You know, new application, review and approval. All expensive, time-consuming and without guarantees.
If it were a form of unsecured debt, we wouldn’t have to pay back the money we borrowed… at least not right away. It also means that instead of walking away with just our profit to use, we walk away with it all proceeds from the sale. Sell a $75,000 house with a $50,000 mortgage and we walk away with just $25,000… profit. We sell this same house with unsecured debt and walk away with the entire $75,000…minus closing costs. What would you prefer?
Turning “bad debt” into “good debt”
Okay, before I go on, I need to respond to all the readers who say I have yet to pay back the debt. I am actually facing monthly payments which are usually very high due to the nature of the terms of most NLDs. So what I’m doing is funding a cash reserve as part of the NLD. The cash reserve is your silent partner whose only role is to make monthly payments until you develop your system to be self-sufficient and self-sustaining. Pool the profits from the first few flips and buy/renovate the 2nd “Flip House” so that you will use those funds over and over again as there will be no debt on that 2nd house at all…you bought with all cash. The idea is to NEVER apply the principle to anything other than the cost of the next Flip House. Now after this second turn you are working with two “flip houses”.
Flip these two houses, combine both profits and buy/renovate a third Flip House. Again, you will reuse the cost of all three houses to buy/renovate the next 3 Flip Houses in a row. You now have three types of flip houses. No matter how many times you are give it a try spend principle… they keep bringing it back. Now the real fun begins.
While you’ve been developing your system, your cash reserve is dwindling to zero. So it’s about time you get your money back, what do you think, and “buy” yourself more time. Keep in mind that these payments you’re making from the cash reserve are actually paying off the debt… or it’s not working, so when you calculate how much to put into the cash reserve, keep that in mind. Now for the real fun.
As I said, the cash reserve is “gone”, so pay it back… with one of the profits from one of the three flip houses. What do you do with the other two profits? Buy/renovate a cash flow “hold house”… with all cash. Then continue flipping the three Flip houses, over and over again, using the “only profits” to buy more “cash flow” houses with all cash and periodic repayment of 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 have we paid these funds?
answer: once… we just didn’t return it all at once, as we would have if it was a mortgage debt.
Question no. 2: How many houses can we use these funds for (remember we will only pay for them once)?
Answer: I don’t know. I will let you know when I stop using them.
We just became our own bank. Now we use our money for ourselves, without additional costs. Each time we reuse these funds, at no additional cost, we reduce the cost of debt on the house. This means that we have just created the initial cost of this type of financing unimportant.
Einstein was right. Compilation is a beautiful thing. Combined with unsecured debt, it can be a “gold mine” for real estate investors.
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