Debt & Real Estate: How is it used and how much is too much?

Debt & Real Estate: How is it used and how much is too much? 

If someone told you they had a million dollars in debt, your first instinct might be to schedule a financial intervention. But in real estate, that same debt load could be completely reasonable, maybe even conservative.

Debt, when used responsibly, is one of the most powerful tools in real estate investing. It can outperform traditional stock market returns and accelerate wealth building. Here’s how.

Understanding Leverage for Real Estate Growth

At the heart of real estate investing is a simple but powerful concept: leverage. Leverage refers to using borrowed money to increase potential returns. In the world of real estate, not only is leverage common, it is expected.

Without leverage, real estate investments would likely offer returns slightly less than the stock market average, around 7percent annually when factoring in appreciation and cash flow and adjusting for inflation. So why deal with the headaches of property management when you could just invest in an index fund?

Because leverage can change the game entirely.

Real Estate vs. Stocks: A Practical Example

Imagine you have $100,000 to invest. Put it into the S&P 500, and assuming a historical return of 10.5 percent, you might end the year with $110,500.

Now, take that same $100,000 and use it as a down payment on a $400,000 rental property, and finance the remaining $300,000 with a mortgage.

If that property appreciates by 4 percent in a year, that is $16,000 in appreciation. Add about $3,800 in mortgage principal paid by your tenant, and your total return in this example is nearly 20 percent on your original $100,000 invested.

That is close to double the average return of the stock market, and it generally comes with lower volatility.

Why Real Estate Can Offer More Stability

Real estate typically moves slower than the stock market and residential mortgages often come with fixed interest rates. There are no margin calls, which means less risk of forced liquidation.

And when markets drop, stocks can plummet rapidly. Real estate, on the other hand, tends to decline more gradually. This can give investors more time to make adjustments.

The Risks of Leverage

Leverage can magnify returns, but it can also amplify losses. That is why investors monitor two important metrics.

Debt-to-Equity (D/E) Ratio: This measures how much debt you carry relative to your equity. A D/E of 1 means you have equal amounts of debt and equity. More aggressive investors may tolerate higher ratios. Those nearing retirement may target lower ratios like 0.5 or even zero.

Debt Service Coverage Ratio (DSCR): This indicates how well your rental income covers your debt payments. If a property earns $1,500 monthly and the mortgage is $1,000, the DSCR is 1.5. 

Should You Pay Off Your Mortgage Early?

For younger investors, the answer is usually no. The funds can often earn more when reinvested elsewhere.

For those approaching retirement, paying off a mortgage can provide peace of mind and reduce monthly expenses. In this phase, stability may outweigh the pursuit of higher returns.

Final Thoughts

Debt in real estate should not be feared when used responsibly. However, just like fire, it can be a double-edged sword. So track your ratios, understand your risk tolerance, and partner with professionals who can help guide you on your real estate journey! Check out the link below to get your free eBook “Financial Planning for Real Estate”. Chapter 2 does a deep dive on debt in real estate.

https://sterlingadams-wm.com/real-estate-planning/