Good debt, bad debt
This week I had some good conversations about how we use the financial calculator as a tool in our business, as well as the difference between good debt and bad debt.
Today I would like to give you an introduction to the calculator and then show you how it can help you evaluate deals.
The deal I want to talk to you about is not mine. It's a friend who is wanting to get into investing. He is a topnotch contractor over in Elijay in his thirties. And he already understands that if he doesn't do something soon to start gaining some passive income, his body is going to wear out and he will still be working into his retirement years.
He and I have had lots of conversations about investing over the years. He likes the idea of cashflow but has not yet been able to commit to making a deal happen. This week he contacted me about a house he found. It was a 2-bedroom, 1-bath bungalow style house very close to his personal residence.
I found it interesting that the house was a Fannie Mae owned property. The reason that is interesting is I haven't seen a REO on market in five years or better. REO means “real estate owned” — meaning it's a property that has been foreclosed on and is now owned by a financial institution. So to see one on market is an interesting sign of possible foreclosed properties beginning to sell.
My friend was looking at the house and it was in need of larger rehab. Based on the square footage, he and I both came to the same conclusion on how much it would cost to rehab it.
He was hoping to be all in for $120,000, meaning purchase price and rehab. And he wanted to do it in all cash. When he told me that I asked how much the house would rent for. He said $1,200.
So, let's put that into the financial calculator and see what his rate of return would be. And just to remind you, a financial calculator has five buttons up top. They are: N — number of payments (in months); I/YR — interest/ yearly return; PV— present value of the loan or investment; PMT — payments; and FV — future value.
In order to use a financial calculator, you have to have four pieces of information from the list above, and then the calculator will solve for the fifth. So we know that the present value of the investment will be $120,000, Future value would be zero in this situation, Payment will be $1,200 and lets look over the next 30 years and solve for I/YR.
So this is what the inputs look like:
N equals 360 month I/ YR=? PV equals -120,000 (it is negative because that money went away from you) PMT equals 1,200 and FV equals 0
Solve for I/YR and you get a yearly return of 11.63%. That is a pretty good rate of return for most investments. And just to put it into perspective, a 10% yearly return means you get 10% of your initial investment back each year. So that means it takes 10 years to get all your money back before you make a profit.
The problem with that is the 11.63% is an inflated number. You see, we didn't take out any expenses associated with running a rental property. Doing that, it brings your PMT down to more like $840.
So with that:
N equals 360 month I/YR equals? PV equals -120,000 PMT equals 840 and FV equals 0
Solve for I/YR equals 7.51%. That means it will take nearly 12 years of uninterrupted rent to get all of his money back before he makes a profit. Still, 7.51% is not a terrible rate of return. But is using all cash here the best way to use your money?
For me, the answer is no. Real estate is one of the few investments that you can get loans for and there are lots of people who are willing to partner with you. For instance, what if you did a participation note on this one with someone's IRA? Let's say they loaned you the entire $120,000 that you needed in exchange for half the net rents and half of the future growth. How would that look?
Their IRA would get a $420 payment. On face value that would look like this:
N equal 360 month I/YR equals PV equals -120,000 PMT equals 420 and FV equals 120,000 (because you owe them the initial investment)
Solve for I/YR equals 4.2%. That means you could loan this money out for 4.2% interest only.
That doesn't sound great for the IRA until you factor in that it gets half of the future growth. Let's say the house
is worth $300,000 in the future. That means there was a growth of $180,000, so you would split $90,000 a piece. So not only did the IRA make 4.2 percent, but they had cash growth of $90,000. That turns this into a good deal for them.
But what about my friend? If he did it this way, he would start making a $420 profit on day one because he would have no money invested in the deal. That means he could take his $120,000 cash and put it into, for example, two doublewides on land. And now he would have three streams of income and growth instead of just one.
Many people are scared of debt. But you can see here that there is such a thing as good debt and bad debt. Bad debt eats you and is mostly personal debt. I think you should be personally debt free. But when it comes to building cashflow, you can use good debt to increase your income much faster than just trying to do it all with cash.