
_Real estate investing is inherently risky. You can mitigate a lot of that risk by following the 3 Immutable Laws of Real Estate (credit of Joe Fairless)._

_Today we’ll be talking about_

# Rule 2: Secure long-term Debt

When we speak about debt (a.k.a. leverage) in a real estate context, we’re generally talking about:
- Money lent from a **lender**, which can be an institution or a private lender,
- For the purpose of **acquiring and positioning** a property
- And **secured** (collateralized) by that property and/or other collateral.

## Should you use debt?

A fair question at this point is: __should you use debt at all?__

After all, if you don’t owe money to anyone, you can’t ever default on a loan and have the property foreclosed on.

While this is technically true, it’s flawed logic for a few reasons.

1. **It greatly limits what you can buy.** No-debt folks in real estate generally end up saving their own money for years to buy one small property, just so they can do it again in 10 years. More often than not, they have to use their own money for these purchases rather than partnering with investors for equity because…
2. **It greatly lowers your return.** We'll get into this in another article soon, but not using debt can greatly reduce your ROI. Generally speaking, it costs more to put equity (your own money) in a deal than a lender's.
3. **It deprives you of a lender's feedback.** Contrary to popular belief, the last thing a lender wants to do is foreclose. A lender will undertake significant due diligence on a project to make sure the business plan is airtight. They have a vested interest in your project succeeding because they want to continue to make money in the form of interest.

In addition, consider what this mindset says about one’s business plan. A friend recently told me about an apartment owner he knows that bought a property for a few million dollars in cash, and purposefully keeps his rents at the bottom of the market. When I asked why he would do this, the response was simple: he didn't want to worry about vacancy, and he needed a place to park some cash. “Besides,” my friend said, “this way he doesn’t have to worry about being leveraged.” Hardly a viable business plan.

## What kind of debt should you use?

So, assuming you want to use leverage in order to acquire a cash-flowing property, it’s imperative to figure out what kind of debt you should use. For simplicity’s sake, I’m going to oversimplify the different types of commercial mortgage debt into two categories.
### 1. Permanent Loans
These are also known as _agency loans_, because the standards and guidelines for the majority of these loans are set by the FNMA (Fannie Mae) and FHLMC (Freddie Mac).

Many lending institutions follow these standards in their underwriting because they want to be able to sell the debt to Fannie or Freddie, but _portfolio lenders_ that plan on keeping the loan on their books are able to set their own standards.

Permanent loans usually have a period of at least 5 years, and can be amortized up to 30 years (although they are normally due sooner).

The requirements to get a permanent loan are pretty strict, and involve the property being stable enough to more than pay the debt service every month. Depending on the lender and property being acquired, there also might be an opportunity to make interest-only payments for a period.
### 2. Bridge Loans
Bridge loans are shorter in term than permanent loans – the idea is that they’re meant to be a bridge to more permanent debt. They have a total loan period of only one or two years and significantly higher interest rates.

Bridge debt comes in very handy when acquiring a property that’s not stable enough to secure permanent debt – maybe there’s exceptionally high vacancy or a lot of “down” units.

## Securing long-term debt
Now that we’ve covered the basics of commercial real estate debt, what do we mean when we say one can mitigate risk by securing long-term debt?

A general rule of thumb is that:

>Debt should be secured for a period at least twice as long as it takes to implement the business plan.

Let’s illustrate with an example.

Suppose you identify a 50-unit property, Main Street Apartments, whose rents are well below market but has high occupancy. You determine that it will take 2.5 years to turn units and bring rents up to market.

Because you can secure a permanent loan from the start, you should secure it for at least 5 years (2.5 x 2 = 5).

That way, if there are time or cost overruns in implementing your business plan, you’re not in a position where you must sell or refinance the property. If everything does go well, you’ll have more time to cash flow and prove the business plan for Main Street Apartments, and have the option of selling it whenever it makes sense.

But what if you can’t secure a permanent loan from the start? Does that mean all risk mitigation goes out the window?

Consider the same business plan as Main Street Apartments for a different property, Grove Street Apartments.

Grove Street shows a similar opportunity for upside, but only has occupancy of about 70%. With the money this property is making, you won’t currently be able to get a permanent loan.

What you _can_ do is use a bridge loan to manage the property for the first year or two and then secure a permanent loan as soon as you are able. This approach carries slightly more risk than Main Street, but the business plan is to secure that long-term debt as soon as possible so that you can reap the benefits listed above with a permanent loan.

## Conclusion
Using debt for real estate makes some people uncomfortable because you're putting a lien on your property that requires you to pay interest.

While this represents risk, a lot of this risk can be mitigated by using financing the right way: being conservative with your business plan and securing debt that's as long-term as possible.


Immutable Rule of Real Estate 2: Secure Long-term Debt


_Real estate investing is inherently risky. You can mitigate a lot of that risk by following the 3 Immutable Laws of Real Estate (credit of Joe Fairless)._

_Today we’ll be talking about_

# Rule 1: Invest for cash flow, not appreciation.
[Cash flow](/blog/cash-flow) is one of the cornerstones of real estate (no pun intended). Simply, cash flow is the money an asset makes after expenses are paid.

Appreciation, on the other hand, is how much we speculate the asset will be worth when we want to sell it. (Please note that this refers to natural appreciation, not forced appreciation, which is a different topic).

**If we invest for appreciation rather than cash flow, we’re opening ourselves up to a lot of risk.**

This strategy is one of the things that led to the real estate crash in the late 2000s — many investors were fine with losing money every month on a property because the market value of the property kept going up. Until it didn’t.

Natural appreciation can be the icing on the cake of a real estate asset, but unless it’s cash flowing, you’re participating in speculation.
## If the worst happens
Investing for cash flow protects investors from risk in case of unfavorable market conditions.

It’s not impossible that the value of a property could drop below its purchase price.

If you’re in that situation and you’re investing for appreciation, you’re in a bad situation. However, if you’re investing for cash flow, you can hold the asset and weather the storm (and even continue making substantial returns) without its expenses putting you in the red.

## But does that mean it's too risky to do new construction projects?

Good question — it might seem like new construction projects might violate this rule because there’s no cash flow from day 1.

For example, let’s say we’re looking at building an apartment community that will be valued at 10 million dollars. In order to build it, we’ll need money from different sources (debt, investors, etc), and there will be a time at the beginning of the hold period where the asset is not generating any cash flow.

However, we’re not just looking at this asset and saying “well, I think it’ll probably be worth 10 million because real estate in this market is trending upward.” This future valuation is based on **expected cash flow** that we can project based on market research.

This approach carries with it potentially more risk than the project that cash flows from day 1, but not the large amount of risk that results from buying for appreciation.

---

In [last week's post](/blog/cash-flow), we talked about what cash flow is and how to think through what the cash flow of a potential investment could be. This is the reason it all matters -- cash flow provides not only financial freedom for investors, but a significant hedge against risk.

Immutable Rule of Real Estate 1: Invest for Cash Flow


Cash flow is the last two words of Robert Kiyosaki’s [six words to financial literacy](https://youtu.be/A8vD_XO0vUU?t=126). It’s one of the most important concepts in real estate as well!

Simply put, **cash flow is the money that an asset makes after all expenses are paid**. In other words,

> revenue - expenses = cash flow

## The phantom menace
Because the formula is so simple, many beginning (and unfortunately, some experienced) real estate investors _overestimate_ the amount of cash flow an asset will generate.

It’s easy to do:

Let’s say you have a house that you can rent for $1000 a month.
Your mortgage payment is $550 a month.
Therefore, your cash flow is $450 a month! 
> $1000 - $550 = $450 cash flow

Not bad, right?

Unfortunately, we’ve left out some significant expenses, making that $450 a month **phantom cash flow**.

## Factoring in other expenses

Let’s take that asset generating $1000 a month and take into account some other expenses you will most likely have on it.

- **Property management**: 10% of revenue = $100
- **Repairs/maintenance**: this can vary, but a safe baseline is 5-10% of revenue a month = $75
- **Capital expenditures reserves**: this is a bit more complex, but this is the amount of money you’ll need to reserve for any major improvement to the asset (e.g. roof repair). Let’s say this is a newer property, so you can safely allocate 5% to capex = $50
- **Utilities**: unless you have the tenant pay all utilities, this will eat into your cash flow as well. In this example, let’s say you pay for water and sewer, which will run you $60 a month.
- **Insurance**: this also varies, but for this example we’ll say $50 a month
- **Taxes**: the assessed taxes for this example property are $840 a year = $70 a month

All of the above expenses come out to **$405 a month**. Factoring in these to the initial calculation gives us:

> $1000 revenue - $550 debt service - $405 expenses = $45 per month cash flow

The good news here is we’re still in the black! The bad news is that the return on investment (ROI) is a lot lower than we originally thought.

The bottom line is this: achieving large cash flow in real estate often involves leveraging creativity in deal structure and thinking outside the box.

At Ursa Capital, cash flow is one of the key metrics we use to see if a deal makes sense for our investors because it’s so crucial to return. [Email or call us](/contact) to find out more about how you can achieve passive, dependable cash flow through multifamily real estate! 


What is Cash Flow?


In a conversation about real estate, interest rates are more than likely to come up at some point. Since most real estate purchases are financed, meaning a bank or some other lender assists a buyer in buying a property, the rate at which a lender will charge interest is one of a buyer or investor’s most important concerns.

## How are interest rates determined?
In the most general sense, interest rates on mortgages are affected by market forces.

When inflation is high, unemployment is low, and the economy’s outlook is good, interest rates rise.

When the opposite is true, as we see during times of economic distress, interest rates on mortgages fall.

In the US, the Federal Reserve directly affects mortgage rates by manipulating the prime rate (which you can think of as kind of a "best case scenario" for a mortgage -- what a lender would issue to a "prime" borrower).

Specific mortgage rates on single family residential properties are largely determined by an individual buyer’s creditworthiness and debt-to-income (DTI) ratio. Your debt-to-income ratio, as the term would suggest, is your ratio of debt service (the money you spend paying off debts, which in this case can also include living expenses like rent) to income. Most lenders abide by the guidelines for creditworthiness and DTI set by Fannie Mae and Freddie Mac.

**This poses a problem** for single family investors — at some point in scaling up their business, they have to deal with the fact that their DTI, even though they’re financially responsible, is much higher than most lenders are comfortable with!

Let’s contrast this with commercial mortgages.

I’ve heard it said more than once that commercial lenders “don’t care about the borrower, they care about the property.”

This simply isn’t true (if you lent out a large sum of money to someone, wouldn’t you want to feel secure that they’d pay it back?), but there is a grain of truth to it. That grain of truth is that _since commercial properties are meant to generate income, lenders base interest rates far more on **the property itself and the business plan** than on the individuals borrowing the money._

Individual interest rates for commercial loans vary based on the type of property and the debt service coverage ratio (the ratio of yearly cash flow to yearly debt service cost) among other factors.

## Do rising interest rates mean investing in real estate is a bad idea?
It would seem to follow that if interest rates rise, debt service will cost more, which will inherently lower return.

Is that true? Let's compare a couple different real estate investment strategies to see how higher interest rates affect return.

### Single family rentals

This would certainly be true if you’re looking to buy a single family rental.

Generally, you’d buy a single family home using a conventional fixed-rate mortgage. If your mortgage payment is $100 more per month than it would have been for the same loan last year, your cash flow decreases by $100.

Since natural appreciation is not guaranteed, a higher mortgage payment can be catastrophic to a single family investor’s business plan.

### House flipping

Okay, what about house flipping?

The business plan for house flipping is very different; essentially: buy a home at a discount, fix it up, and sell it to a buyer at a premium.

Higher interest rates don’t affect flippers on the "buy" side like they do in single family rentals. In fact, it’s worse — it affects flippers **on the "sell" side**.

To illustrate, let’s say you buy a home for $250k that needs $50k of work put into it, and your holding costs are another $15k. When all is said and done, you expect based on sales comps that it will sell for $400k, leaving you with $90k in profit.

Now, it’s unlikely that rising interest rates will cause the price of residential real estate everywhere to decrease. What _is_ certain is that it will affect your pool of buyers and their ability to pay what your flip is worth.

This can lead to more time on market, price reductions and ultimately a drop in your return.

### Commercial real estate

If you invested in commercial (including multifamily) real estate, however, higher interest rates wouldn’t affect returns in the same way.

True, a higher debt service cost could translate to less cash flow during the hold period, but yearly cash flow is not the only metric you’re concerned with.

A [value add investor](/blog/value-add-investing) is able to force appreciation into the property while increasing cash flow, regardless of interest rates. Since the mortgage expense on such a property doesn’t affect the Net Operating Income, the business plan is still able to be carried out effectively.

That, essentially, is the dividing line in regards to how rising interest rates affect single family vs commercial investors.

> Interest rates don’t affect the business plan for commercial investments as drastically as they do for single family investments.

## Conclusion
Higher interest rates **do not** make real estate a bad investment.

Even in types of real estate where interest rates greatly affect returns, it doesn’t negate the power of real estate investing in general.

With that said, single family investing businesses are much more affected by rising interest rates than commercial investing businesses.  This is a consideration that _you_, as a real estate investor, need to make.


Ursa Capital Blog

Immutable Rule of Real Estate 2: Secure Long-term Debt

Immutable Rule of Real Estate 1: Invest for Cash Flow

What is Cash Flow?

What Do Rising Interest Rates Mean for Real Estate Investors?