Good debt vs bad debt

Marty, thanks for addressing this topic of debt. This is one thing we that we struggle with every day, everywhere, despite warning about the risks of living beyond one’s means. Debt can be ruinous especially if its acquisition has to do with keeping up with the Joneses. A lot of times, we don’t budget for the debt we take for that personal loan or a loan to buy a car or furniture. At the time of purchase, we find it expedient to think that we can repay the loan easily. Then comes the bill and we realize that the 200k or the 400k we borrowed will take time to repay; and the income is still stagnant. Then the real needs come in putting pressure on our income. We start to refinance with the hope that another loan will ease the pressure; and miss out the real lesson that it is our expenses that have to be cut and the rat race begins….However, there are times when debt is a result of factors beyond one’s control, like it happens if one has to meet unbudgeted medical expenses. Again one can argue that medical expenses need not be unbudgeted if one has medical coverage, but it happens.

I get your points and are valid. Financial advisors will tell you to have an emergency fund. The same may not only be used for medical purposes but life presents other challenges like losing your job abruptly and many other emergencies. The reality for most people is kinda different coz I know those with emergency funds are very very few.

Leveraging in Real estate

Leverage (debt) magnifies outcomes. What does this mean?

To illustrate how leverage works in a real estate investment, we'll take the following investment parameters (The figures are hypothetical but not so far from reality, just to put the points across):

•Construct 5 units for sale each at construction cost of 5M (inclusive of land)
•Financing at 14% interest (service interest during construction) and repay loan on sale of units
• Sale price of 7M per unit for total sales of 35M

Let's look now at the ROI (Return on Cash Invested) with different options:
25M utilized by the developer from his/her pocket for all the construction costs:
Profit of 10M on 25M invested = 40% (return on cash invested)

50% (12.5M) cash from developer and 50% (12.5m) construction loan:
•cash out will include interest on loan (say 1M) and full loan repayment (principal) 12.5M for a total cash out of 13.5M
•Return = 35M – cash out (13.5m) – developers cash (12.5m) = 9m
•9m/cash invested (12.5m) = 72% return


30% (7.5M) cash from developer and 70% (17.5M) construction loan
•cash out will include interest on loan (say 2M) and full loan repayment (principal) 17.5M for a total cash out of 19.5M
•Return = 35M – cash out (19.5m) – developers cash (7.5m) = 8m
•8m/cash invested (7.5m) = 106% return


As you can see, even though your risk increases with leverage, especially if the sales are not made fast enough it might be a wise choice when you can increase your ROI by as much as the margins above. A seasoned investor will actually use OPM (Other People’s Money) as much as possible. Now this is good debt.

Assuming you got the 25M and as opposed to just utilizing the same for the 5 units…and do without a loan, suppose you put the entire amount as 30% (read last option above). This means, you can now get a loan of around 60M. In other words, you can now construct 17 units.

Sell the 17 units @ 7M for total sales of 119M. If you manage to sell the units within 1 year, then you’ll have paid an interest of around 7M (coz you’ll not draw the cash all at a go).

Cash out is now 7M (interest) + loan repayment (principal (60M))
Returns = 119M-67M = 52M/25M (cash invested) = 208% return……this one will drive someone crazy……or let’s say if I made this, then I’d be off to Benidorm for a month... and switch off my phone

The above figures paint a good picture about debt if well utilized. Take note that the above example(s) are purely driven by sales in good time. This is quite an assumption and a seasoned developer will tell you that without sales, then you are doomed. Notice how crazy it can turn out if you got a 60M loan and sales are not forthcoming…..you will cry in the toilet… But trust investors to take huge risks….after all what would be the worst case for this type of investments????????.....

Next post we shall think along this line.

Hi Marty,

Just a confirmation, how many lessons have you posted so far?
i usually copy paste. I want to know if I am on the right track.

mmmmmm now i know....i have to try this..