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..

..@marty..very informative...one of the best methods to reduce risk is through off-plan sales whereby you gauge the market using architectural plans and 3d images before investing in brick n mortar

Mitigating against Leverage Risks

The higher the leverage, the higher the risk but as we saw last time the higher the profit margin.

We all agree that in Kenya, a developer’s world only makes a lot of sense when the concept of OPM (Other Peoples’ Money) is utilized to the maximum. So then along the same line of thinking, developers in Kenya are clever enough to utilize the less risky of the OPM. Off plan sales

The idea is of course to sell concepts on paper and expect that potential buyers will show up, pay deposits for yet to be built units. As the construction goes on, the buyer injects more cash and preferably by the time the construction is over, the buyer has fully paid for the unit. This is clever coz it essentially means the developer utilizes the cash from the would-be buyers and makes some coins. However, this arrangement works best when there is a show house and buyers can see how the end product will look like. In some cases even without the show house buyers could still trust the developer especially if they have a name…importance of a name?

The other very important idea that developers consider is to ensure that a loan is structured with several draw downs. Interest is normally charged on the amount drawn as opposed to the total loan amount. After the first few draw downs. A clever investor is able to gauge on the response from clients on the units. One can reasonably tell whether there is interest on the units once the ground breaking is done. Most buyers will be comfortable once they see progress on the site. And by the way, one might be very happy to see so many would be clients visiting the site and commenting on the good work done, but a seasoned investor knows that a lot of demand may not translate to effective demand.

Effective demand is quantity of a good or service that consumers are actually buying at the current market price.

Of course we also have latent demand when a customer/consumer is unable to satisfy their demand, mostly due to lack of money.

What if you already have the loan and the sales are not forthcoming? One option would be to re-negotiate the re-payment terms with the bank so that they extend the period where u service the loan interest without paying the principle and whenever a sale is done, the bank receives their cash. Kenyan banks are kinda flexible and are also alive to the market conditions.

Developers are also keen to change the prices as the construction continues. In other words, the buyer who buys off plan will always get a very good offer and the one who comes in when the unit is ready, then pays much more. Sometimes the increase would be as much as 10-15% so it is always wiser to buy off plan or at least when the ground is broken.

Next, we shall talk about how best to involve your kids in your business

Marty, fantastic article as always!

As you are an insider in the industry, I would like to hear your thoughts on the issue of a property bubble in Kenya as some have alluded to. Is a bust really on the cards?

Seconded please add mwangismall@yahoo.com to your mail list. Gob bless

Succession Planning

We have seen it happening. Some hardworking chap struggles to set up a business that becomes and empire. Soon after transition, the empire collapse like a stack of dominos. Or you could have noticed a cycle in family fortunes that change from generation to generation. One generation finds nothing to inherit, and then they struggle so hard and by the time they are going they leave massive wealth. The generation that inherits the wealth and the businesses that they got on a silver platter squander the wealth and die poor only for the next one to redo the cycle.

Succession planning is crucial for any company. Importantly so, even at a personal level it is still absolutely necessary. But trust people to keep deep lying and long standing secrets of their business away from their wives and kids where they have absolutely no idea of how to run your business after you are gone.
So then, how best do you get your kids in the mix?
Proverbs 22:6: Train a child in the way he should go; even when he is old he will not depart from it.

Teach them the value of hard work and that money does not come from above. Some simple things like ensuring that the small cash they receive from you is well utilized. Let them learn the good habits of managing the little they got. Being frugal becomes something they treasure. Let them know that were it not the case, they’d probably not be enjoying the good life.

Entrepreneurship starts early…enroll then to entrepreneurial courses if you must…Let them start small home businesses like rearing rabbits for sale…chicken etc if possible…Personally by the time I was in class 5 I had so many rabbits that I had raised and was selling…It taught me a few things about business at a tender age.
Get them understand your business operation-wise. Give them some role in the set up. Observe and where necessary guide them. Let them graduate slowly from small roles to bigger roles gradually ability is demonstrated. At some point let them even get some shareholding in the company. Somehow they’ll understand the intricacies of the business and they’ll own it. Slowly by slowly relinquish your hold on the company but keep an eye on the manner it is being managed. In your sunset years you’ll probably own like 5% and the rest distributed amongst your heirs. Teach them the essence of teamwork and drawing into each other’s strength.

Someday I was buying some land from a company owned by the family of a big shot (former politician and cabinet minister, name withheld). When I received the completion docs, they included a CR12. This is a document that outlines the ownership of a company as per the records at the registrar of companies. I actually realized the shareholding was distributed amongst the former minister (5%) and the rest between the daughter and son. It is amazing coz the daughter was only 23 at that time and the son 32. The company had expansive lands all over and the son and daughter are the ones who signed the docs and the father remained in the background. I noted that the daughter is very knowledgeable on land matter and at her age that was quite impressive.

Next post will dwell more on succession planning and avoiding conflicts