Why are ‘real estate’ and ‘debt’ interlocked in the minds of so many investors?

The first reason that comes to mind is the high cost of buying a single property. For most families, buying a home is the single largest purchase of a lifetime, and it usually takes place with borrowed money. (Home purchase is not investment, see here.)

When it comes to investing, however, borrowing is always a risky strategy. Few would borrow money to play in a casino (assuming you can find someone to make the loan!). Some borrow to bet on sports, often with unfortunate outcomes. Laws prevent all but the most experienced investors from borrowing on margin to invest in the stock market. Yet for real estate, it’s almost a given that you borrow. Why should real estate be different?

It shouldn’t be. The reasons are simple:

  1. Borrowing entails risk. The risk is that by failing to repay borrowed money, you can lose your entire investment.
  2. Borrowing entails cost. The cost is interest you must pay. You pay it on a regular basis for as long as you owe the principal debt, regardless of your ability to repay.

Borrowing, be it against real estate or anything else, is a time-based bet. Not only do you have to guess right on the direction of the investment, but you have to be right as to how long it takes. The bet is that (every month, year, whatever) you can make more money than you have to pay back in interest. This is a bet on inflation of the borrowed money, (meaning you pay back the loan with cheaper dollars than you borrowed) a gain in the value of the asset, or both, all within a fixed period of time.

Over the last 50 years this has been a good bet. Inflation has diminished the value of the money to be repaid, and property values rose. Will it continue? It’s hard to say. Governments with high debt try to inflate it away. This trend suggests borrowing is a good strategy. Every so often, such as in the 1930’s and at the present time, property prices decrease. This leaves those with high mortgages vulnerable to reduced rents and the possibility of losing their entire investment. Why take this risk?

People usually take the risk of borrowing because they have no choice. Mortgages allow investors to purchase properties they could otherwise not afford to buy outright. Our firm offers a debt free way to invest smaller sums in real estate. Our partnerships offer investors fractional ownership of a large debt-free property. (Partnerships are the most common structure in the US for private real estate investment.)

We expect our properties to do well. Without debt, we have no interest costs, lower risks, and we can reliably pay our investors immediate income, without the risk of losing our investors’ principal.

Reading the business press of late, we are told that inflation is dead. Worse still, we need to worry about deflation. This may well be the case and we may yet again have inflation again after the deflationary bout has passed. So what to do? I’d say the conservative wisdom of our grandparents (and of Shakespeare) is best. Neither a borrower nor a lender be.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.