How Much Debt is Enough for Investors?
So, I want to unpack when the amount of debt is enough for investors.
When do investors need to stop taking out debt to fund their investments?
Reflection on The Velocity of Money
Before delving into the topic of debt, it’s important to understand the concept of velocity of money.
There’s no question that when we’re in that stage of our investing where we’re trying to build capital or income, the velocity of money as a concept is super important. The concept is essentially about taking the returns that you achieve and reinvesting them to amplify your results. This means that you’d get a far superior result than you would, even with simple compounding.
For example, if you had $100,000 and applied simple compound interest to it over five years, you would make around $28,000. But, if you applied compound interest and applied leverage to assets (which will give you additional growth), you can 10X that result.
One of the great benefits of being a real estate investor is the ability to access compound returns and leverage in a way that allows you to create maximum velocity (in the bounds of what’s actually possible).
The Concept of ‘Lazy Capital’
One of the worst things an investor can do is have assets worth a lot of money, but that sit around and either drain you of your resources or produce very little income.
I call them big fat lazy pandas.
Some investors can tolerate having a few big fat lazy pandas that only make up a small portion of their portfolio. But for the vast majority of investors, they don’t have the luxury of holding assets that don’t perform well.
On the other end of the spectrum, you have skinny cheaters who are investors that end up pushing their leverage to the max, wanting to see every dollar they have put to work.
Using Debt as Leverage
We use debt to leverage to invest with more potency. And without it, it’s a very slow train to financial freedom.
But when is enough, enough? When do you stop?
It’s all good and well borrowing to invest in assets that are going to perform overtime. But you need a game plan to either manage your debt or extinguish it all together when it comes time to leave your business.
If you’re going to add debt to your portfolio, you need to do so cleverly and carefully. You need to give thought to the “what, how and why.” If you’ve been mindful about how debt is added to your portfolio, then it’s a great game to be playing.
But, if you’re someone who has leveraged to the max and squeezed every extra dollar out of every asset as soon as equity has been created, then you’re going to be in a situation where you’re maintaining a very high level of debt to asset value instead of having it decline over time.
And that’s a pretty dangerous situation to be in.
What is The Debt Spectrum?
If you have a high or low level of debt, it’s important to understand that there’s a spectrum that people sit on.
If you have a freedom formula game plan that you want out of in the next three to five years, then the debt management component needs to be addressed. It’s great to plan to create a portfolio that’s going to generate income, but you also need to have a plan to accommodate the risks that come with carrying debt.
For example, debt rates can go up and down, banks can call in loans, or the wheels can come off the economy somehow. So, you need to keep good cash buffers and plan to manage debt in those circumstances.
So, what does your exit strategy look like if you’re planning to get out in five years?
At the one end of the spectrum, you have a situation where you’re debt-free. You’re able to sell your business and sell down your assets because you’ve put an aggressive pay down in place.
Or, if you’re quite comfortable with holding debt and you’re very clear about the risks around carrying debt and how it’s managed, you can sit on the other end of the spectrum of where debt is untouched come the time that you want to change your strategy or exit it because you’ve hit your financial freedom number.
However, you need to have ample cash flow to service that debt, a cash flow buffer and instructions in place for the recipients of your assets who will have to manage the debt – you have to bring some mindfulness to the risks associated with the debt.
When is Enough Debt, Enough?
When it comes to establishing when enough debt is enough, you need to go back to your freedom formula.
Once you have clarity about the timeline, the level of income you’re trying to produce, the types of investments and returns – it’s very easy to reverse engineer what that number looks like and how much debt is associated with it.
Joe has been investing in property for a while, runs a successful business and has a bit of money in his superannuation fund.
Every time he’s been able to accumulate funds, he’s been able to go to the bank and put down a 20% deposit on every property he bought. And over time, that portfolio has performed excellently.
He’s reaching a point where the focus of his business dividends has gone more towards lifestyle, and he is finding it harder to save the 20% deposits. So, he starts to refinance some of the assets that he has to continue investing – which goes on for a while.
He eventually found himself in a position where he was ready to step out of business, so he assessed his investment portfolio. The last few assets he accumulated haven’t performed well, and he’s carrying a fair bit of debt.
So his options are:
- sell down some of his assets and bring his debt to value ratio down, or
- sell his business and use the funds towards debt reduction.
The big thing that he has to consider is whether he can manage the debt regardless of the level of income coming off his assets?
Joe’s situation is not uncommon. In fact, generally, there are people whose entire strategy around accumulating property has been to refinance at every opportunity to springboard into the next property – which is great in a really buoyant market.
But in a flatter market or where you’re not going to give yourself the time to have those exponential increases in value, the situation could, potentially, be risky.
So, to sum up the concept of “how much debt is enough” and Joe’s case study, you need to be conscious of:
- the assets you accumulate,
- your plan to extinguish debt, and
- how you’re going to de-risk from a cash management perspective.
Debt can be your best friend, or it can be a noose around your neck.
Without the use of leverage, it’s very hard to accelerate your asset base. But, at some point, if you don’t start demanding that your capital generate strong, predictable and consistent cash flow for you, you’re going to be in the situation where you’ve only got one or two options available to you to get to your ultimate goal.
Suppose you’re looking to exit your business in the next three to five years. In that case, it’s really important that you start looking at your debt situation, how to manage it, and whether your investments are producing at the level that you need them to, to safely retire and go onto your next project or pursuit comfortably and confidently.
If you’re interested in understanding how to create wealth through alternative strategies, please check out my programs, where I help you catapult your investment income and blend strategies to shave decades off your timeline to financial freedom.
Or, you’re welcome to get in touch today, book a call with me, and I would be happy to talk you through it – no obligation!
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