Taking on debt to make money: When should you do it?

Taking on debt for a reliable business venture can be a smart move if you follow a few simple guidelines. 

By , Guest blogger

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    A "for sale" sign is seen outside a home in New York. Hamm advises a reader that going into some debt to buy an investment property is a good move, with a few major caveats.
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Connie writes in:

My husband and I are in great financial shape thanks to living well below our means for many years. We are in our mid 40s and have $300,000 in the bank along with no personal debts.

We’ve been thinking about buying an apartment building in our area. There’s a person who may be selling a six unit apartment building for about $400,000. We talked to him and looked at the books and it looks like it would generate about $25,000 a year in profit provided we keep at least four of the units occupied. There’s a property management company already in place.

So, we’re considering going into debt to buy this building. Do you think this is a good idea?

This is an interesting problem that deserves a longer answer than the typical reader mailbag response. While this situation doesn’t really apply to the life of many of my readers, it does provide some potential goals and some insight as to how this might work.

First of all, I don’t really view this as personal debt. If you do this purchase correctly, you’ll set up a corporation to own all of these properties. I won’t guide you through this, as I couldn’t possibly write a guide that would take you through the nuances of this for every local area in the country. You can figure out the process by stopping at your local library or by contacting a lawyer.

Recommended: How savvy are you about real estate? Take our quiz.

So, let’s say you set up a corporation to handle all of this. Is it still okay to go into debt for this?

I think it is, with a few big caveats.

First of all, you have no personal debt when you start this business. Connie does not. Her personal finances are in great shape. It doesn’t matter what interest rates are like – I am never comfortable leveraging my personal life in the hopes of earning more money through a non-guaranteed investment.

Second, you’re maintaining a very large emergency fund for yourself. This means I wouldn’t put nearly all of that $300,000 into this endeavor.

Third, any debt your corporation incurs is merely to buy an asset that retains value. With the purchase of a property like this, the corporation you’ve started can theoretically sell it pretty easily to recoup all of the debt at the very least and ideally can extract a large portion of the money you invested.

In other words, I wouldn’t go into very much debt for my corporation, but I would be more willing to go into debt to buy a property.

Fourth, the lowest reasonable expected income from the asset you’re purchasing will cover the interest on that debt. In other words, take a look at the lowest number of tenants that the apartment has had over the past several years. How much income did that generate? Would that income be enough to pay the interest on the debt and all costs associated with the property?

In other words, does the corporate debt turn this corporation into a personal money drain? You do not want this corporation to be draining any money from your personal state after the initial investment. If you keep having to add more of your personal money to the corporation, it’s not a winning proposition for you.

Fifth, I’d want to know exactly why this person wanted to sell the building, and I’d have it fully and carefully inspected before purchase. Make absolutely sure you’re not stepping into some kind of trap here where there are deep faults with the building.

A final question: why not just pay cash for this building by waiting until you can pay cash for it? That is absolutely the safest stance here.

However, the debt incurred by this corporation is wholly collateralized, meaning that if you sell the property, you can recoup the mortgage amount. The property is also not your home, meaning that if you do have to sell the property, you’re not homeless – you still have your house. You won’t devastate your personal way of life if the corporation sells the property. This isn’t personal debt, it’s corporation debt, and as long as that corporation has a positive balance sheet and a positive cash flow, it’s not a personal issue.

So, let’s take a look at how this might work. Connie and her husband form a corporation and seed it with $200,000 of their money. This money is basically investment money. This leaves them with $100,000 in personal savings for an emergency fund and other purposes.

The corporation buys the property with their $200,000 in seed money, along with a $200,000 thirty year term mortgage at 3.75%. Since they can sell this property at any time to easily recoup that $200,000 in mortgage debt and the debt isn’t covering anything they need in their life, they’re in good shape. The monthly mortgage payment for this debt is $926.23.

It’s worth noting that this plan works reasonably well because of the incredibly low interest rates available right now. If you double that interest rate to 7.5%, you bump that monthly payment up to about $1,800 a month, and you make this entire proposition much more challenging.

The apartment building costs $25,000 a year in property taxes and building upkeep, or $2,000 a month.

Each of the apartments in the building rents for $900 a month. If four of the six apartments are occupied, that’s $3,600 a month. With the expenses totaling $3,000 a month, that’s $600 in income to the business each month. Every additional apartment that’s rented generates another $900 a month.

The problem comes in if there are fewer than four apartments rented. If only three are rented, this doesn’t cover the monthly expenses on the building – $2,700 versus a hair under $3,000 in expenses. (On the other hand, if the building is paid for in cash, three apartments will generate about $800 or so in income per month, with additional rentals generating even more.)

The exact numbers here will depend on the research Connie does. They may find that the rent they can charge is higher or that the tenant rate is really variable or that the expenses are lower. They need to see the history of the building. They need to run the numbers for themselves.

For this to work, Connie and her husband need to make absolutely sure that (a) their personal finances are strong regardless of what happens with the corporation and (b) the corporation is extremely likely to maintain a positive balance sheet and a positive monthly income. If it fails to maintain a positive monthly income and a positive balance sheet, they need to sell out and get out because it’s not a good investment.

This isn’t a labor of love – it’s here to make money. If there’s even the slightest indication in the property’s history that it won’t make money, then they shouldn’t do this.

A final thought: I would never take on personal debt to invest and I would never feel comfortable running a business that didn’t have positive cash flow and a positive balance sheet. I wouldn’t even try this unless I were debt free, I could start the corporation with enough of an initial investment to ensure stability, and that initial investment wouldn’t destabilize my personal finances in any way. If any of these things ceased to be true, I would sell things off until it became true. I’m pretty conservative with my money, after all.

The post Financing to Make Money appeared first on The Simple Dollar.

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