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Striking the Right Balance

QUESTION: Ray in Nevada earns $150,000 a year and just got a huge bonus. He loves real estate but also loves the idea of being debt-free. He’s not sure how to balance the two. What suggestions does Dave make?

ANSWER: You can do two or three things. One is to stay on the track you’re on and continue to buy. You don’t have huge equity here. The numbers you gave me say you’re in a 15% or 20% equity position here. That’s not very good. A swing in the market could really get you in a pinch.

If you multiply this by 10 instead of three, you could very quickly get yourself illiquid here. You might run out of cash and, even though you have a net worth, end up broke. That’s actually what happened to me 20 years ago when I went broke. One part of me going broke was that. I was just leveraged up to my eyeballs, which, 85% loan to value is overleveraged in these situations.

I love real estate. I’ve got a bunch of real estate now. After I recovered from the tough times, I started buying again and paying cash. You certainly can continue ahead. What feels safe to you right now when you scale it is going to become unsafe. That’s what I’m trying to point out. You certainly can go ahead; a lot of people do. But you’re going to stub your toe there eventually.

I’ve been around and in real estate my whole life. I love it, but I see people get themselves in these messes all the time.

The second thing you could do is just slow down and develop some other kind of game plan where you at least have more equity position and more cash, more liquidity. If I were in your shoes, the third thing I’d choose to do is grow my real estate portfolio more slowly. When you get three properties that are paid for, the rents net of expenses off those three properties will buy another property every so often. You have real cash flow then.

If I woke up in your shoes, I don’t think you have to panic, but if you decided that you love real estate so much but also love the idea of being debt-free so much, and the debt-free part slows down your purchases but also insures that you won’t hit the wall later. This portfolio won’t look like a NASCAR wreck later and be disintegrated on the wall, where you lost your job and three renters and the whole thing came crashing down.

Instead of doing that, I think the first goal is to say that you’re not going to buy anymore until you get these three paid off. Systematically tear into these. If you want to get even more aggressive on that, pick out the one you like least and sell it and throw the equity at one of the other properties. Debt snowball these rental properties where you end up with one or three paid for within the next few years using your great income.

Then, between cash flowing out of your great income as well as these rentals, which will be cash flowing like crazy, buy another rental that’s paid for. I’ve been doing that for several years and it’s pretty sweet at the end of the month when all the rents come in and expenses are paid and you see how much money those things make.

And there’s no risk. I don’t have to take a bad tenant. I don’t have to hurry. I don’t have to panic. I don’t have to lower the rent, because I’m not in a hurry. We try to rent the things at market value, but we don’t have to get the thing rented because some payment is killing me. That never enters into my mind.

I bought a huge office building a year and a half ago. The thing was almost empty and still is, and I’m not panicked. I’m starting to get a little aggravated, but I’m not panicked because I don’t have any payments on the thing. I can sit in that thing forever until I get the right tenant in there at the right price. I don’t have to give the building away because I’m desperate. I don’t have partners or banks breathing down my neck.

That’s how I’d do it. I’d build my real estate portfolio, but I’d rather have 10 paid-for houses than 100 leveraged.

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