How to Keep Debt Levels Sustainable

Recently I posted an article quoting this ancient Hebrew proverb from the writings of Solomon, the third King of Israel:

“The rich rule over the poor, and the borrower is the slave of the lender.”

Those are pretty strong words. According to Solomon, if you owe someone money, you’re their slave. He was fairly qualified to talk about the subject. Many historians consider him to be the richest man to have ever lived. Some estimate his net worth in gold holdings to be about $1 trillion.

When it comes to consumer debt, we would all likely agree with Solomon’s metaphor of slavery. Consistently borrowing to pay for items that depreciate in value is not only foolish, but it will inevitably lead to poverty.

But what about investment debt? Surely that’s different. You’ve probably heard property gurus talk about good debt and bad debt. So, is there really such a thing as good debt?

If Solomon’s proverb is true, we must ask the question, “Is there such a thing as good slavery?”

An ancient Hebrew story from the life of Jacob, who was one of the founding fathers of the nation of Israel, illustrates the issues around this question of good slavery. Jacob was in love with a girl named Rachel. She was beautiful and Jacob was so captivated by her, he agreed to enslave himself to her father Laban for seven years in exchange for the right to marry her at the end of that time.

I’m sure if you could have asked Jacob, he would have considered his arrangement a form of good slavery.

So what can we learn from this? For slavery to be called “good,” it requires two key elements: a limited time frame and a valuable reward at the end, which in Jacob’s case was a time frame of seven years and the reward of a beautiful woman.

There was a problem, however; as a slave, Jacob was not in a position of power. At the end of seven years, Laban pulled a switcheroo on Jacob. After the wedding feast, once nightfall arrived, Laban secretly sent Rachel’s older and uglier sister, Leah, into Jacob’s tent to consummate the marriage.

The next morning, Jacob cuddled up next to his woman, and then opened his eyes to find a surprise. As you can imagine, he was furious. When he confronted Rachel’s father for his deception, Laban simply replied,

“It’s not our custom to give the younger sister in marriage before the older. I’ll give you Rachel now, as well, but you’ll need to agree to work for me another seven years.”

If Jacob was to gain his “valuable reward,” he had no choice but to remain enslaved to Laban for an additional seven years. The slave owner, the one who had the power in the relationship, had moved the goal posts.

So, what can we learn about investment debt from this story? Sometimes your limited time frame is not as limited as you might think. Like Laban, your slave owner, the bank, the one who has the power in the relationship, can change the rules.

I have a friend who was very asset rich, but cash poor coming into the global financial crisis (GFC) of 2008. As a developer, he had just invested most of his cash into land for some upcoming subdivisions. As asset prices declined, the banks grew uncomfortable with their level of risk, so they began tightening up.

The ANZ bank manager called my friend in for a meeting. They lowered his loan to value ratio (LVR) requirement from 80 percent to 70 percent. After scraping together as much cash as he could, he was able to comply.

A month later they called him in for another meeting. Now they wanted him at 60 percent. After his bank changed the rules a second time, do you think he was calling his investment debt, “good debt”? Looking back, he’s still amazed that he didn’t go bankrupt.

As Steve McKnight says, “There are only two types of debt: bad and worse.” We must have a healthy fear of our investment debt. Borrowing may be necessary to gain the valuable reward of financial freedom, but we must always remember that the bank is calling the shots. They can and will move the goal posts. If we become complacent, investment debt can turn on us when we least expect it.

Today we find ourselves in a high growth market with low interest rates. The temptation is to take advantage of the season and leverage up. But we need to consider the risks.

To that end, here are three pointers on how to keep debt levels sustainable:

1. Use The Right Mix Of Cash And Debt

Because real estate is expensive, for most people, it’s unrealistic to expect that we could use all of our own money to buy property. Investment debt serves a purpose. It not only makes the purchase possible, it also enables us to use the power of leverage to supersize the impact of capital growth.

But, we also don’t want to use too much of other people’s money to buy property, because this could put us in a precarious situation. If property values decrease, we could easily end up owing more than our asset is worth.

Besides, lenders are often more risk averse than investors, which means they’ll face maximum limits on the amount of money they’ll be able to borrow. Usually, that limit is well below 100 percent of the purchase price of a property.

When investing in real estate, the sweet spot is to use some of your money and some of the bank’s money. But the key question is, “What percentage mix do you use?” That depends on two key factors:

1. Your experience and skill as an investor.
2. The current trend of the property market.

In From 0 to 260+ Properties in 7 Years, Steve offers the following matrix as his suggested guide to sustainable debt levels.

Click on image to see enlarged table

You’ll notice that the higher your level of skill and the hotter the property market, the higher the level of debt you should be able to sustain. The opposite is also true. If you’re a novice investor, you should have the discipline to leave yourself plenty of margin and take on less debt.

Here’s a quick word of caution regarding hot property markets. Property markets are often hottest just before they crash. If you recall 2008, we were all enjoying a big boom and great times just before the proverbial crap hit the fan.

Whatever you decide, if you take on investment debt, have a plan for paying it off. As we learned from the story of Jacob and Laban, good slavery, by definition has a limited time frame.

2. Set Growth Benchmarks For The Properties You Hold

The change in value of a property has a significant impact upon the risk of holding it. As your property appreciates in value, your LVR decreases. This, of course, means less risk for you.

Conversely, if your property depreciates in value, your debt becomes a higher percentage of the value of the property, which means a higher level of risk for you.

Therefore, you should set goals that represent your desired growth target for each property. Most investors don’t think through an exit strategy, given future variations in the market. If we just accept whatever the market brings, then it shows we’re not being proactive toward the achievement of our long-term goals.

3. Consider Selling Some Properties

Are you carrying debt that could financially cripple you if the property market softens? If so, your situation could be made much less risky by selling a property or two and reducing the amount of debt you’re carrying.

Many investors in today’s market are highly negatively geared. If this is true today, imagine how the situation will worsen when interest rates rise in the future.

A property that is ripe for selling will have the following characteristics:

• It is experiencing little or no capital growth.
• It represents a relatively high percentage of your total investment debt, as well as your negative cash flow.

By selling, you will own less property, but you could also have a far superior cash flow, and you could find yourself armed with a larger bank balance. This would create a good position you to take advantage of better deals that may come along in the future.

Just keep in mind; it’s always advantageous to sell when the market is hot, rather than when it’s flat or cold.

Conclusion

Most people wait for the financial storm to come before they start patching holes in their leaky roof. The problem is, by then it’s too late to keep the house dry. When times are good, it is especially important to be proactive in managing debt. We should consider Solomon’s words carefully and always maintain a healthy fear of borrowing, even for purchases we think will go up in value.

For more insights on Steve’s “Guide to Sustainable Debt Levels,” check out Appendix A in From 0 to 260+ Properties in 7 Years. You’ll also find two full sessions on “Identifying and Mitigating Investment Risk” in our Property Apprenticeship course.

By Jason Staggers

Jason was a personal mentor working with Steve McKnight's Property Apprentices. He helped hundreds of investors apply Steve's teachings in the real world and achieve greater results on their journey to financial freedom. Jason now lives in Perth, WA where he leads Neuma Church.