Debt is often the lifeblood of real estate enterprises because, to put it simply, debt is what helps firms access properties that would otherwise be unaffordable. By going into debt, it becomes possible to have more deals going at any given time than would be possible without debt and—assuming that we can secure a deal with a cap rate that is greater than the cost of borrowing— it can be tempting to go deeper into debt because it can increase the overall projected return on investment (ROI).
However, while debt is something that undoubtedly can be useful, it is also something we believe firms have a responsibility to be cautious about accepting. Debt is a double-edged sword, and just as debt can cause firms to thrive when times are good, too much debt can also cause firms to come tumbling down whenever times are bad.
During the 2008 financial crisis, the acceptance of bad debt caused countless previously thriving real estate firms to fail. When we accept debt, we are accepting a future responsibility, and if we put ourselves in a situation where we cannot fulfill these responsibilities, we are putting both ours and our investors capital at risk.
Keeping the importance of diversification in mind, some developers and real estate investors will take on debt for twenty properties at once because, after all, what are the odds that these properties will all fail at the same time? But when an industry moves cyclically, as it undoubtedly does in real estate (especially industrial real estate), the possibility of a firm-wide collapse becomes very real. We have seen this happen to our friends in the real estate industry.
Here at Brit Properties, we have had people tell us that the portfolio is overly insulated from risk. These individuals, typically very risk-tolerant, claim that if we are not giving back a deal now and then, we are not accepting enough risk. In essence, these individuals would prefer to take ten steps forward followed by one step back. We simply do not follow that philosophy.
Perhaps high risk thinking makes sense if you are playing at a casino. But, for better or for worse, we are not playing at a casino—we are running a business, and in the course of running this business, we have a consistent duty to protect our investors. It is not that we are unaware of how powerful leverage can be in real estate. But we are keenly aware that just because we can get away with borrowing more, that does not mean it is responsible to do so.
Deciding What Really Matters
Of course, Brit Properties does not avoid debt altogether—executing only cash deals is inherently limiting. We do, however, work to ensure that our properties are safely leveraged and that our loan to value ratio is low.
On a ten-million-dollar property, raising 7 million dollars in equity and taking on only 3 million in debt will put us in a much better position than if we raised just 3 million dollars of equity and stretched our credit to the greatest extent we possibly can by taking on 7 million in debt. We will pass on a deal if it requires too much leverage. Security is something we consider to be inherently more important than risk. This, fundamentally, is the difference between the firms that are able to last for more than a decade and those who simply come and go.
When all else is equal, we know our investors would rather accept a project with a slightly lower projected return than a project that looks promising because of a low interest rate in today’s environment. The problem, however, is that these things are rarely predictable in the long run. We would much rather offer a project with limited risk that offers modest returns than a project with much higher possible returns and much higher risk. By continuing to make empirically safer choices, we can continue thriving and, even more importantly, sleep comfortably at night knowing both our capital and that of our investors is safe and their chance of loss substantially mitigated.
Across the broader real estate community, you will find that there are many different ways to approach debt. Some developers will assume that if they can borrow more that means they should borrow more. These developers will often do very well for a limited period of time, only to eventually have one key investment backfire and reveal just how overextended they really were. We know this because we have made that mistake several times in the past… and plan to avoid that trap in our current and future deals.
By taking a conservative approach to debt, we reveal what is really important: our investors. We make active efforts to ensure that our capital is continually protected, regardless of how the broader market is performing. Though it may be true that limiting our acceptance of debt leads to a “slow and steady” approach to investing, we believe—and have ample evidence to support this belief—that this philosophy is what has kept Brit Properties successful since the 1980’s and what will keep our investors safe and our enterprise thriving for many more years to come.