At first glance, the words snowball and debt may seem counterintuitive. After all, what real estate investor in their right mind wants to increase their debt?
The truth is that the snowball debt strategy in real estate investing means the exact opposite. As you snowball or grow the cash flow from income-producing real estate, the more money you will have to scale up and grow your real estate portfolio while simultaneously reducing your overall levels of debt.
If that sounds too good to be true, then keep reading to learn how successful real estate investors use the debt snowball method to generate large amounts of free cash flow and retire early while their neighbors are still working for someone else.
The Debt Snowball Method: What is it?
Here’s a good way to visualize the debt snowball method for investing in real estate.
Imagine that you’re at the top of a mountain in wintertime and a fresh snow has just fallen, creating a blanket of white as far as you can see. You reach down and begin making a snowball, but it slips out of your gloved hands and begins rolling down the hill, faster and faster.
When the snowball comes to a stop, it’s grown so large in size that what was once your tiny snowball is now almost as big as a house.
That’s similar to what the snowball debt strategy in real estate investing is. With income-producing property, your snowball increases in both size and speed by investing, holding, and building up cash flow over the long term.
In fact, the further you allow your snowball to roll, the more profitable your real estate portfolio will become.
The Debt Snowball Method: How Does it Work?
The concept behind the debt snowball method is pretty straightforward.
By creating a plan to strategically eliminate debt one payment at a time, you’re better able to measure your progress of paying off debts. Then, as your debt levels decrease month after month, you’ll become more motivated to prioritize paying down debt from your real estate cash flow and even allocate extra funds each month toward reducing debt instead of increasing your expenses.
With enough planning and discipline,
investors are able to use the debt snowball method to
retire much sooner than they believed was possible.
The basic steps for using the debt snowball method in commercial real estate look like this:
1. Allocate capital for the initial down payment
As a rule of thumb, a conservative down payment is at least 25% of the purchase price. When underwriting a loan, lenders will review criteria such as loan-to-value ratio (LTV), debt service coverage ratio (DSCR), and the past track record of success a borrower has investing in commercial real estate.
2. Purchase an income-producing property
Multifamily properties have performed exceptionally well throughout the pandemic, with the beginning of this year creating a solid foundation for continued rent growth and occupancy increases. According to CBRE, an improving economy and additional fiscal stimulus will continue to drive demand for multifamily investments throughout the year.
3. Divert free cash flow toward debt reduction
Redirect the cash flow generated from the apartment building you’ve purchased, along with any extra savings from personal income you can set aside, toward paying down the existing loan principal as quickly as possible. When you apply for the initial loan, be sure to ask your lender about prepayment penalties and how to structure the loan so that you can pay it off early with no extra costs or fees.
4. Save for the down payment on another property
Once the mortgage on your first multifamily property is paid off, use the existing cash flow from the apartment building to save money for the down payment on another property. Then, apply the same snowball debt strategy you used for the first building. Divert the free cash flow from the first property that you now own free and clear – plus income from the second property – to pay off the debt on the second property as quickly as possible.
5. Wash, rinse, and repeat
Before you know it, you’ll have mastered the art of the snowball debt strategy in real estate investing to build a portfolio that generates solid and consistent cash flow year after year. In fact, with enough planning and discipline, many investors are able to use the debt snowball method to retire much sooner than they believed was possible.
Ready to invest in commercial real estate? Contact Smartland to become a commercial real estate investor and leverage their expertise.
Debt Snowball Benefits
Before we discuss early retirement, let’s take an in-depth look at the benefits of investing using the snowball debt strategy. When the debt snowball method is applied properly, you can end up owning multiple income-producing buildings free and clear.
Owning property debt free makes it much easier to increase asset values by offering competitive rents to gain market share, or install tenant-friendly amenities such as smart home systems that in turn justify higher asking rents.
Using the snowball debt strategy to build a portfolio of cash flowing rental properties isn’t an all or nothing proposition. There may be months when you choose to increase the amount of extra cash being used to pay down your debt, and there may also be times when you need to pay a little bit less.
For example, cash flow from rental property isn’t always consistent from month-to-month, such as when rents are raised earlier than expected or budgeted capital improvements are made to increase property value. As long as the minimum monthly mortgage payment is made, there’s no harm in deviating from the increased mortgage payments in the debt snowball method every now and then.
However, it’s important to keep the end game in mind if you do. The larger portfolio you have of free and clear income-producing properties you have, the more cash flow you will have when everything is said and done.
Employing the debt snowball is an excellent strategy for real estate investors who want to have more control over the planning and scaling of an investment portfolio. With the way, the stock market has been behaving lately, what investor doesn’t want to be calling more of the shots?
When you use the snowball debt strategy to invest in commercial real estate, your ultimate success depends on your efforts and not some algorithm in an exchange-traded fund that may be designed to maximize profits for the stock broker instead of yourself.
When the debt snowball method is applied properly, you can end up owning multiple income-producing buildings free and clear.
As you formulate a plan for investing in real estate using the debt snowball method, there are several important factors to keep in mind:
1. Discipline is required year after year to divert as much free cash flow as possible toward paying down debt until you own the rental property free and clear.
To be sure, it can be tempting to want to touch all of that extra cash. But the longer you resist the urge, the easier and more rewarding debt reduction will become.
2. Identifying and buying the right additional properties is also a key factor as you plan your snowball debt strategy.
Some investors may be lured by the appeal of retail and office property that appears to be priced below market. But with the growth of ecommerce and working from home, it’s questionable whether distressed asset classes like these will ever generate as much cash flow as multifamily investments.
People always need a place to live, and increasingly they’re migrating to smaller cities where the cost of living is lower and the quality of life is higher.
3. Financing is another important component when you purchase rental property using the snowball debt strategy. Oftentimes, commercial real estate loans have terms that penalize the borrower for making more than the scheduled payment or for paying off the mortgage early.
Obtaining financing on a commercial property is much more difficult than a home you own, which is one reason why many investors choose to place capital in private equity real estate deals.
In fact, firms such as Smartland underwrite every multifamily investment they sponsor to increase value and then refinance within five years. At that point, the original capital invested is returned, leaving each investor with their share of the building that continues to generate passive income each and every year.
The third benefit of using the snowball debt strategy to invest in real estate is that the process improves over time. That’s because the debt snowball method creates a positive feedback loop each and every month as you watch your mortgage balance get smaller and smaller.
In addition to the psychological benefit of having less debt, the debt snowball method also allows you to use clear and measurable steps as you work toward your long-term goal of holding your rental properties free and clear.
In fact, the snowball debt strategy employs all five elements of the SMART model for goal setting:
Setting well-defined goals are used by successful business people and real estate investors around the world to make more money faster.
Looking for rental real estate investments in Ohio or Florida? Learn more about how Smartland can help.
Related Link: How to Recession-Proof Your Real Estate Portfolio
How to Retire Early With Real Estate Using the Debt Snowball Method
There are two different ways you can use the cash flow generated by the debt snowball method to retire early, if you choose to do so.
Method #1: Pay Off Each Mortgage in Succession
If you’ve been investing in real estate for a while, you may already have several rental properties with mortgages. You can use the snowball debt strategy to pay off one mortgage after another, until your real estate portfolio is completely debt free.
This can be a good strategy to use as you scale up and grow your real estate investments, because lenders often limit the number of mortgages you can have under your own name. It’s important to focus on paying off one property at a time, then channel the extra cash flow you have to paying down the mortgage on your next property, and on down the line.
Paying off each mortgage in succession can take longer than setting aside cash flow for the down payments to buy more rental properties. However, this debt snowball method is ideal if you are further along in your real estate career and want to generate as much cash flow as possible as you near retirement age.
Method #2: Buy More Rental Properties
On the other hand, if you’re just beginning your real estate investment business, you can use the cash flow from one rental property to buy more rental properties. Each property you add will generate incremental cash flow, which shortens or snowballs the time it takes to save up for additional down payments.
For example, let’s say you begin with a small multifamily property that generates annual cash flow of $25,000 per year after operating expenses and debt service. After five years, you will have generated at least $125,000 to use as a down payment on a second property or invest in a private equity real estate offering.
A few years later, provided that you stick to your plan, you will have accumulated $250,000 to use as a down payment on your third property – another $125,000 from your first investment and the second $125,000 when your capital is returned from your private equity investment. Keep in mind that even though your capital is returned, the private equity you invested in is still generating passive income, since you still own your share of the real property.
Some real estate investors believe that debt is good, because they’re able to use other people’s money to buy more property, while using the mortgage interest payments as a tax deduction.
Employing the debt snowball is an excellent strategy for
real estate investors to plan and scale an investment portfolio.
While strategically using leverage to acquire income-producing property can make good business sense in the short-term, the fact remains that you’re using cash flow that you’ve earned to pay interest to the bank. By using the snowball debt strategy for real estate investing, your goal is to eventually pay yourself more instead of the lender.
To be sure, the debt snowball method requires creating a plan with small incremental goals and sticking to it year after year. It may not be easy at first, but the longer you do it the easier it becomes, and the sooner you’ll be able to retire early with the income produced by your real estate portfolio
Interested in multifamily rental investments? ? Contact Smartland to learn more about investment opportunities that can diversify your portfolio.
Related Link: The Ultimate Guide to Investing in Rental Properties