Mark Williams, a third-generation builder, recently joined the podcast to discuss his career in building custom homes, as well as his love for bubble tea. These days, Mark mostly builds for clients, but he got his start with spec homes, which he purchased with debt and learned some tough lessons.

With his wealth of experience, Mark shared some valuable lessons around how to think about debt, which is often called “leverage” because it allows you to buy more stuff.

In this post, we’re sharing the key things to know about debt:

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• The three primary factors
• Is the interest rate lower than your “unlevered return”?
• How large is the investment opportunity?
• What’s the risk?

The Three Primary Factors

Say you think there’s a spec home investment opportunity that you think will cost $100. You also happen to have $100 of cash in the bank. Should you use your own cash to pay for the project or should you use debt? To answer this question, there are three things you need to think about:

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1) Is the interest rate lower than your “unlevered” return? Your “unlevered” return is the expected return on the project before including any debt. If the interest rate is higher than your unlevered return, it generally doesn’t make much sense to take on the debt.

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2) How large is the investment opportunity? Debt is called “leverage” because it allows you to buy more stuff. Instead of taking your $100 of cash and investing in one $100 project, you could take out 80% debt and invest in 5 projects ($20 of your cash for each project * 5 projects = $100). However, if you truly think there’s only one investment opportunity, then it probably doesn’t make sense to take out 80% debt, because you won’t be generating a return on the remaining $80 of cash.

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3) What’s the risk? Your expected “unlevered” return and the size of the investment opportunity are based on future projections. The future is never certain. Before taking on debt, you must develop a view on how confident you are in your projections, because if things go south, debt will lead to additional losses.

1. Is the interest rate lower than your “unlevered” return?

To understand this factor, let’s break it down with some simple math. Suppose you have a project that will cost $100 to invest in, and you expect it to generate a return of 15%. This means your unlevered return (return without any debt) is 15%.

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If you decide to use debt, you need to consider the interest rate on the loan. Let’s say the interest rate is 10%.

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Here’s how you compare the two:

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• Unlevered Return: 15%
• Interest Rate: 10%

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To determine if it makes sense to take on debt, compare the interest rate to the unlevered return. In this case, 10% is lower than 15%. Since the interest rate is lower than the unlevered return, it makes financial sense to take on the debt. The debt allows you to leverage your investment, potentially increasing your overall percentage return.

For example, if you invest $100 of your own money in a project that you expect will sell for $115:

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• Percentage Return without Debt: $15 / $100 = 15%

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If you instead invest $20 of your own money and borrow $80 at an interest rate of 10%, your returns would be calculated as follows:

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• Total Project Return: 15% on $100 = $15
• Interest Payment on Debt: 10% on $80 = $8
• Net Return: $15 - $8 = $7
• Percentage Return With Debt: $7 / $20 = 35%

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By leveraging, your percentage return on your own investment increases from 15% to 35%.

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This higher percentage return demonstrates the power of leverage. However, notice that your actual total profit drops from $15 to $7. To fully realize the benefits of debt, you need to consider the next factor: the size of the investment opportunity.

2. How large is the investment opportunity?

In the prior example, we assumed 80% debt on a $100 investment. This would leave you with $80 of additional cash sitting around. If you don’t think there are any other investment opportunities, then it doesn’t make a lot of sense to take out the debt, because while your % return increased from 15% to 35%, your total actual profit decreased from $15 to $7. Why is this? Because your $80 would be just sitting there earning zero return.

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However, if you do think there are additional investment opportunities, let’s look at how much your total profit would increase by taking on leverage:

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• Total profit without debt: $115 sale price - $100 investment = $15

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Here’s a scenario with debt:

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1. Own Cash: $100
2. Debt Ratio: 80%
3. Own Cash per Project: $20
4. Debt per Project: $80
5. Total Projects: 5 (since $20 \times 5 = $100)

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For each project:

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• Investment: $20 (own cash) + $80 (debt) = $100
• Return per Project: $100 times 15% = $15
• Interest per Project: $80 times 10% = $8
• Net Return per Project: $15 - $8 = $7
• Percentage Return per Project: $7 / $20 = 35%

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For 5 projects:

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• Percentage Return on Total Investment: $35 / $100 = 35%
• Total Net Return: $7 times 5 = $35

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By leveraging, your total profit increased from $15 to $35. This is a massive jump. You made over 2x the profit by using debt!

3. What’s the risk?

The two factors above—your expected unlevered return as well as the size of the investment opportunity—are based on future assumptions. The future is not certain, so that means there’s risk.

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Let’s revisit our example but consider a scenario where the market turns, and the unlevered return drops to 5%.

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Without Debt:

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• Investment: $100
• Return: $100 times 5% = $5
• Total Value: $100 + $5 = $105
• Percentage Return: 5%

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With Debt:

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• Investment per Project: $20 (own cash) + $80 (debt) = $100
• Return per Project: $100 times 5% = $5
• Interest per Project: $80 times 10% = $8
• Net Return per Project: $5 - $8 = -$3 (a loss)

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For 5 projects:

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• Percentage Return on Total Investment: -$15 / $100 = -15%
• Total Net Loss: -$3 times 5 = -$15

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In this scenario, using debt caused your total profit of $5 to drop to a total net loss of $15. This is a disastrous result. You would go from making a modest profit to losing a substantial amount of money.

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Leverage goes both ways. When you use debt, it amplifies both gains and losses. If you are right about your assumptions, it will substantially increase your returns. However, if you are wrong and the market performs worse, it will substantially reduce your returns or create losses.

Conclusion

Understanding these three primary factors—interest rate vs. unlevered return, the size of investment opportunities, and the risk—helps you make informed decisions about using debt. Leverage can enhance your returns when used wisely, but it also introduces additional risk that needs to be carefully managed.