In 2008, I was invited to give a strategic overview to a board meeting. One observation that I worked into my presentation was, “the assets aren’t generating any net cash flow before interest expenses.”

One of the directors asked me to clarify, “Do you mean after interest expenses?”

“No, there isn’t any cash generation before interest.”

The CEO talked about timing issues with the refurbishment of existing properties and the conversation moved onwards.

A little over a year later, the entire group was insolvent. The CEO filed for personal bankruptcy and left the country.

+++

How is the above relevant today?

Once again, debt is readily available to finance assets with low, no or negative yields.

This is a good mantra to repeat out loud.

I will never borrow money to buy an asset with a cash yield lower than my cost of borrowing

Why?

You will never, ever, ever, ever… have the same discipline with borrowed money as you do with a cash investment.

• Land speculation
• Gold & silver
• Residential buy-to-rent
• Vacation homes
• Fancy cars, boats and RVs

By forcing ourselves to pay cash, we buy far less of these assets.

++

Why do we like to borrow?

• We can consume more, earlier
• We can buy more, quicker
• We can increase the rate of equity appreciation

When greed and ego are involved… pay cash!

++

For whom does leverage work best?

• Managers that receive a share of gains but have no responsibility for losses
• Brokers that receive commissions when you borrow or buy
• The owners of firms that are valued based on assets under management

Look for the above when advisers tell you to borrow more.

++

Many asset classes have had three, or more, years of gains. Our brains are hardwired to assume the last 1,000 days are going to continue indefinitely.

When low yields combine with momentum and easy finance… things can get ugly suddenly.

We’re all going to live through bear markets. They will happen.

Bear markets crush people with debt service greater than operating cash flow.

My friend, the CEO, had personal debt service of $50,000 per week, then his bank went bust, then his employer went bust, then he went bust.

Some risks aren’t worth taking.

+++

This article was triggered by hearing an Australian lawyer rave about a (negative cash flow) buy-to-rent deal. I thought it was going to be decades before I saw that asset class overheat again. Same story, different hemisphere!