In 1978, Donald Trump launched his real estate empire by buying the dilapidated Commodore Hotel in Manhattan. The Week reports that he funded it with a combination of $70 million in bank loans (cosigned by his father Fred Trump), a $1 million loan from his father, cash from the Hyatt Corporation and a 40-year tax abatement partnership with New York City in exchange for a share of future profits.
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It was a bold plan — and it worked. Trump reopened the hotel in 1980 as the Grand Hyatt, and later sold his remaining share for $140 million.
Trump certainly isn’t alone in his use of debt and leveraging other people’s money to build his own wealth. So how do billionaires use leverage differently than the middle class?
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Buy Cash Flow, Not “Things”
The middle class uses debt to buy furniture and cars and burritos with Klarna. The rich buy assets that generate cash flow.
“Billionaires use leverage to build wealth; the average person uses it to buy liabilities,” notes Josh Tolley, CEO of business brokerage Kingsbridge. “They use business credit, real estate loans or asset-backed lending to generate cash flow.”
For a simple example, imagine buying a rental property for $100,000. You borrow $80,000, make a down payment of $20,000, and put up $4,000 in closing costs. The property generates $200 in average cash flow each month. You invested $24,000 of your own cash, and in exchange you earn $2,400 in the first year (a cash-on-cash return of 10%).
That $80,000 loan helped you start earning cash flow. It didn’t go toward filling out your wardrobe.
Amplify Returns
Debt can help you earn higher returns on your cash. In the example of a rental property, the rent might rise by 5% each year — all while your mortgage payment remains the same. Over time, that earns you disproportionately higher cash flow compared to your own investment.
For example, after two years the rental property now generates $3,600 in annual cash flow. That comes to a cash-on-cash return of 15%, which means your cash flow jumped by 50% even though the rent just rose by 5-10%.
That’s leverage.
Counter Inflation
Inflation doesn’t hurt real asset owners. If anything, it helps them.
Remember, the monthly loan payment on that rental property is fixed. But the hotter inflation runs, the more the owner can raise rents, creating an ever-wider cash flow spread.
Inflation also drives up the value of real assets alongside the cash flow. Real estate agent and investor Eli Pasternak of Liberty House Buying Group explains further: “The key is using fixed rate debt on appreciating assets, because inflation makes your loan payments cheaper over time while property values increase.”
Cash Out by Borrowing, Not Selling
As your assets appreciate in value, you could cash out by selling them of course. But then you’d owe capital gains tax and you’d lose out on the future cash flow forever.
“Billionaires often refinance to pull cash out of appreciated assets, rather than selling and triggering capital gains taxes,” adds Pasternak.
Consider the rental property example. Imagine the investor borrowed a 15-year loan, and after 15 years they now own the property free and clear. Instead of selling, they take out another 15-year loan — and let their renters pay it off for them all over again.
The property keeps generating greater cash flow, and keeps appreciating in value. Every 15 years, the owner can tap the equity to pull out nearly the entire value in cash.
And they can turn around and use that cash to buy even more income-generating assets.
Shield Your Personal Assets
Billionaires take calculated risks, not reckless ones. They don’t bet the proverbial farm on every business deal or investment.
Instead, they silo each in its own legal entity, limiting the risk to each separate business. If something goes wrong, such as a litigious tenant suing over a “slip-n-fall,” the most that the owner can lose is that single entity’s asset or property.
“The wealthy separate personal liability from business risk through LLCs and layered financing,” explains Lucia Lu of business solutions provider Nextpins. “Middle-class earners can model this by forming LLCs for investment properties or side ventures, keeping debt off their personal balance sheet while reaping the tax benefits. Structured right, this limits exposure and opens doors to deductions.”
Debt is a tool. In skillful hands, it can supercharge your investments and business results. And when used poorly, it can injure or even destroy your personal finances. Before you begin, find a mentor to help you learn how to build your own empire by leveraging other people’s money — and without risking everything you own personally.
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This article originally appeared on GOBankingRates.com: Trump’s Debt Secrets: How To Use Leverage Like a Billionaire
