I’ve never taught it to my students, but it’s something I ‘discovered’ a few years ago and it’s so important, that I finally decided to let my readers know about it.
It’s the concept of
Equity vs. Debt in real estate
and determining which is
the safer investment
A few months ago, I attended an OREIO investor meeting here in Ottawa and I was involved in a conversation with a mortgage broker and a local investor. The investor had found a private money lender through a mortgage broker, but he couldn’t understand why the lender didn’t want to participate in the ownership of a rent-to-own investment he had available.
The lender was only interested in loaning money in the form of a secured 2nd mortgage – he did NOT want ownership in the deal (even though the investment was projected to earn quite a bit more than his 2nd mortgage interest rate).
I knew the answer, so I explained to the investor that a lender never wants to own the property they are lending on… all they want is the interest and their principle paid back. Compared to collecting interest payments on a secured mortgage, owning a property with tenants is risky. I continued to explain it in more detail until it made sense to him.
It’s this concept that I want to expand on and explain in this (and a future) article.
First, let’s start with some definitions…
A debt investment is pretty straightforward. You loan money to someone, and they pay you back with interest. Your loan is a debt investment because the other person is ‘indebted’ to you (they owe you money).
Here are a few scenarios to illustrate different kinds of debt investments, as they are not all created equal…
Scenario #1 – Verbal Unsecured Loans
If you just give money to a family member, a friend or a colleague and they promise to pay you back, that’s the riskiest of all types of investments and you better trust them to make payments. If they don’t pay you, the only real recourse you have is to hound them until they pay you. You have no security to cover your investment and no method to enforce payment.
Would you take a friend or family member to court? Probably not. Would you take a colleague to court? Maybe… but good luck getting a judgment in your favour if you didn’t have a signed agreement.
If you’re going to make ‘investments’ by loaning money out to people, I recommend you try something else. Years ago I decided that if I was going to ‘loan’ money to a friend or family member, mentally I would just consider it a gift. Then the decision was ‘do I give this person money?’ – a much easier decision to make.
If I got the money back, great! If not, it was a gift in my mind, so I wouldn’t lose a friendship or family relationship over it. If you’re thinking about making completely unsecured loans an ‘investment’, you might want to consider the same approach.
Scenario #2 – Written Unsecured Loans
This is almost the same as scenario #1, but it includes a written contract. Some people might consider this more secure… but is it? Think about it… your investment is not secured by anything except the promise of someone to pay you back (same as #1) but now they also have put it in writing.
What can you do with your written loan contract if they decide not to pay you? Your only recourse is to sue them. Depending on the amount involved, you may be able to take them to small claims court (which is faster) and get a judgment against them to garnish their wages.
But what if they don’t have a job or any assets? You are out of luck and you’ve lost your capital. Even if you can collect the money, you have to spend your time and energy going to court to get a judgment against them and then more time collecting.
Do people actually invest in this way? Yes they do! And incredibly, they don’t realize how risky it is.
In fact, a recent BC-based company filed for bankruptcy and the BC securities commission banned the owner from offering investments for 10 years after he lost $12 million of investor capital — all loaned with a basic contract with no security backing it (I know this because I know people who invested with him, and fortunately they got out before the company folded).
Another example is a couple of investors I know in Ontario who filed for bankruptcy late last year. I am actually a secured creditor, so I am privy to all their bankruptcy financial details. What was amazing to me was that this couple was able to raise millions of dollars in completely unsecured loans from people so they could keep their real estate holdings ‘afloat’… some of the loans were as high as $400,000 (imagine losing that from your home equity!)
I’m sure there was a written contract of some kind, but that means NOTHING if they go bankrupt. Secure creditors (like myself) get paid first, and then if any money is left over, the unsecured creditors are paid.
So what is a secured creditor?
Scenario #3 – Written Secured Loans
This is the most secure and least risky form of loan investment because not only is there a written contract, there is something ‘securing’ the investment. In other words, if the borrower doesn’t pay, the lender can recover some or all of their investment using the ‘security’.
For example, if an investor needs to borrow cash for short-term operating capital (e.g. to renovate and flip a house), they could…
- approach a private lender
- agree to borrow $50,000
- sign a written loan agreement or promissory note for the loan amount and terms
- record a caution or caveat against the title of the property that states there is a loan outstanding
A caution or caveat is simply a notice on the title of the property warning the lawyers involved in a real estate transaction that there is something important to consider for the closing – in this case, a loan outstanding. The lawyer would then contact the lawyer mentioned in the caution and determine the next steps to get title cleared and close the deal.
The most common form of secured written loan is a mortgage. This is a ‘charge’ against the title of the property that must be ‘discharged’ before clear title can be passed on to the buyer. The big benefit with a mortgage over a caution is that all mortgages, by law (which varies in each province), have a certain set of actions that can be performed if the borrower defaults (and big banks will usually add more using extra clauses added to the contract).
- an investor borrows money from a bank to buy a property
- a mortgage charge appears on the property title
- if mortgage payments are not made at any time, depending on the province of the property, the bank can either foreclose on the property or sell the property out from under the seller (power of sale)
- this allows the bank to recover their investment
If the bank had simply used a caution or caveat registered against the title, their only recourse would be to sue the owner in court and obtain a court order to sell the property, or force the owner make up the missed payments.
Now if you carefully review the above 3 scenarios, you’ll now understand why banks will loan money to the average person under only very specific circumstances.
- If the loan is a small amount (less than $50,000), it is ‘secured’ by your ability to repay it (e.g. your job). They will analyze your income, expenses, assets and liabilities ‘just in case’ they need to come after you for the balance owing
- If the loan is a large amount, the money must be secured either by property or some other collateral they will accept. And for most small investors, they will still analyze your financial details ‘just in case’ they need to collect.
Is this fair? If you’re the borrower, you may not think so… but if you’re the bank in business to make money and reduce risk, it’s the best thing to do to protect and increase profits.
Average Investors Don’t Know This
These 3 scenarios provide a high level explanation of the most common real estate debt investments (if you’re a financial planner or investment advisor, I’m sure you could add to the list, but we’re focusing on real estate for now).
The biggest reason more people don’t know about these various types of debt investments, and the pros and cons of each, is that this information is not really taught anywhere. And if it is, it’s not really put into context for the average person (or investor) to understand and apply to their circumstances.
So what happens is that an investor will find a great deal, run to the bank and then wonder why they are denied funding (insufficient collateral, insufficient personal financial ability to repay, or insufficient property financial ability to repay).
An investor might also be tempted to make unsecured loans, lured by the promise of extremely high returns. As a result, they fumble through investment ‘minefields’, hoping not to step on the wrong spot. Worse yet, they may not even know they are in a minefield until it’s too late and they’ve lost tens of thousands or more.
2 Critical Items To Consider
Is ALL debt safer than equity in a property? The answer is ‘NO’… only written secured loans are the most secure. And the most secure of all is a mortgage because it gives the mortgage holder a built-in process to enforce payment or claim the security (the property) to recover the investment.
The important thing to keep in mind is that if you are going to invest in a debt investment, you MUST always consider 2 things:
- what is your security
- what is the process to collect that security if the borrower defaults
If you forget about either one, you may be in for an expensive lesson when the borrower stops paying.