When I tell people that I lend money to developers for property projects, one reaction is more common than any other: “wow, that’s too risky for me – I’d rather just own property myself”.
Which is funny, because I used to feel the same way. But now I perceive it as being less risky than ownership over an equivalent length of time. In this post, I’ll try to similarly re-wire your brain when it comes to debt investments.
Why? Not because I think it’s better – that’s entirely dependent on your goals. But it’s always worth having a realistic picture of all your options…and by understanding debt investments, you’ll start looking at your regular property purchases differently too.
Should you read this article?
This article will be beneficial for you if one of these 3 situations applies to you:
- You're interested in peer-to-peer lending. Peer-to-peer is exactly the same as making a debt investment, so this article will help you understand the underlying risks and rewards better.
- You're interested in lending money to a property investor in exchange for a fixed return. If you've got a lot of cash sitting around and you're short on time, this can be a brilliant way to put that cash to work: but you must understand the risks and rewards first. This article will help you do that.
- You're a regular property investor who's up for thinking a bit more deeply about the risks/rewards you're exposed to, and the relationship you have with your mortgage lender. You can invest perfectly well without ever giving this a moment's thought, but I found that thinking about this more philosophical stuff really helped me with my own investments.
So, we'll talk about debt investments in this article: but to do so, we also need to understand what an equity investment is…
What are equity and debt investments?
An equity investment is your typical buy-to-let purchase: your equity is the proportion of the property’s value over and above any mortgage secured against it. It’s easy to understand because it’s part of everyday language: people talk about drawing on the equity in their homes, and being in negative equity when the property is worth less than the mortgage.
A debt investment is just flipping it around and putting yourself in the place of the mortgage lender. While you’re unlikely to lend for a 25 year term like a mortgage lender would, it’s otherwise exactly the same: you lend an amount of money based on the property’s value, and the borrower pays you an agreed interest rate in exchange.
Critically, the value of your debt remains the same regardless of what happens to the value of the property. Your claim against the property is just a means of making sure you get your money back: the borrower must pay you a fixed amount of interest for a fixed period of time, whatever happens.
Looking at it like this, we can see two clear advantages to owning the debt in a property compared to the equity…
Your capital is safer
If your money is properly secured against an appropriate asset, you’re taking less risk by issuing debt rather than owning equity.
To understand why, imagine for a moment that you’re taking out a mortgage to buy a house for £100,000. A mortgage lender puts in 70% (£70,000) in debt, and you put in 30% (£30,000) in equity.
If the market goes up by £30,000 so the house is now worth £130,000, you’re quids in: your original equity of £30,000 has doubled to £60,000.
But if the market goes down by £30,000, your equity has been entirely wiped out. Yet the mortgage company is fine: their loan of £70,000 is still secured against a property worth £70,000.
They won’t be happy in this scenario and might start making your life difficult because they feel too exposed, but the point is you took the first loss. You started making a loss as soon as the house lost £1 in value, but it took a lot longer for the lender to start getting worried.
This is what’s known as the “capital stack”. By having what’s technically called “senior debt” (meaning you’re the first person with a claim against the property), you’ll be the last person to suffer if the value of the property falls.
Conversely, the equity holder gets all the upside, but is also the first to suffer the downside.
Your return is known, not speculative
When you’re buying a property, you don’t know exactly what return you’re going to make. However comprehensive your spreadsheet, your returns will be made up of two inherently variable components:
- Rental profit – derived from income which might go up or down, and expenses that are unknown.
- Capital growth – the extent of which is unknowable, if it happens at all.
By contrast, with a debt investment you know at the start exactly what return you should get: if you agree to lend £10,000 at an interest rate of 0.5% per month, if the borrower sticks to their obligations you’re going to get paid £50 per month for the length of the loan.
I’ve said that this is an advantage, but actually it’s both good and bad depending on your point of view.
It’s bad because your returns are capped. You could be lending money to someone so they can do the deal of the century: they use your cash to make a return of 200% in just a few months, and you’re sitting there feeling a bit sorry for yourself with your 0.5% per month.
But it’s good because you know you’ll get that 0.5% (or should – we’ll come to risk later). If you’re trying to generate an income, debt is an attractive way of doing it because there’s no sitting around worrying if the rent is going to get paid or the project is going to pan out as you hoped.
Growing wealth, not creating wealth
I’d file debt investment as growing wealth, not creating wealth. It might sound at first like they mean the same thing, but I think there’s an important difference.
Normally when you buy a property, you’re hoping to create wealth by one means or another. You’re either buying to create value that previously didn’t exist (through refurbishment or development), or you’re looking to participate in the growth of the market when wealth is created for everyone.
Property is great for this: you can use leverage (which is really just someone else’s debt) to maximise your returns, and it’s easily understandable by most people.
A debt investment is about growing wealth: you’re hoping to take money you’ve already got, and put it to work to make more money.
Lending your money out – even at a high annual rate of interest like 10% – isn’t going to make you insanely rich, at least not until after many years of compounding. But it does mean that you’re almost certain to end each year with more wealth than you started, even if the market performs weakly or projects don’t go entirely to plan.
As it happens, property is great to lend against too: there’s a whole profession dedicated to establishing its value, that value is relatively constant, and there’s a liquid market for its sale. Debt can be secured against anything else (or nothing!), but given a choice of assets property is always going to be the winner.
Who is it right for?
In the same way that most investment portfolios contain a mix of stocks (equity) and bonds (debt), I’d argue that debt investments in property could be right for anyone – but the percentage of a portfolio that should be allocated to it will vary.
This is going to sound weird, but if you’ve got little in the way of funds you’ll probably want to take more risks. Why? Because £25,000 growing by (say) 10% per year isn’t bad, but even with compounding it’ll take you a long time to get anywhere. It might make more sense to seek quicker progress by using leverage, taking on renovation projects with a high ROI, or looking for investments with a greater upside.
But if you’ve got £500,000 kicking around, there’s a stronger case for allocating some of it towards debt investments. Allocating half of it to loans (for example) would produce a healthy £25,000 per year income, while leaving plenty left over for the racier stuff with a higher payoff.
Controlling the risk
I said I was going to rewire your brain in terms of risk, and hopefully I’ve done so in two important respects:
- You’re taking the bottom portion of the investment rather than the top, so you’re the first to get paid back and the last to lose out.
- Your return is known at the start, not speculative.
But I don’t want to skirt around the risk that does exist: the risk of the borrower being unable or unwilling to pay you back.
Your protection (or “security”) against this risk is your claim to the property itself. So to reduce risk as far as possible, you need to have a satisfactory answer to three questions:
- Is the underlying asset worth enough? You want to make sure that even if the market tumbles and you incur costs in taking legal action, you can still sell the property for a high enough price to get all your money back.
- Are the legals watertight? It’s worthless having claim against a property if you can’t enforce it legally. A big benefit of property is that the legal system allows charges to be registered so it’s impossible to bypass them – but your legal agreement still needs to be written in such a way to be un-wriggle-out-able.
- Is the borrower a good risk? While you could take back the property to recoup your funds, you really don’t want to. You also don’t want the borrower to run out of money and vanish leaving a project half-finished, because it will be very difficult to sell in this state – so faith in the borrower’s abilities goes a long way.
The caveat to end all caveats
Even though I’ve explained why debt is structurally safer than equity, that by no means implies that your money isn’t at risk as soon as you take it out of the bank: it is.
What makes lending psychologically difficult is that you’re very aware of your lack of control over the outcome – whereas when it’s your own project or purchase it feels like you’re in the driving seat, even if that control is illusory.
So is lending against property too risky? Done properly, I’d say no: if anything, it could be too pedestrian for what you’re trying to achieve. But in the right circumstances, it’s great way to grow your wealth backed up by property.