Which is better; investing in real estate with debt or equity?
Is it better to invest in properties with all cash, to use as much mortgage financing as you can, or to loan your money to investors with a debt investment? This is frequently a hotly debated question. On one side, you have the Dave Ramsey fans who shun virtually any type of lending or borrowing. Then you have the polar opposite real estate gurus recommending extreme leverage, and never using a dollar of your own. So, which strategy is best? How do they stack up against each other?
Take a look at some of the pros and cons of equity vs. debt investing, and you decide…
The Pros & Cons of Debt Investing
Investing with debt can either mean using debt and borrowing to fund investments. Or it can mean using your capital to make loans and provide debt financing to others.
Loaning your money for a return is a popular strategy with banks and venture capital firms, as well as affluent private lenders. On the upside, it can mean less management and overhead. You don’t own the property, so you normally don’t expect to pay taxes or insurance, or have to worry about repairs or tenants. That is unless the borrower stops paying. The downside is that you are only getting a percentage of the cash flow and return potential, and usually don’t get any share in rising equity.
Others don’t have a ton of cash, and may be considering borrowing money to fund investments with debt. This can be through mortgages, lines of credit, loans from retirement accounts, or pooling together money from friends and family. There are great advantages in this, including lowering your risk in any one investment, while being able to diversify and grow your investments fast. It can also bring extra risk from lender fraud, and ending up underwater if property values take a temporary nose dive. While many would prefer not to borrow, it can seem like a necessity for many who need a way to get ahead, and who just can’t save fast enough.
The Pros & Cons of Equity Investing
Equity investing can have its advantages and disadvantages too. First and foremost, it has traditionally meant limiting the ability to invest and diversify. Most people can’t save $180,000 a year to buy an average home all cash to turn into a rental. Putting your entire nest egg into just one property can be risky. One major hurricane or earthquake, and you could have a nightmare situation on your hands.
On the bright side, equity investing is often seen as less risky because you don’t owe the bank anything. You don’t have to worry about monthly mortgage payments, or banks faking foreclosure documents, or fraud like force placed insurance. You’ll also have more flexibility and liquidity if you ever need to sell.
Plus, equity investors can enjoy superior net returns as they avoid all those bank and borrowing fees, extra closing costs, and interest.
As we can see; there are benefits of both types of investing. However, there are also hybrid options. For example; you could team up with your friends and family to invest equity into an opportunity. It’s not all your cash, but you don’t have to worry about a bank loan. Or you could partner up with peers like you and invest a small amount of cash into a small pool of rental properties. This again gives you equity advantages, but retaining the ability to break through the traditional limits and risks of going it all alone.
How will you invest?