In today’s episode, I dive into a question that may seem a bit counterintuitive: could debt actually be safer than equity?
When it comes to real estate, we’re often taught to pursue ownership and build equity, but what if taking a debt position – being the lender instead of the owner – offers more security?
I share how banks view debt as a low-risk investment by ensuring they’re first in line to be repaid, a concept known as “priority in the capital stack.”
As I’ve seen in my experience, lenders often get paid before equity investors, particularly in challenging economic times. I cover how debt positions can yield stable returns with less risk compared to traditional equity investments, especially in uncertain markets.
TRANSCRIPTS
Speaker 1 (00:00):
Could debt actually be safer than equity. I know it sounds like heresy. Let’s talk about this. Hello, my fellow Ripples. This is Chris Miles, your cashflow expert and anti financianal advisor. This show is for you, those that work so hard for your money and you’re now ready for your money to start working harder for you today. You want that freedom, that cashflow, that prosperity right now, not 30 or 40 billion years from now, but you want it today so you can live that life that you love with those you love. And most importantly guys, it’s not just about getting rich, it’s about you living a rich life. Because as you have more resources, more money, more ability, more stewardship, you can bless the lives of those around you even better. And that is the ripple effect I’m here to create for you today. Thank you for tuning in.
(00:58)
You’ve been binging on this show, and thank you so much for those of you that reached out and you actually put all those reviews on Apple Podcasts. Even some of you guys have put reviews on Google. Thank you so much for doing that. Hey, quick ask for you guys. If you’re looking for ways to actually increase your cashflow, increase your passive income, and really do that today, and you’re wondering how you could do it, go to a website, money ripples.com, try our passive income calculator to see how much is actually possible in your situation. The answer might surprise you, so go check that out@moneyripples.com. Alright, so I pose the question for you. Is debt actually owning debt safer than owning equity? Now, what do I mean by this? What I’m saying is can you have debt on a property? Could that actually be safer than having equity in a property?
(01:43)
And so I’m specifically talking about real estate, although this could apply in other areas. Now, here’s the thing that you’re going to have to deal with here when we’re talking about this. To kind of preface this, is that I’ll tell you from my own personal experience, I always valued having equity. For example, I would always say, listen, if I can own a property that’s better than just having the debt on a property, like lending somebody money for a property, I would say that a lot, I would say would even on podcasts before like, Hey, you can have equity in it. Have equity in those apartment syndications, have equity in oil and gas or whatever it might be. Have equity in self storage, have equity in land, have equity in your rentals and equity in everything else, and equity in your own home, but only a little bit.
(02:22)
We don’t want the bank to take it away. I had that problem too in the last recession. And so you know me, I definitely don’t have an issue with wise use of debt being a wise steward of debt, not being irresponsible with debt. I’m not a big fan of consumer debt. So when we’re talking about investing, why would debt be better? Understand that from a saver mentality, we are always taught that equity is better. We we’re always taught that we should own things. That’s been ingrained into us. I think for me, it seems like since birth is you got to own stuff. And especially at the depression era mentality. It was really big when it came to real estate. It’s always about you need to own that property, pay off that mortgage so that the bank can’t take it away from you, even though technically you can have the property foreclosed on if you don’t pay your taxes on that property, but I get the point, you don’t make your payments.
(03:11)
They could take it away. Now, the Great Depression had a very different situation going into the Great Depression versus coming out of the Great Depression. Going into the Great Depression, they were allowed to call notes due. That means that your mortgage, even if you were making on-time payments, if the bank was under stress, they could say, you know what? We just need the money back now. You need to pay us back in full. And how many people actually had that money in full, especially when they were going through the depression, cash was tight, especially when they were told to turn in all their gold for cash and they got paid what eventually became four times less the value because that’s what good old FDR decided to do is quadruple the value of gold when he had everybody in the America turn their gold and silver in.
(03:52)
But anyways, but despite that fact, having to cash to pay that property outright was tough. And so we’ve had this generation, now we’re going almost a hundred years past this period of time, but the echoes of the Great Depression still affect us to this day. We still hear guys like Dave Ramsey out there telling you, you got to pay off that mortgage. And in fact, when you go and buy real estate, you buy it all in cash. Don’t you dare get debt on it. Now, when I’m talking about debt, the question you have to ask yourself is this, who’s usually smarter with money? You or the bank? And be honest here, who is a better steward of money? Who makes more money with the money they have? You or the bank? If you’re really truly honest to yourself, and now there might be a few exceptions out there.
(04:38)
My guess is for most of us, and I’m putting myself in this camp as well, I would say even myself, I’m not even that smart. Even though I’ve made a lot of smart decisions with money, I’ve done a very good job, especially given the circumstances I was in and just years ago, I would say that the banks are smarter. Now, do they always make good decisions? No. Do they end up taking more risks than they should? Yes, some of them do. Most banks, however, do not. They’re not the ones that make the headlines, the ones that make the headlines take a little bit of unnecessary risk. But for the most part, banks and financial institutions make the best decisions. So if that’s the case, I try to learn from what they know and especially from what they do. Let me ask you this. Do banks, are they all about just holding cash?
(05:26)
Now they have to obviously if they want to lend, but where do they invest their money? Do they put their money in the stock market? No. Do they want to go and buy properties? No, they don’t. What do they buy? They buy the paper. They buy the notes, they buy the mortgage, they buy the loans, they invest in debt. Yet we’re always taught to invest in equity. Do you think that’s by accident? Think about it. Do you really think it’s accidental that we’ve been ingrained to believe that we should be focused on equity while banks don’t? And if you’re ever curious about whether banks really care about equity or not, just go look up the financial section. Like anywhere you go look up stocks. It could be like Yahoo Finance, it could be MSN. Wherever you go, look up their fundamentals. Look at the actual reporting of banks and financial institutions and look at what’s called their debt to equity ratio.
(06:21)
Debt to equity ratio just says how much more debt do they have compared to their equity? And banks do have a lot more debt than equity. So why aren’t they investing in equity when we have always been taught even by them that we’re supposed to invest in equity? That’s because they want the debt and they want you to have the equity. So I want to show you an image here when it comes to real estate investing, especially certain investments, right? Again, like I said, I personally was always in the equity camp. You got to have ownership. I’ll tell you, even my wife and I reached out a discussion and she was like, no, we got to have the equity and the ownership. I said, but it seems like debt can actually be safer, and here’s why. If you’ve been following this podcast, you’re probably looking for great ways to create passive income right now, right?
(07:06)
Well, we got you covered here With central lending. Central lending specialized in alternative investments that actually are designed to create steady returns and long-term financial security for you and your family. Now, they prioritize transparency. They love building those strong relationships, giving you that confidence, peace of mind, knowing that you have your money working harder for you so you don’t have to work so hard for that money. You want to learn more how to do that, go to central lending.com and check out what they’ve got today to create your passive income and wealth creation right now. So this is the example of what people refer to as a capital stack or a waterfall when it comes to equity. If you’ve ever invested in more of the bigger deals, I’m talking about car wash businesses or apartment buildings and things like this, you’ll usually see that you’re offered different things.
(07:51)
You can either in a syndication where you’re pulling your money with other investors, either you’re pulling your money to go buy equity or they might even do it as debt and the debt, they’ll usually put a fixed interest rate or a fixed payment that you get just like anything. So imagine, remember that whenever a bank has a mortgage, they pay with debt. They’re basically giving you the debt, right? They’re giving you the money to be able to buy that house. You put the down payment on, there’s equity involved, but they’re having the actual mortgage. The note on it. Now, a lot of people say, I don’t own the house. The bank does. Well, that’s only partly true. You guys kind of co-own it together. They have a lien on the property, which means that if anything happens, they have first right to get their money back because why?
(08:36)
They’re a debt investor. They’re investing in debt. They would be in this example right here, senior debt. Notice that the bottom has the highest priority of payback while the top has the highest risk. Those common equity you ever bought, common stock versus preferred stock. This is not much different. Common stock. Stock, right? Common stock shareholders get the dregs, preferred stock shareholders get a little bit more, right? This is like what Warren Buffet tries to go for when he’s trying to get preferred equity if he can. Senior debt means the first position, that first mortgage, that first loan. So think about this, when you have a house with a mortgage on it and you sell that house, who gets paid first? The bank. The bank gets paid first, don’t they? So say that you have a $500,000 house that you sell. You’ve got a 300,000 mortgage on it, you have 200,000 of equity, but as you sell that property, they get that $300,000 back, you get the remaining $200,000, awesome.
(09:40)
Now, what if we got a repeat of 2008 and 2009? What if all of a sudden that property went down and it lost value and it’s only worth 300, 300,000, $300,000, which is exactly what you owe. So you’re fortunate because you get out from under it. You say, oh, at least I got my money back. But think about it. Who gets paid back the money first? The bank does. They get their 300,000 and what do you get? Big fat goose, egg don’t. You are a lower priority than the person that’s investing in the debt. The debt gets paid first. So when you see this little thing here, when you talk about investments that you’re looking at and they’re telling you, Hey, you can have equity, you can have possible I rrr or 16, 20, 25, 30 5000%, whatever it might be, and if you’re an equity investor, just know that may not be true.
(10:34)
The power position, the power play is to be in debt. Can you be the lien holder? Now, I’m not saying there’s not a purpose for equity, there’s still good purpose for equity. I’ll still go buy properties. Doesn’t mean I won’t buy properties, but you already know if you are dealing with a situation when there’s debt on that property, debt gets paid first. Well, if you’re worried about risk, you’re worried about whether you going to get paid back or not. Being in a debt position means you get paid back first, especially when you have a lien on that property. So when you’re in a senior debt position or you have the first mortgage, let’s just say in this example or first trustee deed, first position they call it. But that first position is like saying, I have the first mortgage on the property. If you lend money on a property, you have a first mortgage.
(11:19)
Even if other people come in with equity investments, you still get paid first and you get paid your interest rate that you were promised, where the equity investors gets whatever’s left over. Now, they could have a huge upside, but they could have no upside at all. They could be in a situation where they might not get any of their money back. We seen this in the last couple of years and since 2022 when interest rates went up so high, so fast, what happened with all these apartment buildings and everything else, they’re trying to sell off these properties and people are lucky to get their money back. Sometimes some people do get their money back at least, which is good, but I’ve known investment operators that literally had to dip into their own cash, their own family’s cash to make their investors whole because it wasn’t just that the debt went out of it went crazy.
(12:08)
That wasn’t the case. The debt was fine. The debt was just okay, even if it went variable, it wasn’t horrible. What happened though is that the value of the property decreased because especially with apartment buildings and commercial real estate, things like that, it’s not based on a simple appraisal like you get when you go buy your own home. It’s based on profits and what they call our cap rates, which they use to calculate the real value of a property. So if interest rates are going up, they’re going to say, well, based on interest rates being higher, the multiple or the actual value of the property will go down. Even if your property doesn’t actually even have variable debt still because you would sell it to somebody else that might get a variable loan or not. Just because interest rates are higher, they’re going to make the value less because they’re going to say, well, based on the profits, because they have to have a higher loan rate, there’s not going to be as much profit from the rent.
(12:58)
Therefore, the value of the property is actually less. It’s like a business. It’s all based on profit. So even though you bought it and when it was interest rates were low and it was amazing, and so the value was higher, the values actually came down. This is why there’s so much stress with apartment buildings. This is why you’ve heard so many people talk about doing capital calls for those equity investors. The equity investors are saying, Hey, you’re really an investor in this business. This business needs more cash. It needs more capital to keep functioning, to help us get to the point where we can finally sell this thing off and hopefully get your money back. So I need you to put more money in. And the fear is with every investor is, yeah, but what if you don’t pay me back? That’s the fear. That’s what it’s like to be in that common equity position right there.
(13:39)
That’s the part that scares people or should scare people in those situations. Now, again, I’m not opposed to equity. I’m not opposed to getting good upside, but just know you are taking higher risks to get that upside potential. In this case, that high risk might get higher returns, but that high risk could also mean you could be losing money too. On the flip side, the senior debt’s possible, you could still get higher returns having the debt because you get that interest. That’s supposed to be your own. It’s contractual, whether it’s like at 8%, 9%, it could be 10 or 11, 12%, whatever it might be, that gets paid off first. Now, mezzanine debt. Think of mezzanine in a hotel. It’s the second floor, right? Mezzan debt is like a second mortgage. It’s the next one in line. So the first mortgage gets paid off first.
(14:26)
So if you have a house and you have first mortgage, but then you get a HELOC as well, the first mortgage gets paid off first, the HELOC gets paid off second, and you get whatever’s left over as the equity investor in your own house. Now, if all of a sudden that value’s a little bit lower than what it used to be, it’s very possible that mezzanine debt may not get paid all the way back because say that use that same 500,000 example, the property was worth was worth 500,000, right? But let’s just say that you owe 300,000 the first a hundred thousand second, and then the value of the property goes down to the three 50. Guess what? The second debt, only half of that money comes back and you get zero. As the equity investor, senior debt gets all of it back, but the mezzanine debt gets half of it back.
(15:07)
Now, if it’s worth four, if it’s worth 400,000, you sell it for 400,000, the senior debt gets paid off the mezzanine debt, the HELOC gets paid off and you’re left with nothing. So you’re just hoping you sell for at least more than what the two mortgages are together. That’s the equity investor. Same thing with investing. So notice that that’s the priority of how you get paid. So when I say that I think debt is safer than equity in many, many cases, this is true, especially when you have claim to the property. Now, if you’re just giving an unsecured loan to somebody that’s just giving somebody a credit card, that doesn’t give you any real value. You could try to make claim on stuff, but you’re going to have a harder time compared to other people that have that kind of debt. This is why guys, I’ve actually seen people that have bought into apartment buildings.
(15:54)
So if it wasn’t a capital call where they’re asking you for more capital, the problem is a lot of people are saying, no, I’m not giving you more money. Well, a few operators have gotten a creative and they said, all right, well then we will raise what’s called mezzanine debt. They already had senior debt, they already had a mortgage, but from the banks, they already had that. And so they have their equity shareholders, but their shareholders aren’t giving them money, but they need cash to keep it alive, otherwise their shareholders will lose all their money. So I’ve seen operators say, Hey, let’s set up a mezzanine debt fund and it’ll be a higher interest rate. And some of ’em even done mezzanine debt funds where they’re actually trying to bail out and rescue in some ways rescue these other people, charging ’em like 15, 20% a year interest on that money.
(16:36)
They’re sending ’em just to kind of help them do it. Now, is that higher risk? Yes, absolutely. It’s higher risk. Could they be doing their due diligence to help lower it? They sure could for those funds that do it. We’ve had Mike Zlotnik on our podcast before. He has an example of a mezzanine debt fund that he invests in several different projects, but they try to screen him first. They don’t just try to really, they’re not really trying to rescue failing projects. They’re trying to get projects that still have good fundamentals, but they need more capital and sometimes they just need capital. They’re just trying to renovate the property so that they can increase the values, increase the profits, and then sell it for a higher price. They’re just kind of in mid projects. They weren’t done getting the higher rents, getting the renovations done and things like that.
(17:16)
So there could be reason to do it, but that that’s mezzanine debt, right? So when I’m talking about this, who’s safer? Well, really if you’re lending your money, if you’re doing a private money loan to somebody on a property, you want to be in first position. By the way, don’t fall for the third position. Stuff that happened with a family member of mine where they got into a first position, they had that equity in that property. There’s plenty of equity in there, and they had first position, so they were going to get paid back first. They did a deal or two with this. One operator did a great job. The next deal, they didn’t read the paperwork. They just said, oh, this guy paid me back last time. I’ll do it again. They were put in third position. That’s like behind the second mortgage. It’s like a third mortgage, which is in third priority position.
(18:00)
And so when things crashed and lost recession, they lost money and they lost all of it because there was not enough equity to be able to pay them back. There was still a first and a second mortgage. I had to get paid back. So be careful. This is why I prefer to be in first position. This is why when you do even short-term lending, Hey, I want to make sure one, there’s a lot of equity just like the bank does. Is there a lot of equity in this property? Can I make sure that I’ve got enough equity that if something happens where the values go down, it probably won’t go down to the point where I’ll lose money? That’s a big thing. So when I’m looking at hard money lending, I had somebody who told me recently, yeah, we only looked for 80, 85%, and I’m like, I mean, that’s good in the appreciating market.
(18:39)
What if the market doesn’t appreciate? I’d prefer to have at least 30 to 40% equity in that property if I’m going to lend my money. This is my own personal thing, you can do whatever you want. This is kind of my own personal thing I see. And so I look for having that equity in the property, and that’s amazing place to be because even if something goes wrong, they don’t sell it for as much because maybe they were off on the values. You should still be getting paid back as assuming there’s plenty of equity, and this is where you got to do still some of your own due diligence to make sure they’re not just giving you some crazy value. That’s never going to happen, right? You got to be careful too of that. So do a little bit of your own due diligence. Don’t just trust people just because they offer you equity or I mean offer you to do a loan that has a lot of equity in it, their own equity in it.
(19:21)
So that’s one thing I look at for sure. There are debt funds out there, and sometimes you may not know the individual deals are doing, but often they’ll pay you, again, a certain interest rate even over their equity investors. I’ll tell you, I was in an apartment syndication where it was just about to the finish line. They were about to sell it. Now, we weren’t going to make a lot of money on the equity side. We were just lucky to get our money back. We were fortunate enough that the operator was on the good end of it, but he did send an email out to the investors, said, listen, I tried to do a capital call. I didn’t get enough offers, and so I’m now offering to pay 15% a year for anybody who’s willing to lend me money. So I reached out to him, I said, tell me more.
(20:02)
What do you think? What do you need the money for? He’s like, honestly, Chris, I just need to make it another three months just for operating costs until we can sell the property off. It’s been a little bit more expensive trying to get a real sale ready for these buyers, and so I just need a little extra cash. And so I lent him the cash, I lent the money, and three months later got my money back. And of course, about a month or so after that, I got my equity distribution back as well. On that, I’ll tell you, I made more on the loan amount on the loan that I did, on the equity. In fact, the reason I did and the reason why I felt more comfortable is because I knew that if I loaned him money, I bumped myself ahead on the priority of who gets paid back first.
(20:40)
So I move myself ahead. This is why those mezzanine debt funds are actually sneaking in ahead of those equity investors that are hoping to get their money back, and then all of a sudden this little debt fund shows up and kind of pushes them down the priority list down the pecking order, so to speak. So anyways, that’s the thing about debt that I’ve learned over the last few years especially that has shifted my perspective, and maybe this has shifted yours as well to realize, oh, debt’s not that bad. Debt can be good, not from the traditional standpoint. I’m not talking about running up your credit cards, not like that, but I’m talking about when you’re the investor, when you’re trying to act like the bank, remember what the banks do. The banks try to find ways to lower risk. They want to make sure there’s equity in that property.
(21:22)
They’re trying to make sure that they’re in first position. They have the first mortgage, the second mortgage, it’s a little bit tougher. They scrutinize you even more if they’re going to give you a second mortgage. But on that first mortgage, they want to make sure the numbers all pen out. They want to make sure the values are there, and then they just want to get paid. They don’t want the property. They don’t want to be the equity investors. They don’t have to foreclose on you if they don’t have to. They have to take over that property. Now, if things start getting tough and you’re not paying them and they’re getting tight, there are going to go for the people that have the most equity in the property, which is why from a personal residence standpoint, I like to have less equity so that the banks have less temptation to want to take a property in case the worst were ever to happen.
(22:02)
If I were in dire straits for whatever reason, I don’t ever plan for that to happen again. But you never know what can happen in the world. But this is one reason why I don’t like to keep a lot of equity stored in my property. I don’t want that to be the temptation for the bank to say, I want that. And then they take it. And even in that case, debt. I like debt. I like it for that protection reason that it does have less equity for them to want to take claim on. I’d rather keep my equity outside of my properties and things like that. When it comes to that same thing, when I buy a rental property, I like to put down as low of down payment as possible. I don’t want to put a high down payment again, I want to leverage their money.
(22:39)
I want to put their money at risk, even though yes, they do have less risk in some ways because the equity investor, but I know also my cash is liquid and available to use for other things to generate more income. So that’s how I view it. So, so you guys are aware when there are things that are offering debt, debt can be a very good strategy. It’s not the only strategy out there. But remember, if you’re looking for safety, even though something might say it’s debt, debt could still be your best friend. Anyways. I know I went through a lot of information there, but just I want you guys to really think about that and consider that being an equity investor doesn’t always mean you are safe. Having the debt, having good, wise debt that you’re lending out to other investors that can actually put you in a safer position and give you a much more predictable stream of income where how much should be coming in each and every month. So guys, ever have questions for us? You can always reach out to us. Money ripples.com. Make it a wonderful process week. We’ll see you.