Higher Return with Lower Risk: Why Investing in Debt Beats REITs

Conventional real estate wisdom states that the lender (debt) has a low risk and receives a low return, while the investor (equity) has a higher risk and therefore receives a higher return, or at least the chance to make a higher return. But when it comes to passive investing, that is not always the case.

Lower Risk
Real Estate Investment Trusts (REITs) offer the opportunity to invest in real estate without the large capital requirement and years of experience that successful direct investment requires. They are basically mutual funds, but instead of purchasing stocks, they buy buildings or develop real estate projects.

Buying shares in an REIT is the easiest and most common way for the average person to invest in real estate. They are considered safe because real estate is (usually) an appreciating asset, and large REITs are often diversified in terms of geography and property types. However, when you invest in a REIT you are investing in an equity position. The REIT obtains bank loans for debt and uses investors’ cash for equity.

Debt Gets Paid Before Equity
The most important concept in lending is that debt gets paid before equity. Lenders keep their loan-to-value ratio as low as possible to protect the lender in a downside scenario. In a foreclosure situation, the equity holder is wiped out and the debt holder takes the property. Hence, lower risk.

Higher Return
At one point, Enact Partners founder and president Michael Schumacher was VP of Development for a well-respected and well-known multi-billion-dollar REIT. This REIT will only invest in a development project if they expect an 11% annualized return or better. However, with the cost of corporate offices, a huge staff and large salaries, the majority of that return is eaten up by overhead expenses. With 11% minimum returns on their projects, their current dividend yield to investors is 3.0%, only 27% of the minimum project return.

Granted, there is also opportunity for an REIT’s shares to appreciate, but this particular REIT’s shares are actually down 9.8% from five years ago.

Investing In Private Debt Can Yield Far Higher Return
For a debt fund, the return is based on the weighted average borrower interest rate. In the previous calendar year, Enact Partners’ lower overhead allowed us to provide a dividend yield that represented 79% of the Fund’s gross revenue, compared to the REIT’s 27%. Additionally, all of the Fund’s loans are in the safer first trust deed position at a 45.1% weighted average loan-to-value.

There is a saying that goes, “Take risks: if you win, you will be happy; if you lose, you will be wise.” Why not be happy AND wise by earning a higher return for lower risk?

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