Can investing in debt be a viable alternative to investing in equity?
The Islamic finance sector is growing at a considerable rate and analysis by Nester, the UK’s first Islamic finance compliant, peer-to-peer investment platform, shows the total value of Islamic banking assets currently sits at $2trn, now accounting for 1.3% of the worldwide total, the largest level recorded since 2012.
Nester is one such platform driving this growth but doing so via investing in debt, rather than the more widely known equity route.
But what does it mean when we say “equity” or “debt” in the context of property?
What is the difference between equity and debt?
An equity investment means that someone has paid for a property with money that they have saved up. They will own the property in their name and benefit from ownership. So, any changes in the property’s value belong to the owner. They may choose to live in the property or rent it out to someone else to earn a return, otherwise known as a buy-to-let investment.
An investment in debt means that you are, in effect, a “lender” to the owner of the property, which is what banks do all the time. A buyer may not have 100% of the money needed to buy the property, so they will approach a bank and request financing to make up the balance.
Banks perform many checks, such as confirming the property’s value and analysing the credit file of the individual or company.
When they agree to provide finance, banks take a mortgage or charge over the property to secure the financing and, if things go wrong, they have the right to sell the mortgaged property to recover the financing and all other costs that was payable, with the owner of the equity in the property suffering the first loss. This is what is also referred to as a “secured property financing”.
Risks and rewards
Owning property (equity) can be great because long-term investors typically find that the value of the property appreciates over time, and it’s possible to earn a return if the property is rented out to a tenant.
However, there is the possibility that the value could go down and, when renting a property to a tenant, there are always maintenance and insurance costs and expenses that need to be deducted from the gross rental before you can see what your actual net rental is.
Finally, HMRC no longer allows you to deduct interest costs in a buy-to-let mortgage from rental income. So, when taking all of this into account, many have found that the net return from being an owner simply isn’t there and the return on equity ownership can often be disappointing.
In contrast to this, those providing debt to an owner receive a steady return on their financing or loan. That is their profit and does not generally go up or down, so you know what you’re going to receive when investing in debt.
As the owner takes all the risks of ownership (such as maintenance and insurance costs), their equity acts as a “cushion” or “buffer” protecting the debt. So, if there are unexpected costs, they’re settled by the owner.
In a worst case scenario, the person who has invested in debt will typically enforce their rights under the mortgage and arrange to sell the property.
They will do this to recover the entire finance or loan outstanding and any accrued unpaid costs and expenses for enforcing the security. Any surplus after this will be paid to the owner and represents their “equity” in the property.