DEBT OR EQUITY REAL ESTATE INVESTING: WHAT’S THE DIFFERENCE?
There are two different ways to get started, debit or equity real estate investing. Each one carries certain benefits and disadvantages for investors. Continue reading to find out which investment strategy is best fit for you.
The risk and return profile is different for each; as a real estate investor in today’s market, understanding the difference is key to adding the right type of investments to your portfolio. Let’s take a closer look at the how debt and equity factor into real estate investing.
EQUITY-BASED REAL ESTATE INVESTING
Starting with equity, when you invest in real estate equity, you own a portion of the property and are entitled to your share of the returns.
Using equity to invest in real estate is similar to buying shares of a stock: you own a fraction of the underlying asset (i.e. a property) and are entitled to receive your share of the profits (i.e. dividends).
If the value of the underlying asset appreciates, the value of your equity increases accordingly.
When you invest in real estate equity, your profits will most likely come from rental income and/or price appreciation. As an equity investor, chances are you will be investing with either a real estate syndication or a REIT, a real estate investment trust.
Many times investors will receive the first payout or return from the property’s rental income. This is often called a preferred return.
Other than the initial return, investors and sponsors will split the remaining profits based on the equity distributions. If investors make up 80 percent of the equity, they split the remaining 80 percent of the profits.
Investors should do their due diligence and make sure they understand how the splits work for their particular investment. These splits can be a little complex, and investors want to make sure they are working with a sponsor who is paying out fair returns.
The last piece to the puzzle is the price appreciation. The value of the investor’s equity stake in the property can fluctuate as prices increase and decrease. If a property is sold for a capital gain at the end of the project, investors see the value of their investment increase.
DEBT-BASED REAL ESTATE INVESTING
Similar to other types of debt investments, the investor makes a loan to the borrower in order to purchase real estate assets.
The borrower pays back the loan in regular installments, along with interest payments, until the full value of the loan (the principal) is returned.
Investors can make short-term loans (maximum one year) or longer-term loans lasting years or decades. Depending on the type of loan, payments include both principal and interest, or in some cases only interest until the final principal payment.
Types of Debt Investments
There are various types debt investments in real estate investing:
- Mortgage: Mortgages are the most common type of debt in real estate. The underlying real estate asset is used as collateral, while the borrower pays back the debt over a pre-specified number of payments (usually over a period of years).
- Bridge Loan: A bridge loan is a short-term loan. It’s used until the borrower secures permanent financing, providing immediate cash flow to bridge the gap (hence the name!).These loans usually max out at one year and come with high interest rates.
- Hard Money Loan: These types of loans are even shorter-term and are more common in situations where the property’s value is high, but the borrower is fighting off foreclosure.The key difference for these loans is that they are backed solely by the value of the property and not the borrower’s creditworthiness. Private investors make up the bulk of hard money loans due to the risky nature of the investment.
WHAT’S THE DIFFERENCE?
With a little background on debt investments versus equity investments in real estate, what are the key differences you need to know as an investor.
Debt investments in real estate investing carry less risk. In the event something goes wrong with the property or project (i.e. if the property is foreclosed), debtholders are the first stakeholders to get paid.
Equity holders have no recourse during the liquidation of an asset like real estate. They have much more risk of taking losses on their investment, or even seeing the project go to zero in the worst of cases.
Debt-based investments come with a fixed return for investors. The quarterly or annual payout is predetermined, and the risk lies in the borrower’s ability to repay the loan plus interest.
This is the flip-side for the higher-risk equity investments. The returns can be substantially higher as they fluctuate based on the value and profitability of the property.
Equity investments carry plenty of upside potential. Debt investments have none.
Equity-based investors get to reap the rewards if a project is successful and produces above-average profits. Debt investments are limited to the predetermined rates agreed to with the borrower.
Liquidity is another factor to consider in your real estate investments. Both debt and equity investments can be structured to give the investor more or less overall liquidity.
Debt investments tend to be more illiquid, especially when the term is longer. Debt investors can increase the liquidity of their real estate investments by choosing shorter-term loans, but that brings more risk into the equation as well.
Equity investments can be illiquid with longer-term projects. However, investors can gain more liquidity by purchasing easily tradable shares of a real estate project or company.
For example, investors who own shares of a REIT or equity in a syndication will probably have an easier time selling their stake to another investor.
When considering real estate investments, it’s important for you to understand the difference in debt vs. equity-based real estate investing. Depending on your risk appetite, and the types of returns you’re seeking, you may opt for either debt investments, equity investments, or a combination of both.
Overall, debt investments help mitigate risk in the real estate market. Debtholders can feel relatively secure with their investment, and can reduce liquidity risk with shorter-term loans.
If you’re considering a debt investment in real estate, it’s important to examine two factors: the value of the real estate collateral, and the ability of the borrower to repay the loan.
Those two factors determine the likelihood of recouping your investment. If the borrower is not able to repay the loan, you want to make sure the property will have value to reimburse investors in the event of foreclosure.
Equity investments are usually longer-term investments with higher yields. Investors get to share in unlimited returns, but also risk losing their investment.
With equity investments, you want to consider investing with a real estate investment company. With the increased risk, you want to make sure there is a skilled team in place to manage the property and generate the higher expected returns.