Understanding Debt vs. Equity Investment in Real Estate
By Michelle Clardie on 01/26/2023.
Reviewed by Dan Gatsby.
When the JOBS Act of 2012 made real estate crowdfunding widely available to investors, it changed the landscape of real estate investing. Suddenly investment companies were able to offer shares in real estate projects to the public, allowing investors to access high-value deals with low investment minimums and impressive return potential. The return potential of crowdfunding made this a favorite high-new-worth investing strategy among wealthy investors, while the ease of the crowdfunding model also attracted beginner investors.
But real estate crowdfunding also created an interesting option for investors in terms of debt vs. equity investment. In this article, we want to explain the difference between debt investing and equity investing in real estate. Understanding the difference can help you make informed decisions as you build your real estate portfolio.
Here’s what you need to know about equity investment vs. debt investment.
What Is Debt Investment in Real Estate?
Debt investment is a type of real estate investing in which the investor acts as a lender, rather than an owner. If, for example, you were to loan cash to a house flipper to cover the cost of the renovation, you would hold a real estate debt investment. You could have the loan “secured” by the property, meaning that you could sell the property to recoup your investment if your borrower failed to pay the debt. But without a default on the loan, you would have no ownership interest in the property itself.
It is important to note that debt investment terms are laid out in advance. Investors receive a fixed rate of return over a set period in most cases. Your returns are determined by the interest rate agreed upon by both parties at the beginning of the investment.
Crowdfunded deals in which investors act as lenders rather than owners.
Pros and Cons of Debt Investment in Real Estate
There are several benefits of debt investment in real estate:
Relatively low risk. Most homeowners are likely to prioritize debts secured by their property over all other debts, making them unlikely to default. Furthermore, debt investors sit at the bottom of the capital stack, which means that they are the first to be paid out. This is particularly important in the event of default, especially if there aren’t enough funds to repay all investors; debt investors have priority.
Predictable income. Since you know the interest rate on the loan, you can project future income from the investment accurately.
Potentially shorter holding period. Some debt investments, like new developments or flip projects, are short-term. You might loan funds for a small multi-family development, expected to be completed in 18 months, for example. When the completed development is sold, you’ll receive your original investment plus the agreed-upon interest. Many investors favor short-term investments because they are not comfortable tying up their investment capital for more than a few years at a time.
There are also potential downsides to debt investments in real estate:
Capped returns. Since the return is based on the interest rate negotiated upfront, there is no way to exceed that yield. No matter how high the value of the real estate securing the loan grows, you cannot claim more than the agreed-upon rate (except, perhaps, in the unlikely event of a borrower default).
Lower potential returns. To win the loan, debt investors need to offer competitive interest rates to borrowers, which limits the rate of return investors can expect.
Exposure to prepayment risk. It is possible that the borrower will repay the loan early. Depending on the terms of your loan agreement, this pre-payment could cause you to miss out on future interest payments.
Potentially higher fees. In addition to upfront fees and monthly service fees, many debt investments require loan origination fees as well. This fee could be passed along to debt investors.
What Is Equity Investment in Real Estate?
Equity investments are types of investments in which investors hold an ownership stake in the property. The ownership stake is proportionate to the amount the equity investor put into the project. For example, if you were to buy an apartment building with your business partner, each of you investing half the required funds, you would own a 50% equity share in the property. In most cases, this would entitle you to 50% of all yields (50% of the rental income, 50% of the tax benefits, and 50% of the proceeds when the property is sold).
Equity investments in real estate include:
Direct property ownership,
Equity REITs, and
Crowdfunded deals in which investors own a share of the underlying real estate (this is most common in a specific type of crowdfunding called real estate syndication).
Pros and Cons of Equity Investment in Real Estate
Equity investors enjoy several benefits from their equity investments:
No cap on returns. Equity investors’ returns are based on the financial performance of the asset. So there is no limit to how much you can earn on an equity investment.
Lower fees. While debt investments may charge upfront and monthly fees, many equity investment providers simply take their fees as a portion of returns as they are received.
There are also a few potential downsides to equity investing in real estate:
Slightly more risk. While real estate is generally considered a low-risk investment, equity investments, with their unlimited return potential, are thought to carry slightly more risk than debt investments with their low, reliable returns.
Potentially longer hold period. Many equity real estate investments are long-term. Buying a rental property, for example, could be a 5-10 year investment or longer. Having said that, it is also possible to find equity investment projects with terms under two years (like equity-based house flips, for example).
Consider Equity Investing through Real Estate Syndication with Gatsby Investment
If you’re on the equity side of the equity-investment-vs-debt-investment debate, consider investing through real estate syndication with Gatsby Investment.
Gatsby Investment is a California-based real estate syndication company, offering real estate investing for accredited investors. We provide a stable ownership structure in which each investor becomes a member of the LLC that owns the real estate project. This equity-based real estate investment model allows for low investment minimums, high potential yields, and completely passive returns!
