When considering real estate investments, one of the primary considerations is whether to invest in debt or equity. Of course, both have pros and cons, and there are various investments that fall under each of these two headings. We’ll discuss a few of those in more detail in a future blog post. Today, however, let’s stick to the basics of real estate debt vs. real estate equity.
On the surface, investing in equity may sound more attractive than investing in debt. For example, when it comes to our own homes, we’d generally rather have equity than debt. However, the situation is a bit more complicated than that. Let’s dive a little deeper.
When you invest in equity, you’re a stakeholder in a property, which means you’re subject to its appreciation or depreciation. Your assets and risk are tied up in the property itself. Any profit you earn is the result of adding value to the property or identifying and resolving issues that cause it to underperform, such as poor management, marketing it to the wrong tenants, and so on. If you invest in equity and the property depreciates in value, (for example, when a geographical area becomes less desirable or the mortgage market fluctuates) you’re left holding the bag. It’s possible to lose the entire amount of your investment, depending upon one’s loan-to-value ratio, how much leverage was used in acquiring the property, etc.
In the case of debt-based investments, you’re not investing directly in a property, though it may feel that way due to the fact that the loans you’re extending facilitate the acquisition of real estate for the borrower. What you’re really investing in is the debt owed by the borrower, the interest income it should produce on a monthly basis, and the borrower’s promise to repay. The property itself then serves as collateral, with owning it becoming a fallback plan if the borrower defaults on his or her obligations
From time to time borrowers, of course, do default, but as a private lender diversified across numerous borrowers, properties and real estate markets, we feel that our investors’ risks are appropriately mitigated. If the borrower defaults, it’s his or her equity at risk in the deal, not yours. Moreover, because the debt is backed by a hard asset, and you’re the person collecting (indirectly) in the event of a default, the chances of losing your full investment are quite small.
Obviously, both types of investment are more hands-on if you’re attempting to serve as an individual owner or lender. Investing in a fund provides you with a more hands-off investment approach, and ideally portfolio diversification as well. Whether you invest in property equity or debt, your risk is spread across a broader pool of real estate and/or borrowers, and hopefully across a broader geographical area, as well. That way, a dip in one local market may mute any overarching effects on the investment at large.
In our next blog, look for a discussion of specific types of debt and equity funds, and their pros and cons.