286: What is the Difference Between an Equity and a Debt Investment?

SHOW NOTES FOR EPISODE 286: WHAT IS THE DIFFERENCE BETWEEN AN EQUITY AND A DEBT INVESTMENT?

As market volatility and an impending recession are on the horizon,  many investors are looking for safer, high yielding investments.  Real estate remains one of the safest investments available as a tangible asset with strong returns.  However, for passive real estate investors, there are also many options available.  In today’s podcast, we hope to clarify some of those options by explaining the difference between equity and dept investments and the risks involved.

Real estate crowdfunding has taken off since the passage of the Jumpstart Our Business Startups Act in 2012, and the market is expected to expand even further. In October 2015, the SEC issued its final ruling on Title III provisions of the JOBS Act, allowing non-accredited investors to participate in crowdfunded real estate deals alongside accredited investors.

Investing in real estate through a crowdfunding platform has certain advantages over REITs or direct ownership of property. One of those advantages is the ability to choose between debt and equity investments. Before taking the plunge into passive real estate and crowdfunding investing, it’s helpful to have an understanding of how the two differ and what the risks are.

How Debt Investments Work

When investing in real estate debt instruments, the investor is acting as a lender to the property owner or the deal sponsor. The loan is secured by the property itself and investors receive a fixed rate of return that’s determined by the interest rate on the loan and how much they have invested. In a debt deal, the investor is at the bottom of the capital stack which means they have priority when it comes to claiming a payout from the property.

Pros:

• ​Shorter hold time-Debt investments are most often associated with development projects. As a result, they typically have a shorter holding period compared to equity investments. Depending on the nature of the deal, the hold time may last between six and 24 months. That’s a plus for investors who aren’t comfortable tying up assets for the long-term.
• Lower risk– Because of the way deals are structured; investors take on less risk with debt investments. The loan is secured by the property, which acts as an insurance policy against repayment of the loan. In the even the property owner or sponsor defaults, investors have the ability to recoup the loss of their investment through a foreclosure action.
• Steady income– Debt investments are more predictable in terms of the amount and frequency of return payouts. While every deal is different, it’s not unusual for investors to earn yields ranging from 8% to 12% annually. These returns are typically paid on a monthly or quarterly basis.

• Capped returns – Debt investments entail less risk, but one major downside is the fact that returns are limited by the interest rate on the loan. Investors have to be clear about whether they’re willing to sacrifice the potential to earn higher yields in exchange for a safer bet.
• Higher fees – While most real estate crowdfunding platforms don’t charge investors anything to create an account and research debt investments there’s usually some type of fee involved to participate in a deal. The crowdfunding platform usually takes a percentage off the top before any interest is paid out, which can eat into your returns. There may also be a separate loan origination fee that’s passed on to investors.

Equity Investment Basics

Most real estate crowdfunding deals involve equity investments. In this scenario, the investor is a shareholder in a specific property, and their stake is proportionate to the amount they have invested. Returns are realized in the form of a share of the rental income the property generates, less any service fees paid to the crowdfunding platform. Investors may also be paid out a share of any appreciation value if the property is sold.

Pros:

• No cap on returns – Equity investments offer a broader horizon, in terms of earning potential. It’s possible to see annualized returns ranging from 18% to 25%. Since there’s no cap, however, the sky is really the limit from an investor’s perspective.
• Tax benefits – One perk of owning an investment property is being able to deduct certain expenses associated with its ownership, such as depreciation and the cost of repairs. With equity crowdfunding, deals are normally structured through an LLC, which is treated as a flow-through entity for tax purposes. That means that investors can reap the benefits of the depreciation deduction without having to own property directly.
• Lower fees – Equity investments have the potential to be cheaper where fees are concerned. Rather than paying upfront fees and monthly service fees, investors may pay a single annual fee to maintain their position in the property. The fee is calculated as a percentage of the total amount invested and often runs between 1% and 2%.

Cons:​

• More risk – Equity crowdfunding may put more money in investors’ pockets, but it means taking a bigger gamble. Investors are second in line when it comes to receiving a payback on their investment, and if the property fails to live up to its performance expectations, that can easily translate to a loss.
• Longer hold period – Equity investors are looking at a much longer time frame compared to debt investors. Hold times can stretch out over five or even ten years, which is an important consideration if you’re interested in maintaining a high degree of liquidity in your portfolio.

The Bottom Line

Passive investing in real estate is becoming one of the most solid and highest return investment out tere.  Some people, with limited funds fund crowdfunding is an attractive option for investors who want to invest in private real estate deals. The minimum investment with many crowdfunding platforms ranges from $5,000 to $10,000, which is a relatively small price to pay to gain access to high-yield multifamily real estate.  Both equity and debt investments have their good and bad sides, which savvy investors must take the time to weigh carefully. Understanding what you stand to gain versus what you’re risking can help you decide whether one or both types of investments is a good fit for your portfolio.

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