With so many options out there for real estate investors to choose from, understanding the pros and cons of debt vs. equity deals will help you make an informed decision.
What is a Debt Deal?
When investing in a debt deal you are the lender on a property. In exchange, you are promised a set rate of return dependent on your investment amount. Principal is either paid back throughout the life of the loan or in a balloon payment after a pre-determined amount of time. Examples of debt deals are real estate notes/mortgage-backed securities and real estate debt funds.
Pro’s of Debt Deals
Less risk – You become the lien holder and are granted certain rights, such as foreclosure, in the case your borrower defaults on the agreed upon terms
Steady Income – debt deals are great for those investors who depend on the income. They have a predictable payment schedule (usually monthly or quarterly) and pay the pre-determined rate.
Shorter lock-in periods – Most debt instruments have a life span between 6 and 24 months or until project completion. This is an ideal time-period for persons not willing to tie up their funds in any one asset for extended periods of time.
Con’s of Debt Deals
Capped Rate – Since your earnings are pre-determined there is no chance to profit more if the project is uber successful. Less risk equals less return.
Pre-Payments – There is always the chance that your borrower may pay off the loan early. This can leave you looking for a place to re-deploy funds sooner than expected. You also risk the chance of not recouping your investment fees and interrupting your expected income.
Higher Fees – Most debt investing opportunities include a fee for bringing you the opportunity. They could potentially pass the origination fees on to you in addition to legal document prep of the transfer documents and recording fees.
No voice – As a lender you have no say in how the project is run. The owner retains this right.
What are Equity Deals?
Equity deals are real estate investment opportunities where you take part ownership in the project. Returns can come in the form of cash flow produced by the asset such as rent, and your share of that return is dependent on your investment amount. When the property is sold or refinanced you too take a percentage of profit. Equity deals can be offered as one-off opportunities, equity syndications, REIT’s, etc.
Pro’s of Equity Deals
No cap on returns – Investors can generate higher returns than they might in a debt deal since returns are based on the performance of the asset.
Hedge against inflation – Real estate appreciates over time and keeps pace with inflation. When the cost of living goes up your cost of ownership does not. Rents are raised and the value of your property investment rises as well. As an equity holder you share in the profit spun from this. Be sure your investment takes advantage of the buy low, sell high mantra!
Tax advantages– You can dramatically reduce your tax liability each year through depreciation. Real estate owners (not lenders) can benefit from this. Always consult your CPA for the pro’s and con’s of any investment and how they might personally effect you.
Con’s of Equity Deals
Risk – Higher reward equals higher risk. There is no guarantee your asset will perform well or even as expected. You run the risk of losing some or all of your investment.
Holding Period – Equity deals are usually accompanied by lengthy hold times and no liquidity.
Before committing to any investment, you should do your research. Learn everything you can about the investment and those offering it. Have your attorney help evaluate the legal paperwork and point out risk. Ask your CPA what the tax implications are for this investment in direct correlation to your situation. Do not be afraid to ask questions to those offering the investment. You want to be well versed in your investment so you can have peace of mind.
In addition, ask yourself these questions:
- What is my tolerance for risk?
- Am I dependent on this income and need to know exactly what to expect and when?
- What is my need for liquidity?
There is no blanket right or wrong answer to these questions. However, truthfully answering these questions can help you to decide what type of real estate investments you should be considering: Debt, Equity, or both!