“The rich rule over the poor and the borrower is slave to the lender.” — Proverbs 22:7
Should you be a debt investor or an equity investor in real estate?
Debt funds are quickly becoming popular.
With those, you typically have a more of a fixed-rate type of return of 8% to 15%.
Sometimes the funds are offered as equity, but they sit higher than the common equity.
Today, I want to talk about the differences between being a debt investor and equity investor.
Which one is a safer position?
Does one have higher returns than the other?
Is one more stable?
Let’s figure it all out together!
1. Advantages of Debt Investing
What are the advantages of debt investing?
Why would somebody become a debt investor?
First, we need to define debt investing.
If you have a deal, it’s made up of different parts.
Let’s use the example of a multifamily deal.
Somewhere between 50% and 80% of that deal will be a loan, and there will be a lender involved.
The lender is actually a debt investor.
A direct lender, family office, or some sort of large fund will invest in the deal.
Why would they do that?
What is the return for them?
There are some definite advantages to this strategy.
The investors’ position provides some protection.
When they invest, they are either in the first or second position.
This is the safest position in the deal.
If the value of the property crashes, the lender will get some or all of their money back.
There are steady payments.
Payments may be lower, anywhere from 7% to 12%, but there’s generally a steady stream.
There’s lower risk because of the collateral and also because you’re sitting in that safer position in the capital stack.
The third advantage is stability.
Debt investing is less affected by downturns.
When the property drops by up to 30%, there’s usually enough equity built in so you’re protected.
That protection can be super important.
2. Disadvantages of Debt Investing
There are some disadvantages to debt investing.
It’s not all sunshine and roses.
There are always positives and negatives to everything.
Debt investing has a limited upside.
Equity investors typically get some cash flow and then some appreciation.
There’s a sense that they’re sharing the upside.
Debt investors don’t typically share in the upside.
There are market dependent returns based on interest rates.
When interest rates are rising, debt investing may not be as attractive.
Debt funds will often return less money because they’re getting paid less, especially when compared to the risk free rate of investing in treasuries.
The third disadvantage is that there’s less control.
There’s less ability to make decisions on buying and selling, whereas equity investors may have some ability to vote or be involved in those decisions.
3. Advantages of Being an Equity Investor
There are some real advantages to being an equity investor.
Firstly, there is potential for higher returns.
You often get some cash flow along the way.
You’ll get most of the upside assuming there’s appreciation at the sale.
Those are perks that debt investors don’t get.
You’re taking the risk by involving yourself in the deal so that you can share in that upside.
The second advantage is that you can have more portfolio diversification.
You can invest in many different types of assets, deals, and even asset classes.
It’s a little easier to put your money in different places as an equity investor.
The third advantage is the control and decision making.
There are opportunities to vote on sales or purchases, among other decisions.
You can influence the management team through voting rights.
That’s pretty cool!
4. Disadvantages of Being an Equity Investor
Finally, let’s discuss the disadvantages of being an equity investor.
The first downside is a higher risk, especially in a downturn.
What happens if the property value comes down?
We’re seeing this in multifamily.
The first person to get hurt when that happens is the equity investor.
If the value goes down, if there’s no money payback, that’s considered a loss.
The equity investor will only get paid if all the debt investors get paid first.
The second disadvantage is that the role is more capital intensive.
Being an equity investor requires more capital to invest.
You can sometimes get in and out of debt with funds designed to help.
But, overall, equity investment can be capital intensive.
The last downside is the lack of regular income.
The cash flow can go away or be reduced.
A debt investor could be getting cash flow basically from day one.
We talked about two different routes today: debt and equity.
I’m not saying you should do one or the other.
But it’s important to know the risks, the benefits, and where you sit in the stack.
When you stack all facets of investment together, who gets paid and in what order?
Even if you have a higher upside, it’s important to remember that there may be times where you really want to have preservation of capital.
That’s when you could invest in a debt fund.
Or, conversely, you can act as an equity investor to be in a safer position.
The question is not whether to choose debt or equity for every investment.
Your choice lies with where in the stack you want to be as you invest.
Now I want to hear from you!
Have you invested in something as an equity or debt investor?
Where have you fit in the stack?
Let us know in the comments.
Before you leave, make sure to check out our special report about inflation investing. It shares the best choices to invest during an inflationary environment.
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Disclaimer: I am not your investment advisor. This is for educational purposes only. I am not giving specific advice on what you can do. I am simply giving my opinions.