Investing in Debt or Equity Deals: Which is Best? (Part 1)
By Christopher Levarek
A Successful Person never Loses…They either WIN or LEARN.
- John Calipari
As an investor and when it comes to capital or investing capital in real estate, there are typically two sides of the coin.
On one side we have Debt Financing which is considered the more traditional method and one understood by most people. This is where capital is loaned at an interest rate and repaid over time, ie. home mortgage, car loan, etc.
The other side of the coin is Equity Financing commonly used in the world of business and real estate syndication/deals. This is where capital is loaned or invested in exchange for some form of ownership or equity in the venture or property, ie. stock ownership, LLC property ownership, business return on investment performance, etc.
Today, in this Part 1 article, we look principally at Debt Financing while in a Part 2 article, to follow, will focus on the Equity Financing model. The aim is to give further clarity on these subjects to allow an investor to choose which method, or both, works for them given their goals.
What is Debt Financing?
As mentioned above, debt financing is the more traditional form of financing most people are familiar with. Most everyone at some point will have had or will have a car loan, credit card or home mortgage. These are forms of debt financing. The individual borrows a specific sum over a timeline and in return pays a interest rate of return to the lender based on the amount borrowed. Without jumping into all the varying structures, the main principle is there is an exchange of capital for a payment in interest or return to the lender.
In real estate investor deals, whether large or small, this same principle is used throughout a variety of property purchases. Pushing aside the debt financing of say a primary residence or traditional banking, we want to highlight how debt financing would work specifically in a larger real estate syndication or private real estate deal between two investors.
Example of debt financing for a 30 unit apartment complex:
An Apartment Syndication Team Goes under contract for a 30 Unit apartment complex. In order to fund the acquisition at closing the team will need to raise Capital.
The Team sets up the following Model to raise Capital from Investors.
Hold Period(Length of Investment) : 5 years
Capital Invested from Passive Investors: $500,000
Preferred Investor Return (Return on Investment) : 5% per year for hold period
Exit Investor Return (Return at Property Sale on Investment at 5 years) : 5%
Total Return to Investors over 5 years : 10% or $50,000
In the above example, capital is lent for a specific time with a preferred fixed rate of return. In the above case, the rate of return is paid 50% over the life of the investment and 50% at closing. This is just one scenario where no ownership or equity is included to the investor in the property. Other examples of debt financing on joint-venture or partnership deals include:
A private investor loaning capital to a person who “flips”, or rehabs then sells homes, at a fixed rate of return
A private investor (A) loaning capital in a Joint Venture with another investor (B) for the acquisition of a duplex. In exchange, the investor (A) receives a Deed of Trust(collateral) and an interest return throughout the life of the deal.
Pros for investing in Debt Financing Deals for the Passive Investor?
For the passive investor looking to invest capital in investment opportunities, debt financing can be a very low-risk and simple to understand investment model. In exchange for capital, the investor receives a consistent return typically with collateral of some kind guaranteeing the investment. The following are some of the key advantages in Debt Financing deals for the passive investor:
Simple: Easy to understand, exchange of capital for a return.
Low Risk: No ownership/equity = No or low liability in case of legal issues for any reason.
Low-Risk: No ownership/equity = Less downside if investment does not perform.
Collateral: In exchange for capital, properties are promised as collateral to investors.
Low-Involvement: For the W-2 investor or retiree with focus/hobbies elsewhere, low-involvement in the real estate deal could be very attractive in an investment.
Shortened Hold Times : Often Debt Financing will have shortened periods before capital is returned such as hard money loans, private money loans for flipping, etc.
Cons for investing in Debt Financing Deals for the Passive Investor?
Although real estate investment opportunities using a debt financing model might be appealing for some passive investors, not all will think similarly. It will largely depend on the investor and some might find the following as reasons to look to other investment models:
Low Upside : No equity ownership = Less upside if the deal over performs.
Less Involvement/Learning Opportunities: No equity ownership = Less need to be involved in the deal which could mean less learning opportunities on real estate or property renovations/management, etc.
Misalignment of Partnership : Established roles in the partnership might be misaligned as one partner/investor is focused on upside and performance on the deal while the passive investor is simply focused on a steady return.
In Final
In this Part 1 article covering the Debt Financing model in real estate investment opportunities, we addressed some typical debt financing structures and the pros/cons of the model. We would like to mention again that each investor should focus on picking a model or investment opportunity that works for their situation.
Investing in a debt financed deal for the working career focused IT professional or dentist might make a lot more sense than for an aspiring syndicator or investor interested in active investing on future deals. Follow us on Facebook for more articles like this and check out our Part 2 article where we cover Equity Financing and the pros/cons for an investor with that model. Invest Smart!