Investing in Debt or Equity Deals: Which is Best? (Part 2)
By Christopher Levarek
“The best way to predict your future is to create it”
- Peter F. Drucker
Last week we looked at funding and financing real estate deals using debt as the fundamental backbone of the transaction. This really is the most common used method for most home-buyers however in the world of investments in real estate there is another powerful method of financing real estate deals called Equity Financing.
Today, in this Part 2 article, we look at understanding the Equity Financing model, see Part 1 for more on Debt Financing. The goal is to help readers understand the power of this financing model and the possibilities available in such a structure.
What is Equity Financing?
With regards to real estate, equity financing is simply when there is an exchange of equity or ownership, in a property or deal, for capital or services rendered. This means rather than, or in addition to, offering a return or payment for a needed resource to complete the real estate acquisition, equity or ownership is exchanged instead. This equity or ownership in the deal can complement an interest return on capital, be in-exchange of a return or even be simply a promise on future returns.
Typically, a legal document such as a “Private Placement Memorandum” or “Operating Agreement” for a LLC owning the property will detail the ownership or shares of ownership on the property in exchange for some contribution. Similar to buying stock of a company in the stock market, equity financing is acquiring ownership percentage or units of ownership in a real estate property.
Example of a equity 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 operating/managing 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
Ownership Split : 70/30 with investors owning 70% and deal managers owning 30% of a LLC owning the property.
Return : Upon preferred investor return being paid, ownership split divides returns to investors/managers for additional upside.
Estimated return up on sale: 15% Internal Rate of Return or ROI with a sale in year 5.
Total Return to Investors over 5 years : 15% or $75,000
In the above example, capital is invested into a real estate acquisition with a hold of 5 years. The rate of return paid to investors is 5% with an upside, based on the income/performance of the property, of a 70% ownership stake in the property for investors. So investors would be able to profit from returns on the property up to 70% worth of the cash flows or income on the investment after being already being paid 5% on their invested capital.
This is just one simple structure demonstrating equity financing and one commonly used in apartment syndication with regards to equity splits. We would like to offer another possible example of equity financing in a small partnership below:
Joint-Venture: Three individuals form a joint venture to acquire a quad or 4 unit rental property. They form a LLC with an operating agreement detailing a split in equity ownership based on roles. Roles are :
1 person brings 70% of capital
1 person brings remaining 30% of capital and handles acquisitions, financials & legal considerations
1 person brings 0% of the capital and handles all day-to-day property management, contractors and renovations.
With this example, we aim to highlight that equity splits or ownership are a way of financing acquisitions by providing returns based on ownership or even roles and not solely upon capital invested.
Pros for Investing in Equity Financing Deals for the Passive Investor
For the passive investor looking to invest capital in investment opportunities, equity financing can be a very lucrative investment with possibility of great upside. In exchange for capital, the investor receives a return based on ownership and possibly other “preferred returns” or agreements. The following are some of the key advantages in Equity Financing deals for the passive investor:
Upside Potential : As a equity owner in the property, an investor is able to tap into the upside of the business plan and property doing well financially. Rather than be limited to a specific return, upside is limited to how good the property actually does.
Tax Benefits : As a equity owner in the property, an investor is able to incur property losses or depreciation on tax returns which can be very beneficial to offset income from business or personal income.
More Involvement : As an equity owner in the property, an investor would have more interest or possibly be more inclined to learn about the property, the investment, real estate, etc.
Alignment : As an equity owner alongside the other equity owners, deal managers/operators, there is an alignment in the interest of the property doing well as this creates a beneficial returns for both parties.
Cons for Investing in Equity Financing Deals for the Passive Investor
Although real estate investment opportunities using a equity 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:
Complexity: Investments into equity ownership can be complex to understand for the passive investor with the varying amount of equity split structures, return structures (waterfall, hurdles, etc.) and terminology such as IRR(Internal Rate of Return), ARR (Average Annual Return), etc largely present in these structures.
Risk: Ownership/equity = Some liability or legal implications depending on structure or ownership agreements.
Risk: Ownership/equity = Possibility of downside if investment does not perform. All owners share upside and downside.
Longer Hold Times : Often Equity Financing will have longer periods before capital is returned. Business plans with equity financing take longer to develop to meet return projections typically.
IN FINAL
In this Part 2 article covering the Equity Financing model in real estate investment opportunities, we addressed some typical equity financing structures and the pros/cons of the model (check out our previous article on Debt Financing). We would like to mention again that each investor should focus on picking a model or investment opportunity that aligns or works in their situation. Invest Smart!