Debt and Equity in Real Estate. What’s the Difference?

As an investor, there are hundreds of different avenues available to put your hard-earned money to work. It is often difficult not to get caught up in “shiny object syndrome”, and stick to one or two strategies until successful. One of my favorite investments is buying, selling, and holding real estate assets. Within this sector of the investment world at large, there are so many ways to make money in real estate. Let’s dive into some approaches that might suit your needs. 

The two main routes in real estate include investing capital into either debt or equity endeavors. Within these two classifications, there are numerous strategies you can choose to invest your money. Each of these strategies come with their own level of risk and reward and come with pros and cons based on your lifestyle and financial goals. Let’s discuss a few ways to invest in each category.

Debt Investments

Private Loan (Promissory Note & Mortgage)

A private mortgage is a lien or encumbrance secured against a property’s title. In this case, the property serves as collateral for the capital provided. The collateral is in place to protect the lender if the borrower defaults on the loan. The lender (passive investor) provides money toward the purchase or repair of the property. In exchange, the borrower is usually required to pay a rate of interest based on the terms of the loan. This rate of interest can be fixed, not changing throughout the life of the loan. It can also be floating, which means it moves based on several different factors such as elapsed time and/or the change in market interest rates (LIBOR). Overall, the structure of this investment vehicle is quite flexible, depending on the needs of the lender and borrower. To learn more, check out this blogs to learn more about private loans.

Debt Fund

Debt funds are often large publicly traded real estate investment trusts (REITs), in which investors can buy shares. Although this is more of an equity investment from the passive investors viewpoint (buying equity in the managing company), the underlying assets that the REITs hold are debt instruments, which is why it is included in this section. These companies source capital or issue shares of the company to investors in return for yield, or cost of capital to the firm. Once the capital is secured, they loan the money to real estate investors looking to acquire assets or consolidate other debts. They may also buy other existing debt from a lender who previously originated the loan. You are paid a return from the interest income generated from those loans and the company takes the difference between your rate and theirs, called spread.

Tax Liens 

A tax lien is an encumbrance placed on a property when the taxes have not been paid and a certain amount of time passes after they are due. Individual investors can then buy that lien for the amount of back taxes owed and hold onto it as an investment. The longer they hold it, the more debt they are owed in interest and other fees. This lien can either be paid by the property owner at some point in time, or the lien holder can choose to foreclose on the house. This foreclosure essentially allows you to own the house for the price you paid to buy the lien (plus attorney fees and other costs associated with foreclosure).

Equity

Direct Ownership

Direct ownership means you own an investment property yourself and retain the equity that is available. Owning real estate directly often comes with responsibilities of managing and maintaining the property throughout the life of ownership. These tasks include everything from leasing, coordinating maintenance, property tax payments, loan payments, insurance, keeping up with rental collections, and accounting. These aspects of ownership can seem daunting for the busy professional or those trying to enjoy their retirement. You could hire a property manager but this is not always the passive endeavor you might think. Other investments that require less time and headache are available, but require more capital, often for less return. Some of these include triple net (NNN) leases, sale leasebacks and others. 

Joint Venture

A joint venture is when two or more people or companies decide to combine resources in the undertaking of a particular project or projects. These partnerships are usually formed to complete one or a certain number of projects to completion, whereas a partnership is normally ongoing. One example of a joint venture could be one partner is responsible for executing the business plan, and the other providing the capital to fund it. In this example, the profit would be split between the two partners based on the agreed upon equity stake each has for their role in the investment. 

Partnership

Partnerships come in all forms and fashions. The most basic in real estate is where two or more individuals come together to split up roles within the organization to perform a for-profit investment strategy. Each member receives a portion of the equity in the company as compensation for their contribution, as well as any profits generated by the partnership. Should the property or properties not perform as expected, the compensation per member is diminished, on a pro-rata basis, by the amount of their ownership stake in the company. This approach can be difficult for busy professionals, if they are taking an active role in the operations of the business or project.

Syndication

Syndication is a private offering of equity presented to a limited number of individuals or entities. In exchange for this equity, the members either provide capital to fund the deal, resources to execute the business plan, or both. This type of investment is typically structured in the form of a partnership and each member is given a share of equity based on their initial contribution of time or money. These partnerships are called “pass through” entities, meaning that all members receive profit or loss from operations, depreciation expense, and capital gain or loss when the property is sold. This partnership is sometimes called a limited partnership, comprised of managing and investing members. This is a great investment for passive investors, as they can retain equity in the project and receive wealth and tax benefits that come with owning real estate, without having to deal with the time commitment that comes with direct ownership. For a more detailed look at the mechanics of a syndication, read this blog.

Crowd Funding

 Crowd funding is relatively new in the last decade or so and allows for individuals to invest in projects around the world. While the barrier to entry is quite limited, the information and personal connection you have with the sponsors running the project is limited, compared to a syndication. This can be a good starting place if you don’t have enough to invest in syndication but still want to grab some equity in real estate projects. 

In general, debt investments present investors with lower risk opportunities, in exchange for a lower return. On the other hand, equity investments usually carry more risk, but can provide much greater potential for upside and higher returns. One main difference in these investments’ risk profiles relates to the repayment obligation. In any leveraged real estate deal, the debt holder of the underlying asset gets paid before the equity holders. This is true no matter the outcome of a project’s execution. For example, if the property does not perform (breaks even or loses money), the equity investors don’t get paid, but the lender does. If the lender is not paid, they can foreclose on the property, liquidate the asset(s), and be made whole from the sale. In contrast, equity investors risk losing all their money, and should understand this risk before investing in any deal. 

To conclude, if you are interested in investing in real estate, there is likely a plan that works for you. This plan should be crafted to your risk tolerance, as well as your financial goals overall. Regardless of where you are in your investing journey, I believe real estate is a great addition to any portfolio. Fill out a form, or schedule a call with us at Nord Ventures. We would love to help you identify your plan of action and give you some potential options to increase your cash flow while building your wealth.

 I believe private real estate is a powerful investment vehicle for passive income and wealth creation. At the same time, the above is only my opinion. I am not an attorney, financial advisor, or a CPA and this is not advice, nor is it a solicitation of any kind. I always strongly suggest you consult with legal and tax professionals before making investments of any sort. 

Feel free to reach out to discuss your goals and mindset, or with any other questions about investing or life. Give us a call at Nord Ventures or fill out a contact form on our website.