In Private Real Estate, What’s the Difference Between Credit and Equity Investing?

Topic:  • By Origin Investments • January 14, 2022 Views

Investors looking for a passive income stream can choose from two Origin Investments multifamily housing funds that offer high risk-adjusted returns and monthly distributions: our Multifamily Credit Fund, whose capital is invested in real estate credit, or our IncomePlus Fund, whose capital is invested in real estate equity. Each has specific benefits and risks, and by offering both strategies in our core lineup, investors can customize their real estate exposure according to their needs.

To allocate their portfolio assets properly, investors should know the differences between real estate credit and real estate equity. Real estate credit is essentially debt. Investors in real estate debt are directly or indirectly lending their capital to another party making an equity investment. Origin’s Multifamily Credit Fund invests in a loan pool of Freddie Mac multifamily mortgage-backed securities.

Equity involves direct ownership in a property. The Origin IncomePlus Fund is invested in common and preferred equity in multifamily properties—both existing assets and development projects. Investors in real estate equity, whether retail or institutional, look for debt financing to lower the amount of upfront capital they need, as well as to use as leverage to enhance their return on investment. They are paying interest to the lender, in this case the credit investor, to compensate for the risk of default.

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The equity investor is making the decision that the interest they will pay is worth the potential upside. In turn, the lender is compensated with the interest payments, which can be a fixed percentage of the loan’s face value or an amount that adjusts, or “floats,” at a premium over a market index.

Real Estate Credit and Equity Investments Offer Different Types of Returns

The level of returns an investor hopes to achieve will help determine whether real estate credit or real estate equity makes more sense for the funds they have available to invest. Real estate can provide substantial long-term returns even when equity or bond markets struggle. For the individual investor willing to accept more risk, real estate equity can potentially maximize returns.

By contrast, real estate credit returns typically consist primarily of the interest paid by the equity investor. If there is a secondary market, the potential for this type of investment—a mortgage bond—to appreciate depends on the ability of the equity investor to make interest payments and ultimately repay the loan’s principal. A strong market that benefits equity also should improve the borrower’s ability to make payments, which helps the associated credit investment appreciate.

Additionally, falling market interest rates make higher fixed payments more attractive, which can lead to higher capital appreciation for real estate credit investments—particularly for investments with sponsors that have good underlying credit.

Real Estate Credit Holds Down Risk

Risk is the most important consideration in the equity versus credit calculation. A real estate equity investment can provide unlimited upside, but that potential comes with a higher risk profile. The equity investor is the first to experience a loss if the value of the investment goes down. On the other hand, a real estate credit investment is better insulated from loss because the equity investment acts as a cushion “in front of” the debt; if the property loses value, the debt investment will not be affected directly until that equity is wiped out.

For comparison’s sake, think of an individual homeowner who holds a mortgage on their house with a bank. If the home loses value in a weakening housing market, the bank’s investment (the mortgage) balance remains the same. The bank does not lose value unless the equity has lost all value.

This is part of the tremendous value that Origin sees in our Multifamily Credit Fund. A Freddie Mac K-Deal bond is traditionally backed by a pool of 25 to 75 loans to institutional-quality multifamily owners and operators that will be cushioned by an average of 30% equity that sits in front of the debt. The credit of assets in a loan pool is a more stable investment if the market price of an asset—or even several assets—fluctuates. Rising interest rates could make the passive income stream less valuable, but still dependable, as long as the credit remains intact.

K-Deal bonds offer lower potential returns than having equity in the properties, but with substantially less risk.

Weigh Tax Efficiency in Portfolio Allocation

Few individual investors look forward to paying taxes. Risk-adjusted after-tax returns also influence investment choices. Real estate equity is more tax-efficient than real estate credit. Direct owners of a real estate investment can write off depreciation and other expenses, improving the after-tax value of a passive income stream. Additionally, once the property is sold, equity investors pay taxes at the lower capital gains rate. Taxes can be diminished even further through Qualified Opportunity Zone investments or 1031 exchanges, which allow for a potential deferral or even elimination of capital gains taxes.

While real estate credit can pay a substantial amount of interest, this interest is taxable at an investor’s ordinary income tax rate, which is typically higher than capital gains rates. Even interest on accrual bonds—securities purchased at a discount to face value, which don’t pay interest until maturity rather than paying interest monthly or annually—are taxed at ordinary income tax rates.

In making a real estate allocation, individual investors or advisors can consider allocating tax-inefficient real estate credit to accounts that already provide tax efficiency. For instance, they can choose to put these credit investments in traditional or Roth IRAs, or in 401(k) plans. Tax-efficient equity investments can be considered for taxable investment accounts. This strategy is a good start in maximizing the after-tax returns of a real estate portfolio. As always, it’s wise to have a tax advisor help structure portfolio investments accordingly.

Real Estate Equity Investors Call the Shots

Equity investors also are compensated with rights that credit investors don’t have, such as the ability to make strategic management decisions. They decide when to sell the property and to whom, when to refinance, any structural changes to be made and which third parties to engage as partners. Credit investors are generally silent partners, relying on equity investors to make good decisions.

However, many real estate equity investors lack the experience, training and time to make these decisions, especially if their investments are more complex and institutional in nature. That is why many invest in credit or become passive investors in real estate funds. Our IncomePlus Fund provides investors, as limited partners with Origin, access to a diversified portfolio of institutional-class multifamily housing a top-ranked fund sponsor making strategic decisions on their behalf.

Real estate, whether in equity or credit, gives an investment portfolio many unmatched benefits and unique risks. Investors and advisors should examine the risks, rewards and tax implications of any real estate opportunity, which accounts they should be used in, and how to make allocations within those accounts before deciding which investment is most appropriate for their needs.

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Origin Investments is a top-ranked real estate firm committed to educating investors on private equity commercial real estate.