Real estate projects are typically capitalized using both debt and equity and investors can participate on either side or both. Equity investments involve ownership, a share of rental income the property generates, tax benefits and the potential for appreciation, while debt investments, like loans, yield regular fixed payments based on interest rates. But the idea of owning real estate and building equity has such a hold on the imagination that it’s easy to neglect the role debt plays in portfolios.
In truth, debt plays overlooked roles throughout a personal investment portfolio. Bonds are essentially debt—the issuer’s promise to repay the bondholder with interest. So are money-market instruments such as repurchase agreements and treasury bills. The difference between debt and equity comes down to control and priority of these cash flows; with debt instruments the investor locks in an income stream that is paid out to them by the property owner but does not share in rising values. However, debt gets paid before equity which places these investors in a lower risk position and contractual monthly payments make for a nice stable income stream.
Private Loans Bridge the Debt Gap Today
Investment companies have stepped up in the last ten years to compete where banks can’t, and many commercial transactions are closed outside of banks today. A Heritage Foundation study suggests that commercial and industrial loans of less than $1 million have plunged since Dodd-Frank compliance requirements took effect in 2010. Banks hold about half the volume of construction loans as a decade ago and even active commercial bankers may stop short of extending the credit necessary to undertake a commercial real estate project. There is a persistent slowdown in lending activity growth for commercial real estate, the Mortgage Bankers Association notes.
As a result, private equity increasingly provides both debt and equity financing to buy and develop property. Real estate debt funds hold a record $57 billion in available capital, the Preqin research service says. In a Bisnow ranking based on the Preqin data, big names like Goldman Sachs, PIMCO and Blackstone are top private debt investors. But tight money has driven debt financing innovation for small business or real estate deals as well: Individual investors make direct loans in peer-to-peer lending networks.
When weighing debt financing vs. equity financing, property owners often prefer to borrow rather than cede control or dilute equity by taking on partners. Also, this strategy lets them focus on the business plan. They opt for private debt investments because they require less red tape while bank loans usually come with strings attached, such as owner equity, credit rating or cash-on-hand requirements. With fewer steps to approval, a deal can get done quickly.
Multifamily and commercial real estate projects need bridge loans for acquisition or construction, as well as longer-term commercial mortgages of five to 25 years. Short-term debt can carry substantial risk, especially for projects started from the ground up without rental revenue. These “hard money” loans are based more on the assets themselves than the project’s financials. The added risk brings the private debt investor high yields, tracking 400 to 800 basis points above the prime rate. Yet its position in the capital structure—always before equity—makes debt more secure than an equity investment that may never meet expectations.
Equity & Debt Investments: Pros and Cons
A debt investment is lucrative: It’s a reliable source of passive income, which can be budgeted to meet current or future obligations. Rather than earning the greater yields that come with appreciation when a piece of real estate is sold, private debt investors get paid regularly, regardless of the revenue the property generates or any rise or fall in value. Returns are capped at negotiated rates that often range from 9% to 13%.
But debt investments can be risky. The more debt on an investment, the more leverage risk—and the more investors should demand in return. Leverage is a force multiplier: added capital can move a project along quickly and ensure returns if things are going well, but if a project’s loans are under stress – typically when its return on assets isn’t enough to cover interest payments – investors can lose quickly and a lot. However, the loan is secured by the property so if the borrower defaults, lenders have first claim on the asset in a foreclosure. That’s easier said than done though. In many cases, owners can tie up properties in bankruptcy for months and even years, forcing the lender to advance more capital to protect a deteriorating asset. Property taxes and insurance still need to be paid and tenants must be retained. When the equity cushion disappears due to a declining market, so do the regular payments and the ability to be passive. Lenders need to make sure they are dealing with reputable sponsors with deep pockets who not only have a history of delivering projects on time and on budget but also paying their debts.
Additionally, private debt investments are not always tax efficient—the interest received from the borrower is treated as regular income. At first glance, it may seem like high yield, but after taxes, the gain may be similar to a lower-yield tax-free investment like a municipal bond. We encourage investors to remember to calculate after-tax returns when comparing investment performance.
In equity investments, partners share in the tax advantages of commercial real estate. The cash flow paid out in dividends is shielded from taxes through depreciation write-offs. When sold, while the lender gets none of the profits, equity owners share in the appreciation as capital gains that are taxed at a lower rate than regular income. Equity holders reap these rewards for assuming more risk than lenders.
Longer hold periods for equity investments can be an issue for some investors. Hold times for real estate properties, which may be ground up or value add developments, often stretch out as long as 10 years. For debt investors, hold times are stipulated upfront and usually last 12-to-36 months.
Choosing Between Equity or Debt Investments
A portfolio should have a mix of both debt and equity investments. Debt investments typically carry less risk than equity, which buffers a portfolio from the volatility of the equity markets. They bring consistent returns that don’t go up—but also don’t go down. That is especially important to meet ongoing obligations such as college tuition and living expenses. Getting involved in debt investment can be as simple as buying shares in a mortgage REIT, which pays out revenues from its loan portfolio as dividends. Investors also can lend even modest sums through peer-to-peer lending websites such as Prosper and LendingClub, or find a private equity firm that specializes in direct lending.
The Origin IncomePlus Fund was carefully designed to deliver consistent tax efficient returns and we deliberately structured the fund of both debt and equity investments. 75 percent of the fund’s capital will directly own apartment buildings, realizing the full benefits of being an equity owner, while the other 25 percent will be deployed as loans to developers and property owners. The depreciation expense created by the equity position in the fund more than offsets the taxable income of the debt investments of the portfolio, resulting in a dividend yield that is equal on both a pre-tax and post-tax basis. And, the addition of debt creates a more stable return without sacrificing upside in today’s lower return investment environment.
Bottom line, the role of debt and equity in a portfolio allocation is different for every investor, based on their tolerance for risk and financial goals. Equity investments have the greater upside: their potential for long-term appreciation makes them a powerful way to accumulate wealth. But debt investment can play a key role in generating income to meet personal investment goals and temper the risks of equity investments. The best strategy may be for investors to strike a balance between both types of investments in their portfolios.
The views expressed herein are exclusively those of Michael Episcope, are not meant as investment advice and are subject to change. This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person. You should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this article.