Equity vs. Debt Investments for Real Estate
June 9, 2022
Commercial Real Estate is incredibly varied. From office, multifamily, industrial, and multifamily, there are also many viable investment strategies. In this article, we’re going to discuss the differences and what to expect from private equity investments in real estate.
The General Capital Stack Split
There are two main ways to invest in real estate: through equity or debt. Equity investments typically involve buying a piece of property and becoming a part-owner, while debt investments involve lending money to borrowers who purchase a property with the expectation of earning interest on that loan. Both have their own unique benefits and drawbacks.
Below is an example of a typical CRE capital stack:
A primary difference in real estate investment strategy boils down to where you sit in the capital stack. The capital stack is the order in which debt and equity are layered in a real estate deal. The most important thing to remember about the capital stack is that seniority matters—in the event of a default, lenders who have seniority will be first in line to get paid back. This is why you typically see a correlation between the level of risk you take on and the reward.
With equity investments, you are buying a piece of the property and becoming a part-owner. This type of investment is typically riskier because you are directly owning the property and hold on to the liability of ownership. If the property appreciates in value, you will likely see a larger return on your investment. Equity investments typically have a longer holding period than some debt instruments, so you should generally expect to see potential larger returns for longer periods of illiquidity.
If you’re curious about the nuances between common and preferred equity, we have more information on that here.
Another way to invest in a commercial real estate capital stack is to participate on the debt side. With debt investments, generally, you are lending money to a borrower with the expectation of being paid back your principal plus interest. This type of investment is typically less risky than equity because you are not directly owning the property, and in most cases will have the underlying asset as collateral. However, if the borrower defaults on their loan, you could shoulder the burden of having to work out the rest of the deal to recover your principal. Debt investments may have a shorter holding period than equity, depending on the type of debt. You should expect to see more consistent repayment though so you can expect some form of a return sooner.
Diversifying Your Investment Portfolio
Regardless of which type of investment you choose, it's important to diversify your investment portfolio. This means investing in different types of assets in order to mitigate risk. For example, if you're only investing in equity, you could be putting all your eggs in one basket. Equity investments fluctuate with their respective markets whereas debt investments tend to stay more even-keeled. However, if you diversify and decide to invest in both equity and debt, you'll help balance out the risk and potentially increase your probabilty of reaching the investment objective.