Equity vs Debt Investment: Which Is Right for You?
June 16, 2022
If you're thinking about investing in real estate, you have two options - investing in equity or debt. When comparing the equity vs debt investment, there is much to consider, including the risk, returns, and how they operate.
Here's everything you must know about equity and debt crowdfunded real estate investments and how they work.
Before Investing: Know Your Risk Tolerance
Investing involves risk. The level of risk you are willing to take on will significantly impact the types of investments that are right for you.
Some people are very risk-averse and only feel comfortable investing in things like cash and government bonds. Others are willing to take on more risk in exchange for the potential of higher returns. Knowing your risk tolerance is an important part of investing. It can help you choose the right investments and avoid ones that are too risky for you.
There are a few different ways to assess your risk tolerance. One is to think about how you would feel if your investment lost 10% of its value. If you would be highly uncomfortable, then you are probably not very tolerant of risk.
Another way to assess risk tolerance is to look at your investment history. If you have always invested in low-risk products like cash and government bonds, then it is likely that you are not willing to take on much risk.
Once you know your risk tolerance, you can start to look for investments that are a good fit for you. If you are risk-averse, you may want to stick with low-risk investments like cash and government bonds. If you are willing to take on more risk, you can look at higher-risk options like stocks and venture capital. No matter what your risk tolerance is, there are investment options out there for you. It is important to find the right fit for you so that you can invest with confidence.
Debt investors invest in a real estate developer or investor's loans. You essentially become the lender, lending your money to individual investors. You'll pool your money with other debt investors and receive a fixed rate based on the interest rate the borrower pays.
Debt Investors receive fixed monthly payments based on two factors: the interest payments received from borrowers and the amount of their own investment. The property the borrower uses the funds to purchase becomes the collateral for the loan. If the borrower defaults on the loans, the debt financing investors generally get paid before equity investors.
Choose debt financing if you have a lower risk tolerance. The returns are lower than most equity investments, but the returns are more guaranteed. Just like with the stock market, when you invest in aggressive investments your rate of return is higher than investments with a lower risk.
When you invest in debt instruments, you give real estate companies or investors the funds needed for their real estate projects. The holding period is usually short - typically no more than a couple of years and they have a fixed rate of return.
You receive monthly interest payments throughout the loan's term, which are prorated based on your investment amount. When the loan matures, and the borrower pays the loan off in full, you receive your principal back.
- Debt financing investments are an excellent way to offset the risk of equity investments
- You'll receive regular monthly payments from interest
- You choose which loans you feel comfortable investing in
- The property is collateral, so you won't lose everything
- The investment is fairly liquid, especially if it's a short-term loan
- You don't get any part of the property's equity or profits
- The returns are lower than equity investments
- There could be a large number of fees
What is equity financing? If you choose equity financing investments, you are a property shareholder and get a part of the property's profits. Typically, equity investors earn monthly or quarterly income from the rental income charged on the property and any capital appreciation earned. You also earn a prorated amount of the capital gains when the owner sells the property and pays off the equity investors.
As an equity investor, you help real estate investors and developers raise capital to fund their project. You become part owner in the project and have a right to a prorated amount of the company's profits.
Equity investments usually have a much higher rate of return than debt investments. However, you must have a much higher risk tolerance, and there is no guarantee of future profits and/or capital gains.
An equity investor invests in a real estate company that buys, manages, and sells real estate properties. You buy shares in the company and earn a part of its profits throughout the investment.
When the developments you invested in do well, you profit. But when the developments perform poorly, you may lose money. There isn't a guaranteed return which is one of the main differences between debt and equity investments.
The timeline for equity financing investments can vary from a few months to many years. However, most are long-term investments, so you must be able to have your money tied up for the duration of the investment.
- Equity financing can earn high returns
- There isn't a limit to the amount of returns you can earn
- The fees are often lower than debt financing investments
- You earn profits from rental income and capital appreciation
- You know how long the investment is upfront
- Equity investments are usually very long-term, sometimes as long as ten years
- The riskiness is much higher with an equity investment versus a debt financing investment
- Equity investors are the last to get paid if real estate projects fail
Comparing the option for an equity vs debt investment means you must look at the differences to help you decide what fits best in your portfolio. Most investors have a combination of debt and equity investments, so they offset one another, allowing them to take chances and earn higher profits with equity financing but offset the risk with more secure debt financing investments.
Understanding the differences between debt vs equity financing investments starts with the legal aspects. If you invest in debt financing, you act as the lender. The investment must follow all state and federal guidelines, including how much interest can be charged and how investors are paid. Debt investors usually get paid first should a project fail too.
Equity investors are shareholders, aka part owners of the company. They have a right to a prorated amount of the company's profits but also take part in the company's losses should it not perform well.
Comparing the required hold times is an important determination in which investment is right for you. For example, debt investments are typically short-term, with investments lasting no more than a few years, giving you more liquidity.
On the other hand, equity investments can last for much longer, sometimes as long as ten years. They are considered illiquid, especially if you choose an investment that doesn't have an early redemption program.
Any investment involves taking a risk, but equity investing is riskier than debt investments. For example, equity investors are the last to get paid should a project fail, but debt investors are the first to get paid.
Investing requires a bit of risk to get rewards, which is why diversifying your portfolio with debt and equity investments that complement one another can reduce your overall risk.
Because equity investments are higher risk, they often have higher rewards too. The rewards aren't guaranteed, but when you do profit, it's usually at a higher rate than you'd earn from debt investments.
Debt investments do have a guaranteed rate of return, but there is still a level of risk you take. There's never a guarantee that borrowers will make their payments. If they do default, the collateral will be liquidated, and debt finance investors will be paid off first.
The Bottom Line- Which Investment Is Right for You?
Whether you're looking for a conservative investment or something with a little more risk and reward, real estate can be a great place to invest your money. You can diversify your portfolio from the stock market risk and give yourself a chance to enjoy the returns real estate often offers. A well-diversified portfolio often has both debt and equity investments to complement one another and offset the risk of a total loss. Learn more by signing up and visiting our blog.
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