Equity vs. Debt Real Estate Investing: An Overview
Real estate crowdfunding has taken off since the passage of the Jumpstart Our Business Startups Act in 2012, and the market is expected to expand even further. In October 2015, the SEC issued its final ruling on Title III provisions of the JOBS Act, allowing non-accredited investors to participate in crowdfunded real estate deals alongside accredited investors.
Investing in real estate through a crowdfunding platform has certain advantages over REITs or direct ownership of property. One of those advantages is the ability to choose between debt and equity investments. Before taking the plunge into real estate crowdfunding, it's helpful to have an understanding of how the two differ and what the risks are. (For more on the basics of real estate crowdfunding, see: Real Estate and Crowdfunding: A New Path for Investors.)
- Real estate crowdfunding is an increasingly popular alternative to REITs and real estate ETFs for adding property to one's portfolio.
- Equity real estate investing earns a return through rental income paid by tenants or capital gains from selling the property.
- Debt real estate investing involves issuing loans or investing in mortgages (or mortgage-backed securities).
Equity Investment Basics
Most real estate crowdfunding deals involve equity investments. In this scenario, the investor is a shareholder in a specific property, and their stake is proportionate to the amount they have invested. Returns are realized in the form of a share of the rental income the property generates, less any service fees paid to the crowdfunding platform. Investors may also be paid out a share of any appreciation value if the property is sold.
- No cap on returns: Equity investments offer a broader horizon in terms of earning potential. It's possible to see annualized returns ranging from 18% to 25%. Since there's no cap, however, the sky is really the limit from an investor's perspective.
- Tax benefits: One perk of owning an investment property is being able to deduct certain expenses associated with its ownership, such as depreciation and the cost of repairs. With equity crowdfunding, deals are normally structured through an LLC, which is treated as a flow-through entity for tax purposes. That means investors can reap the benefits of the depreciation deduction without having to own property directly.
- Lower fees: Equity investments have the potential to be cheaper where fees are concerned. Rather than paying upfront fees and monthly service fees, investors may pay a single annual fee to maintain their position in the property. The fee is calculated as a percentage of the total amount invested and often runs between 1% and 2%.
- More risk: Equity crowdfunding may put more money in investors' pockets, but it means taking a bigger gamble. Investors are second in line when it comes to receiving a payback on their investment, and if the property fails to live up to its performance expectations, that can easily translate to a loss.
- Longer hold period: Equity investors are looking at a much longer time frame compared to debt investors. Hold times can stretch out over five or even ten years, which is an important consideration if you're interested in maintaining a high degree of liquidity in your portfolio.
How Debt Investments Work
When investing in real estate debt instruments, the investor is acting as a lender to the property owner or the deal sponsor. The loan is secured by the property itself and investors receive a fixed rate of return that's determined by the interest rate on the loan and how much they have invested. In a debt deal, the investor is at the bottom of the capital stack which means they have priority when it comes to claiming a payout from the property. (For more, see the tutorial: How to Make Money in Real Estate.)
- Shorter hold time: Debt investments are most often associated with development projects. As a result, they typically have a shorter holding period compared to equity investments. Depending on the nature of the deal, the hold time may last between six and 24 months. That's a plus for investors who aren't comfortable tying up assets for the long-term.
- Lower risk: Because of the way deals are structured; investors take on less risk with debt investments. The loan is secured by the property, which acts as an insurance policy against repayment of the loan. In the event the property owner or sponsor defaults, investors have the ability to recoup the loss of their investment through a foreclosure action.
- Steady income: Debt investments are more predictable in terms of the amount and frequency of return payouts. While every deal is different, it's not unusual for investors to earn yields ranging from 8% to 12% annually. These returns are typically paid on a monthly or quarterly basis.
- Capped returns: Debt investments entail less risk, but one major downside is the fact that returns are limited by the interest rate on the loan. Investors have to be clear about whether they're willing to sacrifice the potential to earn higher yields in exchange for a safer bet.
- Higher fees: While most real estate crowdfunding platforms don't charge investors anything to create an account and research debt investments, there's usually some type of fee involved to participate in a deal. The crowdfunding platform usually takes a percentage off the top before any interest is paid out, which can eat into your returns. There may also be a separate loan origination fee that's passed on to investors. (For more on real estate crowdfunding platforms, read: Top 5 Real Estate Crowdfunding Companies.)
- Lower potential returns: with lower risk comes lower expected return.
- Exposure to prepayment risk: mortgagees sometimes pay off their loans early, either with selling a home or through a refinance. Doing so can interrupt the cash flows associated with your debt investment and decrease the duration of your loan portfolio.
The Bottom Line
Crowdfunding is an attractive option for investors who want to invest in private real estate deals in a cost-effective way. The minimum investment with many platforms ranges from $5,000 to $10,000, which is a relatively small price to pay to gain access to this asset class. Both equity and debt investments have their good and bad sides, which savvy investors must take the time to weigh carefully. Understanding what you stand to gain versus what you're risking can help you decide whether one or both types of investments is a good fit for your portfolio.