Pros and Cons of Debt vs Equity Investment

By Ketan Patel
Date February 7, 2018

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Pros and Cons of Debt vs Equity Investment

Changing laws have led to an explosion of investments in real estate. The 2012 JOBS Act relaxed strict SEC regulatory requirements for raising capital, benefiting real estate crowdfunding. Now non-accredited investors can participate in real estate crowdfunding deals along with investors who are accredited. As a real estate investor, you can make the choice between debt investments and equity investments.

So the question is, which type of real estate investment is better, debt investments or equity investments?

Equity Investments Pros and Cons

Many crowdfunding deals include equity investments. As an equity investor in a crowdfunding real estate deal, you are a shareholder in the property. Your share is proportional to the amount you invest, and your returns are a share of net operating income less service fees to the crowdfunding platform. You might also get a share of appreciation when the property is sold. As an equity investor you have no cap on your returns and you enjoy the benefits of tax deductions and lower fees. However, you might have to hold the investment for years, and you can suffer a loss if the property doesn’t perform.

Pros of Equity Investments

You have the potential to realize high returns with an equity investment along with tax shelters and lower fees.

• Greater Potential Returns: With equity investments, there is no limit or cap on your returns which can be substantial – sometimes up to 25% on an annual basis.

• Tax Advantages: Equity investors can deduct expenses for the property, including maintenance and depreciation. These benefits are typically realized through the crowdfunding LLC.

• Low Fees: You will likely be asked to pay an annual fee of 1% – 2% of the amount you invest, instead of upfront and monthly service fees.

Cons of Equity Investments

Equity investments are suitable for investors who are willing to tie up their money for years and take a risk in return for the potential of higher rate of return.

• Higher Risk: Equity investors are second in line for payback. If the property does not perform as expected, you may suffer a loss.

• Less Liquidity: To realize a profit, you may have to hold on to your equity investment for 5-10 years.

Debt Investments Pros and Cons

When you invest in a debt instrument you are acting as a lender to the sponsor of the deal or the owner of the property, like providing a mortgage from a bank. Debt investments are considered a lower risk than equity investments. The property functions as collateral on the loan and debt investors have priority in the event of a claim. However, you have to be willing to accept limited returns according to the interest rate on the loan and you may be liable for higher fees.

Pros of Debt Investments

Debt real estate investments appeal to individuals who are looking for an attractive, steady income with lower risk than equity investments and a hold time of a year or less.

• Predictable Income: Returns on a debt investment are generally paid out monthly or quarterly. Investors generally earn yields of 8% – 12% yearly, depending on how the deal is structured.

• Less Risk: A debt investment loan is secured by the property to insure repayment of the loan. If the owner or sponsor of the property defaults on the loan, you can foreclose on the property and recoup your loss.

• Shortened Hold Time: The hold time for debt real estate investments is commonly 6 – 12 months, ideal if you don’t want to tie up your assets long term.

Cons of Debt Investments

With debt real estate investments, you sacrifice higher yield potential in exchange for lower risk and you are responsible for paying higher fees.

• A Cap on Returns: As in other investments, you give up the opportunity for greater returns for lower risk. Debt real estate investments have returns that are capped by the interest rate on the loan.

• Fees to Participate: There are typically fees to participate in debt investment crowdfunding deals. Normally the platform takes a percentage and there may be a loan origination fee.

Tips for Choosing Debt or Equity Investments

Debt investors receive a fixed return with a fixed interest rate and time frame. They are ideal if you want an attractive return with lower risk and a short investment period. As an equity investor, you are a stakeholder in a business. As such, you have unlimited profit potential, but you may also have to share in a loss and need to invest for a longer time frame. Ultimately, your best investment option will depend on your experience, investment goals, and risk tolerance.