One needs to understand the various risk/reward profiles and the capital stack while doing due diligence.
All investments in real estate eventually include either the land itself or the buildings situated on it. On the other hand, investing in real estate may be done in two distinct ways: via loan or equity.
Understanding the distinctions between the two and where they sit in what is referred to as a “capital stack” is essential for choosing the investment that will provide you with the highest rate of return with an acceptable amount of risk.
Debt
When you purchase debt from a borrower, you effectively provide them with a loan. In exchange for using your money, they will pay you back the initial loan amount (the principal) and the interest incurred throughout the borrowing period.
Mortgages, bridge loans, and hard money loans are a few investments considered debt the investments. Because a promissory note is a legal instrument that outlines the conditions of debt repayment, some individuals refer to investing in debt as “note investment.” However, the phrase “promissory note” is more often used.
You can lend money for a short period (anything from a few months to a year) or a more extended period (years or decades). The borrower’s payment arrangements may demand them to pay both interest and principal with each installment (like mortgages). When it comes to other loans, such as hard money loans, the borrower usually is responsible for paying just the interest on the loan throughout the term. At the end of the loan, the borrower is responsible for repaying the whole principal balance.
Equity
When you invest in equity, you become a partial property owner and are entitled to a share of the property’s earnings. These revenues stem from rental income or an increase in property value.
Typically, returns on equity investments are organized as an “equity waterfall” that divides earnings between you and the sponsor depending on specified milestones. For example, you may invest in an apartment complex that offers you one hundred percent of the income up to a 7 percent internal rate of return (IRR). If this is the case, the investment agreement might provide that you will split the profit 75%/25% up to a 14% internal rate of return (IRR). Once this barrier was met, any remaining gain would be divided 80/20.
You must thoroughly comprehend how the split is performed and be confident that it will protect your interests as an investor without being too generous to the sponsor.
What Then Is the Difference?
In general, debt on the same investment is safer than ownership. This is because debt holders get compensated before the property owner is repossessed and sold. In a scenario such as this, equity investors sometimes have a little remedy. Even when they do, they have a significantly greater danger of incurring losses or being entirely wiped out than a loan investor in the same business.
On the other hand, while debt is safer than equity, its return is more minor.
Moreover, equity investments have upside potential, whereas debt investments do not. If a real estate project is phenomenally successful, the debt investors will only get the agreed-upon interest rate and not any unanticipated profits. However, the equity owners will share in the additional windfall.
Here is a hypothetical investment illustrating the two possible outcomes. When things are going well, equity is preferable to debt. When things go wrong, it is preferable to be invested in debt.
Note that these do not imply that all debt investments are safer than all equity investments. Investing in Bernie Madoff’s debt is riskier than investing in income-producing core real estate. Therefore, you must use discretion and evaluate each particular investment. It is a helpful rule of thumb that the whole universe of debt is safer than the entire universe of equity.
The Balance Sheet
Not all forms of debt and equity are equivalent. Even within a single real estate project, there are often several classes of debt and equity, each with its own payment terms under normal and liquidation circumstances.
This arrangement is referred to as the “capital stack.” Before investing a single dime, you must thoroughly understand the project’s capital structure and your position within it.
Here is a sample example of a capital stack:
Senior debt is the most secure and predominant component. As the most secure investment, it has the lowest predicted return.
Mezzanine debt is less secure than conventional debt because it lacks actual property as security (but simply equity in the controlling company). There is a more significant possibility that both your return and the principal may be wiped out in the effect of a default on junior debt. Therefore, its return is more powerful.
Common equity comes next, followed by preferred equity.
Not all real estate developments have the whole stack of documents. For instance, a complex money loan investment consists only of the senior debt element at the bottom of the preceding structure and often involves no other forms of debt or equity. Other projects may have even more intricate stacks.
Regardless of the project’s structure, you must comprehend its components entirely before investing in it. After determining this, it is crucial to understand where your individual investment would fall in the stack and what it entails in terms of risk and return. You may then determine whether or not this investment is constructed to fit your investing requirements and objectives.
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