Comparing Real Estate Equity to Real Estate Credit is important for investors to understand so that they may deploy their portfolio assets wisely. Credit in the real estate industry is borrowing. Loans made by investors in real estate debt are a form of indirect equity investment.
To have equity in a property means to own a stake in it outright. Investors put their money into apartment complexes, established and in the planning stages. Debt financing is sought by retail and institutional real estate equity investors alike to both reduce the outlay of initial capital and increase returns through leverage. They are compensating the lender, in this case, the credit investor, for taking on the default risk by paying interest.
The equity investor is deciding that the interest they would pay is fair in light of the future return. In exchange, the borrower must pay the lender interest, a set percentage of the loan’s principal, or a variable amount that “floats” at a premium above a market index.
Returns on Credit and Equity Investments in Real Estate Can Vary
Whether an investor should put their money into real estate credit or real estate equity depends on the returns they expect. Long-term investors can still expect big profits from real estate investments, regardless of the condition of the stock or bond markets. Real estate equity offers the possibility of high returns for the individual risk-taking investor.
Equity investors receive dividends from the economy, while real estate credit investors receive interest. The equity investor’s ability to make interest payments and eventually return the loan’s principal is crucial to the appreciation potential of this type of investment (a mortgage bond) if a secondary market exists. An increase in the borrower’s ability to make payments is good news for the associated credit investment when the market is robust.
Investments in real estate credit, especially those backed by sponsors with strong credit, can be appreciated due to dropping market interest rates and rising fixed payments.
Real Estate Credit Reduces Risk
The most critical factor in the equity vs. credit computation is a risk. A real estate equity investment has the potential for unlimited upside, but it also has a higher risk profile. If the value of the investment falls, the equity investor is the first to suffer a loss. Alternatively, a real estate credit investment is superior and protected from loss since the equity investment acts as a cushion “in front of” the loan; if the property loses value, it will not immediately harm the debt investment until that equity is wiped out.
Consider an individual homeowner with a mortgage on their home that a bank holds. The bank’s investment (mortgage) balance remains unchanged in a declining housing market. Unless the equity has lost all of its value, the bank does not lose value.
A Freddie Mac K-Deal bond is typically backed by 25 to 75 loans to institutional-quality multifamily owners and operators, with an average of 30% equity in front of the debt. If the market price of an asset—or even multiple assets—fluctuates, the credit of assets in a loan pool is a more reliable investment. Rising interest rates may reduce the value of the passive income stream, but it remains dependable as long as the credit is intact.
K-Deal bonds provide smaller potential profits than equity in the properties but with far less risk.
Consider Tax Efficiency When Allocating Portfolios
Most people who invest their own money do not look forward to having to fork up tax money. Returns on investments, risk-adjusted and after taxes, are another factor that goes into investment decision-making. The tax benefits of real estate equity are greater than those of real estate credit. It is possible to raise the value of a passive income stream after taxes by increasing the depreciation and other expenses that direct owners of real estate investments can write off. In addition, once the property is sold, equity investors are subject to the reduced rate of taxation applicable to capital gains. Investing in Qualified Opportunity Zones or engaging in 1031 exchanges, both of which have the potential to postpone or even do away with the payment of capital gains taxes, are also excellent ways to reduce your overall tax burden.
Although interest on real estate credit can be rather high, it is subject to an investor’s regular income tax rate rather than the lower capital gains tax rate that applies to most other investment income. Accrual bonds are discounted securities that accrue interest until maturity rather than paying interest semiannually or annually and are subject to taxation at the same rates as other regular income.
It is possible to relocate tax-inefficient real estate credit to accounts that increase tax efficiency if an individual investor or advisor makes this move. They may, for instance, place their credit investment funds into a 401(k) or a standard individual retirement account. There may be ways to invest in stocks that save on taxes for taxable investment accounts. Following this technique, you can get the most out of your real estate portfolio after taxes. Always consult a tax expert for advice on how to best structure your investment portfolio.
Real Estate Equity Investors Make the Final Decision
In addition to monetary returns, equity investors receive privileges such as a say in the company’s strategic direction, while credit investors do not. They choose when and to whom to sell the property. Also, when and how to refinance it, what changes in structure are required, and who the partners will be. Credit investors typically take a backseat to equity investors in decision-making.
Many real estate equity investors, especially those with more sophisticated and institutional holdings, lack the experience, skills, and time to make these selections. Many people put their money into things like real estate funds and credit.
Adding real estate investments through stock or debt to a portfolio brings unparalleled benefits and specific risks. Before choosing a real estate investment, investors and advisors should weigh the opportunity’s risks, potential returns, tax consequences, the accounts in which they belong, and how to allocate funds within those accounts.
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