When investing in commercial real estate, understanding the capital stack, which includes both debt and equity investing, is crucial. Most personal investors typically buy physical properties, banking on the property’s equity growth. However, those who prefer less risk might lean towards real estate debt investments, where you essentially act like the bank.
In simple terms, “debt” means you loan money that must be paid back with interest. When you invest in real estate debt, you’re lending money to the property owner or sponsor, similar to how a bank would. This loan is secured against the property. As a debt investor, you usually earn a fixed return, paid out regularly based on the interest rate and your investment size. This type of investment is generally less risky, but also yields lower returns. If the borrower defaults, debt investors may recover their investment through foreclosure.
On the flip side, “equity” involves owning a part of the property directly. Equity investors are more like shareholders in the property’s financial gains or losses. Returns for equity investors come from rental income or from the property’s sale, potentially yielding higher returns but also involving higher risks.
The Layers of the Capital Stack
Investing higher in the capital stack typically means higher risk but potentially higher returns. At the bottom, senior debt holders get paid first, providing lower returns but higher security. Mezzanine debt sits above this and gets paid next, offering a balance of risk and return. At the top, equity investors are paid last, facing the highest risk but possibly gaining the most if the property does well.
Leverage and Its Role
Leverage plays a pivotal role in real estate investing. It involves using borrowed funds to increase the potential return of an investment. For instance, if a sponsor has $1 million and uses 50% leverage, they can purchase a $2 million property, amplifying both potential gains and losses.
Equity’s Importance When Debt Financing Shrinks
During economic downturns, when banks pull back on lending, sponsors may need to raise more equity from investors. Platforms like CrowdStreet, which focus on larger projects in burgeoning cities, thrive in these times by offering investors opportunities to step in where traditional lenders have stepped back.
Deciding Between Debt and Equity
Choosing between debt and equity depends on your risk tolerance and financial goals. Debt investments are generally safer but offer lower returns, suitable for those who prioritize security. Equity investments, while riskier, offer higher potential returns and suit those willing to accept greater risk for potentially greater rewards.
In conclusion, understanding where you stand in the capital stack, how much leverage is involved, and the type of investment—debt or equity—will help you make informed decisions that align with your financial objectives in the realm of real estate investing.
