117: The Difference Between Debt and Equity and Why You Should Care
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So you’re thinking 🤔 about investing in multifamily apartment complexes, but you’re not sure if debt or equity investors are the right choices for you. Well, don’t worry, because we’re going to break down the difference between the two and help you make the best decision for your investment.
In this episode, we are going to talk about the difference between debt and equity investors in multifamily apartments. A lot of people get confused by this topic, so we’re going to clear it up for you to help you make the right decision for your investment. 😉😉
Debt vs. Equity
You can’t talk about something unless you really understand first what it is, so let’s start by defining debt and equity.
Quite simply, debt refers to borrowing money with the promise to pay it back with that fun little thing called interest. This can come in the form of a mortgage, a loan, or a bond.
On the other hand, equity refers to ownership of a company or asset. This can come in the form of stocks, partnership interests, or other forms of ownership.
Please keep in mind 〰️ that equity is a little bit different than shareholders’ equity, which is the total amount of a company’s assets and liabilities that you would find on its balance sheet.
We won’t get super in-depth into that distinction today, but you should be aware and we will link an article in the show notes/ show description for you to explore further on your own time.
Apartment Syndications
Okay, so let’s focus on apartment syndications, which are our bread and butter, and the reason why we are here today.
Apartment syndications are a form of real estate investment where a group of investors comes together to purchase and manage a multifamily property.
In apartment syndications, depending on the established investment structure, the investors can either invest through debt or equity. 🤩🤩
Are you still with us? This actually is pretty fun to talk about!
Debt Investments
Investing in real estate debt instruments can be an attractive option for investors because they’re essentially acting as a lender to the property owner or deal sponsor.
Acting as a lender has its benefits – the loan is secured by the property itself, providing peace of mind and security should any unforeseen events occur. 😲😲
Yeah, and on top of that, there’s the fixed rate of return that’s determined by the interest rate on the loan and how much has been invested.
And Cashflow Multipliers that’s not to mention being at the top of the capital stack – often referred to as ‘first in line’ – affords them higher priority when it comes time for a payout.
Let’s chat next about some pros and cons of debt instruments. ☝️
Here are some Pros for debt instruments:
There are a couple of major pros when it comes to debt instruments.
Low-Risk Profile:
The first is that debt investments involve less risk for investors due to the structure of the deals. The loan is backed by the property being purchased, which provides protection for the investment.
If the property owner or sponsor fails to make payments, investors have the option to recover their investment through a foreclosure process.
Predictable Income:
The next major pro is that debt investments offer a steady stream of income, as they typically provide regular payments of returns at a rate of 5-8% per year.
The frequency of these payouts may be monthly or quarterly. While each investment may vary, debt investments generally offer a more predictable level of income compared to other types of investments.
Okay, so we talked about pros, Nan let’s move on to some cons.
Yes! Let’s do it! 💪
Debt Instrument Cons:
Restricted to smaller investment properties:
The first con is that unless you are a family office. A quick note here, a family office is a private wealth management advisory firm that serves ultra-high-net-worth individuals.
Imagine if you are a lender on a $100 million dollar apartment complex, you are essentially forking out anywhere from $30 to 50 million dollars depending on the loan-to-cost.
That’s a pretty hefty sum for us ordinary investors. 😦
Capped Returns:
Another drawback to debt investments is that the returns are capped by the interest rate on the loan. 👀
This means that the potential for earning higher yields is sacrificed in exchange for a lower-risk investment.
Investors need to consider whether they are willing to accept this trade-off before deciding to invest in debt.
Exposure to Prepayments:
Finally, there is the risk of exposure to prepayments. If a mortgage holder pays off their loan early either by selling their home or refinancing, it can disrupt the expected cash flow from the debt investment and shorten the overall length of the loan portfolio.
Equity Investments
As an equity partner, you are essentially buying a piece of the property and becoming a co-owner. This means that you are able to enjoy the upside from the property with no cap on your earning potential based on your pro-rata share interest in the property.
Benefits of Equity Partnership
So why would you want to be an equity partner in apartment syndications? 🤔 There are several benefits to this approach:
- 1 Potential for higher returns: As an equity partner, AKA passive investor, you earn a share of the profits from the property.
This means that you could potentially earn higher returns on your investment compared to debt financing, where you are simply receiving fixed interest payments.
- 2 Shared risk: In an equity partnership, the risk is shared among all the partners.
This means that if the property performs poorly, the loss is distributed among all the partners rather than being solely borne by one party.
- 3 Passive income: As an equity partner, you earn passive income from the property without having to actively manage it.
This can be a great way to diversify your investment portfolio and generate passive income streams.
The Big Picture
So let’s take a step back and look at the big picture here. The difference between debt and equity lies in the type of financing and ownership involved. In apartment syndications, equity partnership offers the potential for higher returns, shared risk, and passive income. 🤓🤓
That’s it for today, thanks for sticking with us all the way to the end! We hope this episode has helped you understand the benefits of equity partnership and how it can fit into your real estate investment strategy.
If you want to jumpstart your apartment investing journey, please Ultimate Passive Income Guide. 👈
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