While debt and equity investments can both potentially deliver good returns, there are differences that may make one more appealing to you than the other.
Most investments can be categorised as either debt investments or equity investments. In an equity investment, you buy an asset and your profit is related to the performance of that asset.
In a debt investment, you loan money to a person, a business, or a government institution. With a debt investment, your profit is not directly related to the performance of the borrower.
How Equity Investments work
Equity investments are seen as higher risk and therefore typically earn a higher rate of return over the long term. This is why we even bother with equity investments, instead of putting our money into (theoretically) safer debt based investments.
Equity based investments include:
- Mutual Funds
- Real Estate
- Real Estate Investment Trusts (REITs)
Most real estate crowdfunding deals (like peer to peer lenders) involve equity investments. In this scenario, the investor is a shareholder in a specific property, and their stake is proportionate to the amount they have invested. Returns are determined in the form of a share of the rental income the property generates, (less any service fees paid to the crowdfunding platform). Investors may also be paid out a share should the property be sold.
How Debt Investments work
Debt investments are seen as lower risk and therefore usually earn a lower rate of return (again, over the long term). However, long term low yield debt based investments struggle against a hidden risk — inflation.
Debt based investments include:
- Savings Accounts
- Peer-to-peer lending marketplaces
- Corporate Bonds
- Government Bonds
When investing in real estate debt investments, the investor is de jure acting as the property’s lender. The loan is secured on the property itself and investors receive a fixed rate of return that’s determined by the interest rate on the loan and how much they invested. In a debt deal, the investor is at the bottom of the capital stack meaning they have priority when it comes to claiming a payout from the property.
Which is best for you?
Both equity and debt investments have their pros and cons, which savvy investors must take the time to assess carefully:
No cap on returns – Equity investments have a higher earning potential. Thus the sky really is the limit from an investor’s perspective.
More risk – Equity crowdfunding typically places more money in investors’ pockets, but it means taking a more calculated risk. Investors are second in line when receiving a payback on their investment, and if the property fails, then the investor may suffer a loss.
Longer tie-in periods – Equity investors are looking at a much longer time frame compared to debt investors. Tie-in periods can stretch out over five or more years, which is an important consideration if you’re interested in maintaining a high degree of liquidity in your portfolio.
Short-term – Debt investments are most often associated with development projects. As a result, they typically have a shorter holding period compared to equity investments. This is great for investors who don’t want to tie up assets for the long-term.
Reduced risk – Because of the way deals are structured; investors take on less risk with debt investments. The loan is secured by the property, acting as an insurance policy against repayment of the loan. In the event the property owner or sponsor defaults, investors have the ability to recoup the loss of their investment through a property sale.
Steady income – Debt investments are more predictable in terms of the amount and frequency of return payouts. While every deal is different, it’s not unusual for investors to earn yields ranging from 8% to 12% annually, like in the case of peer-to-peer lending.
Capped returns – Debt investments have less risk, however the returns are limited by the interest rate on the loan. Investors have to be clear about whether they’re willing to sacrifice the potential to earn higher yields in exchange for a safer bet.
Although investing in equity can often carry a more emotionally led motivation to support small businesses to get off the ground, the same can be said of debt investments. Both are valid forms of helping local and world economic growth. And both enable investors to support local industry whilst possibly earning something back.
Any type of investment carries a degree of risk, it’s up to you to determine what level of risk you are comfortable with and whether you can afford it. This is why some investors choose to have a portfolio of debt and equity.
Understanding what you stand to gain versus what you’re risking can help you decide whether one or both types of investments is a good fit for your portfolio.