When you take the decision to make an investment, you will generally be presented with two options – debt vs equity investments.
While these two investment classes carry many similarities, it is the differences that will make an investor pick one or the other.
When making an equity investment, you buy an asset and the profit you make is directly related to the performance of your asset. As an example, you may invest in a new restaurant and your investment will then earn you a proportionate amount of the profit generated by this business venture after all costs have been paid.
In a debt investment, you will loan money to a person, a business, or any number of other institutions. The borrower will have an obligation to repay the money loaned as well as the interest agreed on. This means your returns are not directly related to the performance of the investment, so even if the business fails, the borrower remains obligated to repay your investment.
Think of it in this way: debt investors are paid first, equity investors last.
Both of these investment options are available in real estate crowdfunding, and they each offer a set of advantages and disadvantages. Choosing one over the other (or even a mixed portfolio featuring both) depends on the individual investor, his or her appetite for risk, and how much liquidity they require.
Now lets lay out the basics in debt vs equity investments.
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 high return rate is the main reason why many people choose equity over theoretically safer debt-based investments.
Equity-based investments include:
- Mutual Funds
- Real Estate
- Real Estate Investment Trusts (REITs)
Most real estate crowdfunding deals involve equity investments. Lenders pool their funds together and give this money to a developer. They then either share in the rental income of the property or the profits, should it be sold.
How Debt Investments work
Debt investments are traditionally deemed to carry a lower risk and therefore usually earn a lower rate of return (again, over the long term). However, there is a hidden danger in long-term debt-based investments, namely inflation. As an example, you loaned someone €1000 at 10% interest over ten years. Should the inflation rate jump above 10% during that period, you may actually end up losing money in real terms.
Debt-based investments include:
- Savings Accounts
- Peer-to-peer lending marketplaces
- Corporate Bonds
- Government Bonds
When investing in real estate debt investments, the investor takes over the traditional role of the bank. The loan is usually secured against 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, also known as first-rank, meaning they have priority when it comes to claiming a payout from the property.
As the investors’ returns are not tied to the performance of the project, they are not subject to market forces like a collapse in the property market. It is important however to keep in mind the Loan to Value (LTV) ratio. This is generally expressed as a percentage. A €75 000 loan against a property valued at €100 000 would constitute a 75% LTV. The lower the LTV percentage, the lower the risk of losing money in the event the borrower is unable to repay the loan.
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. Consider market trends and your own financial needs before choosing between debt vs equity.
No cap on returns – Equity investments have a higher earning potential. Thus the sky really is the limit from an investor’s perspective. As an example, someone who invested in Apple stock in the early 1990s probably made a massive profit beyond their wildest expectations.
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 business fails, the investor may suffer a loss. In the case of property, construction delays, slow or non-existent sales, or rental defaults by tenants can all impact the expected return of investors.
Longer tie-in periods – Equity investment generally requires a lot more patience as the returns generally come over a longer time frame compared to debt investing. 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 in property and real estate are typically associated with a development project and mostly span a period no longer than twelve months. This means they are perfect for investors who require high liquidity and are looking for quick profits on their investments..
Reduced risk – Because of the way deals are structured; investors take on less risk with debt investments. The loan is secured against 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. Provided the LTV was low enough and due diligence on the saleability of the property was done, default is an inconvenience rather than a disaster.
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. This predictability is what many debt investors love.
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.
What returns can you expect?
To give you an example of the best-case scenarios for debt vs equity investments, let’s look at the very best performers.
The best overall Equity Trading Fund (ETF) comes from the largest mutual fund company: Vanguard. This ETF tracks the S&P 500 and charges an expense ratio of just 0.04%.
Buying into this fund will gain the investor exposure to 500 of the biggest public companies in the United States. This means you get lots of diversity and can take advantage of the USA’s healthy economy (at the time of writing).
Historically the S&P 500, which many label a mirror of the overall US economy, returns about 10.71% per year over a long horizon. While past performance can never be a guarantee of future events if you are looking to invest long-term, this remains a good choice.
On the other side of the coin, real estate has done incredibly well compared to the S&P 500 since 2000. Real estate crowdfunding has done even better than the 10.71% annual return since 2012 due to the rapid growth in this space. Investors have become used to seeing returns of 12% – 16%, although predictions are that this will fall as more and more capital enters the market and borrowers are given more choice. Nonetheless, even the most conservative experts are confident in predicting a minimum of 8%, and those returns will come over a shorter period than they would with equity investments.
This means that real estate debt investments outperform even the very best of the equity investments over the short term.
Choose what works for you
The first piece of advice any investment guru will give you is to diversify your portfolio. A mix of long-term v short-term, high v low-risk and a geographic and asset class spread are all important factors to consider.
Many people also feel that equity investment gives them the opportunity to support local businesses and entrepreneurs, with this emotional motivation carrying a lot of weight.
The truth is that you can achieve the same thing via judicious debt investment. Any good alternative financing-based real estate platform will allow the investor to choose which projects to back, meaning they can support their local economy in the same manner.
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 containing both debt and equity.
Understanding what you stand to gain versus what you’re risking can help you decide whether you choose debt vs equity investments and which is a good fit for your portfolio.
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