What is Debt Vs Equity Investing?

What is one of the more common ways to invest in real estate? That would be to buy a house, build up some equity in it and hope that it appreciates. But contrary to popular belief, this investment option is not as secure as investing in debt. So, for folks that prefer less risky investments, the better choice would be to invest in debt offerings.

The difference between debt investing and equity investing is simple. Debt offering is a type of investment, which essentially entails that you be the bank and act as the lender and subsequently, loan borrowers repay funds to you with interest. On the other hand, equity investment entails buying some sort of interest (aka shares or “equity”) in a company.

As mentioned earlier, in a debt offering you make a loan that is backed by the purchased property as collateral. Typically, this primary loan is made by an actual bank. As expected, the bank loan has set terms and must be repaid regardless of whether the property is making or losing money as well as how much money it is losing/making. As an example, income funds invest in such loans. If an income fund is of an investment grade, it will have more primary loans. Therefore, this type of investment involves the lowest type of risk, and in turn translates into lower type of return. Vice versa, if such a fund is of speculative grade, it will have more secondary loans. This means that this loan doesn’t cover enough to purchase and operate the property, and a secondary loan is needed. If you happen to invest in a secondary or mezzanine loan, then you position yourself behind the primary lender. In this case, your position is less secure, and hence the return offered on a mezzanine loan is higher than for the primary position.

Now let’s look at the equity investing. Let’s say you are investing in exchange for some equity stake in a company. An example of such an investment type would be growth fund investing. Usually, such fund companies raise money through syndications. In this case your stake is proportionate to your funded amount, and returns are delivered to you from rental income that is produced by the properties, as well as via additional returns to you as a stakeholder (for being a fund investor) when each property sells.

Usually, debt offerings are senior to equity investments.

Therefore, equity investing is a great example of the application of the general risk-reward correlation rules where debt is senior to equity in terms of the security.

To determine the overall safety of your investment, it is important to determine where on the capital stack your investment falls. The priority of payments of course starts with primary (aka senior) debt, then mezzanine debt, then preferred equity, and lastly common equity. So simply put, what you need to understand first and foremost is that the higher your investment stands in the capital stack, the lower the payment priority order of distributions eligibility.

Senior debt, or the debt to the bank, must be paid out first on a recurring (usually monthly) basis, and it must be paid no matter what. This type of debt investment has the lowest returns because of its higher than anything else safety stack component. Next is mezzanine debt, which is subordinate to senior debt, meaning that it can only be repaid after the senior debt receives its payment. Next on the capital stack, if it is offered, is preferred equity. Preferred equity distributions are typically paid after all debt is paid, and since preferred equity is not a debt offering so the borrower is not responsible to return it. Then there is the common equity, and as you have already guessed, preferred equity distributions are senior to common equity, so common equity distributions are paid last.

To summarize, essentially the investment repayment structure is that senior and mezzanine debt are paid prior to preferred equity and lastly common equity. Since the risk level grows with the diminishing priority of the repayment order, the returns typically grow with the level of risk.

Note, while not all the layers maybe present in each individual investment/syndication, those that are part of the investment are typically used as a leverage. Leverage (or OPM, Other People Money) is needed to increase the returns. When OPM is used, the borrower/sponsor increases their buying/investing power by bringing various layers of funding into the syndication.

Let’s look at a specific example. Let’s say there is a syndication to buy a $10M apartment complex. A bank issues a loan for the 60% of the property, or $6M – that is considered high, so let’s say it’s because the property has higher than usual vacancy (this is the primary or senior debt). The sponsor is forced by the bank to get a bridge loan in the amount of $1.5M to cover another 15% (this is the mezzanine debt). The syndication raises another $3.5M to cover the down payment, closing costs and renovation expenses. In this case, the recurring loan payments to repay the $6M to the bank will have the highest safety and highest priority order, followed by the repayments of the mezzanine debt of $1.5M, and then the regular investors’ distributions to repay the remaining $3.5M. The return payout would be directly proportional to the increasing risk.

While each debt versus equity offering comes with its own set of risks and returns, you as an investor need to decide for yourself how much risk you can and should handle.