Debt Vs Equity Investments. Which is Best?

By Amanda Cruise

You’ve made the decision to invest passively in real estate. You are ready for your returns without the headaches of tenants and repairs. You start looking for opportunities to invest and get a bit overwhelmed by all of the options.

Does this sound familiar? It did to me when I started investing. Even within a seemingly narrow investment like real estate investing, there are infinite ways to invest your money. In this article, I’ll focus on two frequent ways we set up investments: debt and equity.

Private Lending (Debt) Vs Ownership (Equity)

Private lending investments are loans made to an investor to fund a real estate purchase. Your loan is secured by the real estate, though you don’t own that real estate. You are the bank.

With equity investments, you have an ownership stake in the real estate being purchased.

Now that we got the super high level basics out of the way, let’s dive in!

Let’s Start With The (more simple) Private Lending Structure

Private lending investments are easy to understand because they are loans that earn interest. I’ll break down a private lending example and the key components.

Private Lending Investment Scenario:

We build brand new manufactured homes outside of Raleigh, NC and sell them. It’s sort of like building a brand new traditional house if that house rolled in on wheels 🙂 These are called land-home packages and we fund these projects with private lenders. Here’s an example:

We raise $200,000 from investors who get a 10% return on their investment. Their investment is secured by a first-position loan on the property that is recorded with the local Register of Deeds.

The project lasts 8 months. Each month our private lenders receive an update on the project’s progress as we move from prepping the land through the home arriving, getting the home setup, final touches, and then listing the home for sale. 8 months after the investment started, the home sells.

The home sells for $260,000. Our investors receive their $200,000 principal back along with their earned interest. We cover any additional expenses (real estate agent commissions, etc) and keep any remaining profit.

Highlights of a Private Lending Structure

Investors have a loan secured by an asset (in this case, U.S. real estate)
Returns with this structure are typically double digits. This tends to be higher than cash-on-cash returns for equity investments, especially in the first few years of an equity investment.
Predictable. Your return is set at the beginning of your investment and doesn’t change no matter how well (or not so well) the property business plan worked out. Even if we lose money on a project, you are still guaranteed your returns in a private lending structure.
Private lending is often used for flipping properties. We also use private lending for our land-home projects.
Private lending investments are often shorter-term. Many last less than 1 year. Some investors prefer the flexibility of these shorter-term investments.
This is passive investing, though it is treated as earned income by the IRS. Private lenders receive a 1099-INT form at the end of the year for tax filing.
Private money loans can be fantastic investment to make from your tax-deferred retirement account.

Now For The Equity Structure

Equity structures are simple to understand as far as having an ownership stake in the property. From there, the term equity structure can mean lots of different things! There are different pieces including ownership splits, rules for cash distributions, depreciation splits, etc. We won’t complicate things here. Let’s focus on a straightforward equity scenario:

Equity Investment Example:

We are purchasing a manufactured home community. The purchase price is $1,000,000. Because we are value-add investors, we are also putting money into improving the asset, not just buying it. We also need money to inspect and close on the property. And then of course there are reserves.

We raise money from investors. This is an equity investment, so we will use a typical syndication structure where our passive investors own 70% of the asset, and we, as the syndication sponsors, own 30% of the investment.

In value-add equity investments, cash flow will typically be smaller at first and grow over time as the property’s income increases through filling in vacancies, raising rents, etc. When the property sells, the profit from the sale is split among all owners (passive investors + sponsors).

Highlights of an Equity Structure

Investors have ownership in an asset
Cash on-cash returns in this structure are typically lower out of the gate compared to private lending investments. That could be the case for the entire investment, and is especially true early on in an equity investment before the main value-add business plan has been executed.
Can be ideal for maximizing long-term returns, as the projected returns from these value-add projects tend to be higher than the interest rates earned with private lending.
Because investors have an ownership stake in the property, they typically share in ownership benefits such as depreciation.
Equity investments have higher risk than private lending because investment returns earned are based on the execution of a business plan. There are many factors such as the economy, interest rates, etc. that can impact the business plan outcome, and therefore returns, for an asset.
All owners in the property including passive owners receive a 1065 form K-1 at the end of the year for tax reporting.

Which Is Best?

Consider where you are in your life and your needs. If you prefer the flexibility of shorter-term investments as well as a lower risk profile, private lending could be a great option for you. If you’d prefer a bit more risk along with tax benefits and the potential for significantly higher returns, equity investments might be a great option.

Many investors also choose to split investments between private lending and equity investments.

If you’re interested in passively investing, make sure you join Voyage Investing’s Investor Circle .