Debt vs. Equity Financing Explained
Investing in real estate is an exciting opportunity to make money and diversify your portfolio, but even experienced investors stumble with one major component of buying property: funding an investment.
The average property purchase costs hundreds of thousands of dollars. As an investor, it’s up to you to make the right calls for your portfolio, by carefully analyzing the financing available to you based on your future objectives, your plans for your property, and even your current financial position. Your choices? Debt or equity.
Financing a Property Purchase
There’s no way around it: buying a property requires capital. It may be a lot, or it may be a little, but there’s no way to claim ownership of real estate without cash changing hands.
As a real estate investor, weighing the pros and cons of debt vs. equity can be among the most challenging decisions, especially in the acquisition of property for commercial purposes. Due to the nature of borrowing large amounts of money and maintaining a high mortgage payment, many investors are hesitant to take the debt route. This is particularly true for buyers who are making potentially risky investments; after all, a sizable loan is almost impossible to pay off when an investment fails to generate income. However, equity financing isn’t without risks either; bringing a third party into your operations opens the door to potential trouble.
Just as you do your due diligence before choosing a property and making an offer, thorough research and consideration are important in financing, too. Here is what you need to keep under consideration while choosing between lending and investing for funding your next property transaction.
Debt financing is arguably the easiest and most commonly used alternative for real estate investing.
In a debt transaction, an investor makes a binding agreement with a lender. Lenders exist in many forms, from personal friends to financial establishments, although the latter arrangement is far more common. To receive a loan from a financial institution, borrowers fill out application paperwork with personal information and financial records and wait for approval. If the lender believes the applicant in question is qualified, a proposal will be made, including a principal amount, an interest rate, and a repayment schedule. There may be some room for negotiation, but in general, loans are presented as-is. If the borrower agrees to the terms, he signs paperwork that creates a legally binding contract.
In a business transaction, most lenders will want to see evidence that a loan can be repaid, and that there is sufficient cash flow to maintain consistent payments. For businesses seeking loans, lenders will often request access to financial statements, like income statements, balance sheets, and cash flow statements. Prior to applying for a loan, be sure all relevant financials are properly organized and preferably audited. Assurance for financial statements can be an issue in lending, so the more oversight available, the better.
Forms of Debt Financing
In general, loans are available in two distinct forms: secured and unsecured debt.
The most common option for those seeking high amounts, a secured loan requires the use of collateral to ensure debts are properly paid back. Collateral, or designated property intended to provide a safety net in borrowing, can come in different forms, but for a purchase of real estate, the secured loan (a mortgage) is always secured by real property.
If the loan is not paid back on time or the borrower deviates too far from the agreed upon schedule, the lender has a legal right to lay claim to the property used for collateral — which is referred to as a foreclosure. When a loan is made with collateral, the lender will record a lien with the county courthouse where the property is located, giving the lender rights to the property in question should taking possession become necessary. The recording process serves as notice to any other lenders if the borrower seeks a loan from another lender using for the same property, although some lenders will be willing to accept a position as a junior lender behind a senior lender.
Collateral generally incentivizes repayment; when there’s a risk of losing the real property, borrowers are more likely to make timely payments. Some lenders only make large loans if collateral is used; a loan of hundreds of thousands of dollars can be exceptionally risky with no guarantee in place.
Unsecured loans do not use any form of collateral to ensure the repayment of a loan. As such, these loans tend to be smaller with higher interest rates, as there is less of a guarantee that the loan can be repaid in any capacity. Unsecured loans are far less prevalent in a real estate transaction, as these transactions tend to require large amounts of principal. Additionally, the property being purchased often serves as its own collateral. Unsecured debt is most common as student loans or in the form of credit cards.
For property investors who do not wish to seek a loan to purchase real estate, an investor may be a better option. Unlike a lender, who provides capital that must be repaid with interest according to a set schedule, an investor contributes capital in exchange for equity. This means that the investor claims an ownership share in relation to the amount of money provided.
For example, if you are considering a property worth $500,000 and an investor is willing to contribute $100,000 toward the purchase price, he will likely be interested in an ownership stake of at least 20%. The more money contributed, the more equity must be traded, making an equity investment potentially risky. Giving up more than 50% of the ownership in a property makes you, the primary investor, a minority owner, effectively diminishing control over a real estate investment.
Finding an investor to participate in a real estate transaction is often less straightforward than borrowing through a bank, and additional due diligence is required. While accredited lenders have some form of industry oversight, investors can effectively be anyone, including collectives of individuals, angel investors, or even a family member with good intentions. Before agreeing to an equity investment, be sure you know exactly who you are involving in your project and how they can add value to your endeavors.
An investor may also want more detailed information than a bank as an investor’s ability to profit relies directly on the success of a property transaction. This may mean anything from bringing in independent auditors to walking through your potential property purchase to a thorough analysis of your business plan.
Evaluating the Pros and Cons
A thorough understanding of both equity and debt financing is a good first step but comprehending the differences and how they apply to you personally as a real estate investor can be more challenging.
Considerations in Equity Financing
Equity financing can be alluring due to the lack of debt; there is no necessary obligation to pay back what your investor provided you if things get rocky, and in most cases, your equity partner will go down with the ship if the investment falls flat.
However, an equity investor isn’t a silent source of a capital like a bank; an equity investor will likely have his own opinions about your real estate objectives and will be able to exert influence on the course of business. A bad investor can ruin any project, even those that should be a near guaranteed success, adding a significant layer of risk.
Questions to ask:
- Do I need a partner?
- What can an equity investment offer that debt won’t?
- How can a partner help my chances of success?
- How will I protect my investment?
- Am I willing to share profits and decision-making?
Challenges in Debt Acquisition
Borrowing money is the traditional course of action because it is easy, reliable, and effective. Lenders offer a guaranteed source of financing through a relatively straightforward process, and approval for committed real estate investors is fairly simple.
However, debt comes at a heavy cost, and if your venture doesn’t succeed, you may be on the hook with no way to pay. If your loan was secured, you may end up surrendering assets just to meet your debt obligations, which can be financially devastating.
Questions to ask:
- Does my risk tolerance allow for more debt?
- Can I afford to meet my obligations even if my investment doesn’t work out?
- Do I have audited financial statements to show a lender?
- Do I have sufficient collateral?
- Do I qualify for affordable interest rates?
Real estate investing can be very rewarding as long as you navigate the financial route. Our professional loan officers can help you navigate your loan options and help you pick the best option for you.
Scott Clift is a licensed real estate broker with Westpark Loans. He has been in the real estate industry since 1994. His team of seasoned professionals specialize in providing real estate loans for investors and other self-employed individuals. When you are ready to invest in real estate, call Westpark Loans to secure your financing at (844) 574 LOAN or by visiting westparkloans.com.