Risk Management in Real Estate: Equity Investment vs Debt Investment
Real estate investing has a long-standing, attractive reputation for being historically stable and is often referred to as the best way to build generational wealth. Under this umbrella, real estate investing can be divided into two main categories: equity and debt. Before diving into either, it is essential to understand their differences and associated risks to optimize your investment strategy.
Introduction to Equity Real Estate Investing
Equity real estate investing has the potential to generate returns through three components. This can be through asset appreciation, improvements to the property, and/or income generation from the property.
1. Asset Appreciation
Asset appreciation refers to the expected—though not guaranteed—increase in property value over time. For example, asset appreciation has historically been correlated with inflation.
Buy-and-hold strategies can apply to single-family dwellings, land, and other asset types in the same way and are not limited to rental buildings as a form of equity real estate investment.
2. Improvements to the property
Improvements to the property, as the name implies, refers to the changes an investor might make to a property to increase its value. In the case of vacant land, this might be obtaining an increased density approval from the local authority. In the case of a rental building, it might be renovations to the units to attract higher rents, thus increasing value, or even for single-family residence, it may be a renovation of the existing dwelling to upgrade its components and thus increase the value.
3. Income generated with the property
Finally, returns from investment in real estate may be realized by holding the asset, and allowing tenants to occupy the building or land for a fee. The rents received, offset the costs, and what remains is known as the Net Operating Income. Comparing the Net Operating Income with the value of comparable assets in the market, or even the price you paid for the asset can yield the return on investment, or what is commonly referred to as the capitalization rate.
There are many ways an equity investor can earn returns in real estate, and the above are just a few common examples.
Equity Real Estate Investment Pros and Cons
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Cap on returns only limited to market demand: Equity investors’ returns depend on the asset’s financial performance, meaning there is no cap on potential earnings from an equity investment, subject to the demand for the asset being offered for sale. For example, a home has no fixed price, meaning you can sell it for the highest offer.
Tax Benefits: Owning a stake in a property entitles you to the tax benefits associated with real estate investing. Consult with your local professional to discuss further how these benefits may be applicable to your investment situation.
Cap on losses: The cap on losses may be higher than the amount initially invested in equity. This happens when a capital asset (such as investment or real estate) decreases in value, and contingent liabilities are formed. For example, if the asset is a property, the property might sell for lower than the original purchase price. During the use of the property, significant debts may have been obtained, furthering the risk of the investor of defaulting under the loans.
Extended hold period: As an equity investor, you might have a much longer period for the investment than debt investors. For example, buying a rental property could be a 5-10-year investment or longer. This is important to remember if you need liquidity in your portfolio.
Higher Risk and volatility in property values: Equity investments, with their potentially higher return potential, carry more risk than debt investments. Additionally, economic fluctuations, interest rate changes, market sentiment, and regional factors can cause property values to rise and fall unpredictably. This instability can lead to substantial financial losses, especially when quick asset liquidation is necessary.
Introduction to Debt Real Estate Investing
Debt real estate investment entails issuing loans or investing in mortgages or mortgage-backed securities. Here, the investor serves as a lender to the property owner and/or the deal’s sponsor, without owning the property itself. For instance, if you loan money to a developer to fund a housing complex, you hold a real estate debt investment. The property secures the loan, and you receive a return based on the interest rate and your investment amount. The agreed-upon interest rate at the start of the investment determines this return. If the borrower defaults under the loan, or in some other way fails to repay the debt, the property may be sold in satisfaction thereof.
Debt Investment Pros and Cons
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Shorter holding period: Some debt investments, like the ones offered by Morrison Financial, are short-term. For example, you might loan funds for a development expected to be completed in 18 months. You will receive your original investment when the loan has been repaid (or, if you are invested in a fund, liquidity may be provided every 30 days). Depending on the structure of the investment, it is likely that you will receive monthly interest payments during the term. Short-term investments like these favour people who are uncomfortable tying up their investment capital for over a few years or for a period that is undefined.
Lower risk: Debt investors generally sit at the top of the capital stack, giving them priority in claiming payouts from the property, especially in cases of default. If there are insufficient funds to cover all investors, debt investors according to their ranking are prioritized.
Steady and predictable source of income: Since debt investment terms are laid out in advance, the investor is aware of the loan’s interest rate and can more precisely estimate future income from the investment. No guarantees, however, are provided for any investment.
Capped and lower potential returns: The return is determined by the pre-negotiated interest rate. This cap limits the rate of return investors can expect. Note, however, that in certain instances higher rates may be agreed to by both parties at some point during the term of the loan, which may improve the yield of the investment.
Prepayment risk: The borrower (for example, a development company) may repay the loan earlier than expected. If this occurs, investors must redeploy the capital at current market interest rates. Technically, there is not an immediate loss of income. However, there is reinvestment risk because the new interest rates may be lower, potentially driving up asset prices. Prepayment penalties are often used by lenders in these strategies to limit the risk of having capital sitting for several months while a new opportunity is sourced.
Methods of Investing in Real Estate Debt
Debt investments in real estate include lending yourself, participating in a syndicated mortgage investment (SMI), and participating in pooled funds such as Mortgage Investment Corporations (MICs) and limited partnership funds (LPs), amongst others.
1. Participating in a Syndicated Mortgage with Other Investors
A syndicated mortgage investment (SMI) is an arrangement in which more than one investor (i.e., lender) participates in a loan secured by a mortgage. For example, a syndication platform will acquire properties deal-by-deal, combining capital from multiple investors for each deal. Syndicated mortgages are marketed as an attractive investment as they enable small investors to pool resources together to provide a mortgage loan or debt obligation, which they may not be able to achieve otherwise.
2. Participating in Pooled Funds
Like an SMI, pooled funds, such as Mortgage Investment Corporations (MICs) and limited partnership funds (LPs), pool funds from multiple investors. The main distinction between MICs and LPs is that MICs are restricted in some ways on how they can invest the funds (multiple mortgages). In contrast, limited partnership funds are limited by the extent of their offering memorandum, which defines the types of investments that can be made by that specific fund. With this, limited partnership funds may offer more flexibility in the investment styles that you might wish to participate in. Conceptually, a mortgage limited partnership fund, and a MIC will invest in multiple mortgages, thereby, distributing the risk of the investment across many loans, and diversifying risk. Note, however, that some limited partnership funds are created for single purpose investments, and so, it is important to understand what is being invested in by carefully considering the offering memorandum, and consulting with professionals for guidance.
Morrison Financial offers two mortgage income funds, Junior Fund (9-10% return projected) and Senior Fund (7-8% return projected), depending on risk preference.
Benefits of Pooled Fund Investments vs Syndicated Investment Styles
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- Reduced risk: SMIs are marketed as “low risk-high reward,” which downplays the often-under-appreciated dangers of relying on loans tied to future financing. FSCO recently outlined the risks of syndicated mortgages, cautioning against guaranteed high returns and repayment uncertainties. In contrast, pooled fund investments raise money upfront to lend to multiple properties, spreading risk across multiple investments. This makes for a more risk-averse investment as investing in various mortgages distributes the risk.
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- Flexibility: In pooled fund investments, funds are either open-ended or closed. Closed funds, akin to syndications, specify a deal duration, while open funds let investors join, earn returns, and withdraw as per the sponsor’s terms, offering greater commitment flexibility. Morrison Financial focuses on short-term mortgages, potentially providing greater liquidity than syndicated mortgages.
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- Steady and reliable income: Individuals may participate in pooled fund investments by purchasing their shares and becoming entitled to dividend payments. The dividends can then be withdrawn or reinvested into the corporation using a Dividend Reinvestment Plan (DRIP).
Takeaway
Both equity and debt investments in real estate offer distinct advantages and risks. While equity real estate investing offers the potential for higher returns through asset value appreciation, improvements and income generation, it comes with potentially higher risk and more extended holding periods. On the other hand, debt investments offer lower risks, shorter holding periods, and more predictable income streams, though with capped returns.
Understanding the differences between these investment strategies is crucial for optimizing your real estate portfolio. Equity investments are ideal for those seeking higher returns and are willing to accept greater volatility and risk. Conversely, debt investments are better suited for those prioritizing stability and a steady income. Pooled fund investments, such as LPs, are desirable for debt real estate investment due to their potentially lower risk, steady income, professional management, accessibility, and flexibility.
In conclusion, debt investments through pooled funds provide a potentially safer, more predictable, and professionally managed alternative to traditional equity real estate investments. They are well-suited for risk-averse investors seeking stability, reduced risk, and steady income in the real estate market.
