Nowadays, most people look for passive income sources that may add to their regular income, increasing it little by little. Real estate investing is a diverse investment strategy that entails buying or selling real estate for profit. Some prefer to invest in physical real estate, buying properties and then selling them or renting them out after doing a comparative market analysis. Real estate crowdfunding is another excellent way to invest in real estate. In recent years, real estate crowdfunding has moved forward, and it is said to expand more in the upcoming years.
Investing in crowdfunding platforms, as opposed to REITs or outright ownership of real estate, has certain advantages when it comes to real estate investing. The ability to choose between debt and equity investments is just one of the many advantages crowdfunding has.
So, before taking the plunge into real estate investing, let’s see what debt and equity investments are.
Equity Investment
Equity investments are the most common form of investment in real estate crowdfunding deals. An equity investment entails buying an asset that would provide you with a profit based on the asset’s performance. One distinguishing feature of investing in equity is that you will be entitled to a portion of the capital gained by the asset. While there are numerous types of equity investments, one prominent example is purchasing and managing a rental property, which generates income from the monthly payments that each renter is required to make. In equity investing, the choice of how to manage one’s stock is entirely up to the investor.
The Advantages of Equity Investing
- There is no limit to the amount of money you can earn in equity investments. The range can be around 18% to 25% in terms of annualized returns. The sky’s the limit for investors because there is no cap.
- There is the potential for lower fees when it comes to equity investments. In place of a monthly service fee, investors can pay an annual fee to maintain their position in the assets. Prices range from 1% to 2% of the total, which is calculated based on the investment.
- There are also tax advantages to investing in equity. If you own an investment property, you can deduct some of the costs that come with it, such as depreciation and the cost of repairs. When equity crowdfunding is used, deals are usually set up through an LLC, which is taxed as a flow-through entity. This means that investors can get the depreciation deduction benefits even if they don’t directly own property.
The Disadvantages of Equity Investing
- In equity investing, the most common problem is that the time between when you buy the asset and when you sell it is typically quite long. If you want to keep your portfolio as liquid as possible, you should think twice before holding onto an equity investment for an extended period of time.
- Investors may be able to get more money from equity crowdfunding, but they’ll have to take a greater risk. For investors, the property’s failure to meet expectations can easily result in losing a significant portion of their investment’s value. Crowdfunding is still not subject to the same regulations as publicly traded securities. To ensure that only high-quality real estate crowdfunding projects are funded, projects and management teams may not be thoroughly vetted.
Debt Investment
When an investor invests in real estate debt instruments, they act as a lender to the property owner or deal sponsor. The property secures the loan, and investors receive a fixed rate of return based on the loan’s interest rate and the amount invested. In a debt transaction, the investor is at the bottom of the capital stack, which means they have first dibs on the property’s payout. Investing in mortgage-backed securities is another way to invest in real estate debt. When you invest in real estate debt, your money is backed by the property used as collateral. Investing in a widespread investment pool such as a real estate debt fund is a unique form of debt investment that can provide a steady return.
The Advantages of Debt Investment
- Debt investments are frequently associated with building projects. As a result, they have a shorter holding period than equity investments. The hold time can range between six and 24 months, depending on the nature of the transaction. This is favorable for investors who are hesitant to tie up investments for the long term.
- Debt investments can help investors better balance the risk levels of their investment accounts. When you invest in real estate debt, you will be acting as a lender to the owner of the property or the deal’s sponsor. Even if the borrower fails to meet your expectations, the loan is secured by the property, so if the borrower defaults, you will be able to seize the property and recoup your investment.
- In debt investments, you can expect a fixed return on investment based on the interest rate on the loan and your investment amount. It can be beneficial to understand that even though the fixed rate of return depends primarily on the interest rate set for the loan, you will receive the same monthly payments.
- As far as return payments go, debt investments are more predictable. While every deal is unique, investors can expect annual returns ranging from 8% to 12% on average. Monthly or quarterly dividends are the most common frequency of these payments.
The Disadvantages of Debt Investment
- You can only earn a predetermined amount of money from your debt investments. All returns are based on the interest rate. Therefore, it gives capped returns.
- Participating in debt investment crowdfunding entails sizable fees. A small percentage of the money will be taken away by the platform from the money you earn through crowdfunding.
- Homeowners sometimes pay off their mortgages early, either by selling their homes or refinancing their existing loans. Due to this, the selling or refinancing of the property may disrupt your debt investment’s cash flow and the loan portfolios.
Differences between Equity and Debt Investments
There are a few things to keep in mind before finally selecting which platform to invest in. Let’s see a few differences between equity and debt investments to help make the decision a bit easier:
Risk Level
The level of risk in both investments is never the same. While equity is more dependent on the performance of its assets, debt is entirely fixed by its interest rates. You might lose your investment if the equity you invested in doesn’t perform well by chance. On the other hand, even if the homeowners fail to make their payments, you can still use the property to recoup your investment.
Ownership
You are a shareholder in the property, not an owner, when it comes to equity investments. The stock you invest in gives you an income as it performs. As for debt investment, you become the owner of the property when you invest in it.
Returns
In terms of returns, you get a limited amount of returns on debt investments because they are capped by the interest rates. Meanwhile, equity investments depend on the amount of shares you have invested in and their performance.
Fees
Debt investments require a substantial fee to invest in a property; on the other hand, equity investment fees are quite lower than debt investment fees. Equity investments charge an annual fee instead of a monthly one.
Conclusion
Both equity and debt investments have pros and cons, but it largely depends on which investment is best for your portfolio. Both can provide good returns with a steady cash flow in some investments, like debt investments. However, when thinking about the future, it’s advisable to put the money you earn to work for your benefit. You can make a more extensive savings account, plan a vacation, or use it to consolidate multiple debts. This side income can benefit you in many ways; you have to figure out the best way to use it. It would help if you also kept in mind that you become its owner when you invest in a property. So you can even turn a failing property into a successful one.