Real estate is a market that never dies and has various opportunities to make a profit. Real estate equity investments are commonly preferred by both experienced and beginner investors.
Equity real estate allows investors to turn their investments into major benefits if it’s done properly. Read on to learn more about real estate equity investing and contact us to get a session with a professional.
Understanding the Basics
An equity investment involves purchasing an asset that will provide you with a profit that depends on the performance of said asset. You will have access to a specific share of the capital that is gained by this asset.
There are various types of equity investments but the one most commonly used is purchasing and managing a rental property that generates a monthly income from each renter.
The investment that goes into a project is referred to as “total capitalization” which may go beyond the purchase of the property and may include other things such as:
- Marketing expenses
- Leasing costs and tenant improvements
- Construction and building improvements
- Business planning services
Equity real estate investments are generally long-term investments and have different cash flow distributions.
The main difference between equity and debt investments is that equity investors continue making money off of the property as long as it is performing well, which is not possible with debt investments.
A chart like the one below can be used to visualize the total money — also known as Capital Stack — that’s committed to a project.
The equity position is at the top orange level. Right below that would be the lower-risk portions of the capital stack including the preferred equity, senior debt, and subordinated debt. The lower you go down the chart the more protections investors have.
Equity investors typically are the last ones to receive their distributions for their investments. Which means they are also the first ones to lose money. Equity investors generally take part in higher potential upside which is uncapped for accepting the risk of losing first.
Anatomy of a Real Estate Equity Investment Partnership
In equity investing, investors usually invest together with a professional real estate company — also known as a Sponsor — whose role is to find a viable project and carry out the related management tasks after acquiring the property. These companies usually need other investors to provide some or most of the capital required for an investment opportunity. Investors taking part in the providing of the capital will then share the project’s risks and benefits. Such projects are called limited partnerships.
Although limited partnerships are sometimes used, most real estate investments are designed using limited liability companies whose role is to prelimit the liability of the investing members and sponsor along with allowing passthrough tax deductions that derive from ownership of the real estate.
Designing the structure starts from dividing the financial benefits of the project between the investing members and the sponsor. For investors, it’s important to consider the risks and benefits.
- Operators with sufficient experience will work hard for success.
- The project can present attractive opportunities if it’s structured properly
- Syndicators can bring expertise that will benefit the investors.
- Sponsors with bigger shares in the upside will aim for maximizing the sale price.
- Syndicators may want to move on and might be motivated to sell the property cheap.
- Operator and investors might have a conflict of interests
- Property class or type, market conditions, and operational concerns
- Sponsors may not put enough effort into the project.
Resolving these issues will require negotiations which may vary depending on the transaction and expected risk and benefits in a particular project. But, some common patterns for transactions are as follows:
- Receive some share of the tax benefits.
- Providing a small portion of the capital — around 5-20%.
- Receiving a promoted share from the remaining profits and cash flow.
- Receiving their preferred return on their own interesting capital.
- Receiving fees related to property purchase, management, and loan financing.
For Limited Members:
- Providing the vast majority of the capital — usually up to 80-95%.
- Receiving the bulk of the tax benefits.
- Receiving their preferred return on their investments – typically around 5-10%.
- Receiving a share from the remaining cash flow and profits – generally around 50-80%.
Pros and Cons of Real Estate Equity Investment
Investors in an equity investment project are shareholders of a specific property. Just like any investment, equity investments have pros and cons.
- Tax Benefits: Being a shareholder in a property means you can get the most of the tax benefits including cost repairs and depreciation. Equity crowdfunding deals are generally built through an LLC which is perceived as a flow-through entity.
- No Cap: Equity investments have a wider range of opportunities when it comes to earning potential. Your annual returns can vary from 18% to 25%. Since there are no caps on returns you can always aim for higher returns and act accordingly.
- Low Fees: When it comes to fees, equity investments have cheaper fees. Instead of paying monthly fees, investors get to pay a single annual fee to maintain their share in the asset. The fee is calculated as a percentage of the capital invested and usually is around 1-2%.
- Longer Waiting Periods: Waiting times in equity investments can go up to 5 or even 10 years and it is an important aspect to consider when you want to take part in equity investments.
- Higher Risks: Since equity crowdfunding allows investors to earn more, it naturally means that investors are taking bigger risks. When it comes to receiving their returns, investors are in second place and if the property doesn’t perform as expected, they are the first ones to lose.
How Revenue is Paid
Equity distributions are paid via the NOI (net operating income) which is the cash flow generated by the tenant leases subtracted from the debt services and operating expenses.
In some cases, equity returns can be wholly or partially conditional on a liquid event such as a partial sale, sale, or refinancing of the property.
Therefore, an IRR (Internal Rate of Return) is used to evaluate the success and provide a comparable yearly metric. Different metrics such as an equity multiple—the total cash distributions received from an investment—or a cash-on-cash return, a calculation of cash income earned on the cash invested (source: Investopedia), can be used to evaluate the investment’s performance.
Learning to Think Like an Investor
In order to complete a successful investment project, you need to shift your mindset and learn how to think like an investor.
Mindset is highly important when it comes to business and it requires training. The first thing you need to do is to change your thinking and be more positive. Most people think about the negative possibilities and linger on this thought: “what if it goes wrong.” Having such negative thoughts will prevent you from taking chances and risks which will eventually stop you from embarking on your journey to success.
Got a rental home or a couple that you’d like to use to start building a passive income that will get you the life you’ve been dreaming of? Investing is a key way to develop wealth, but learning to change your mindset and embarking on your journey in real estate is rarely easy. It’s very normal if you don’t know where to begin. Join me in my