Investment Consideration 1: Capital Stack
What is the Capital Stack? I can promise that no where in any investment documents will you see which side of the capital stack your investing in. Whether this is intentional or lack of clarity from the investment offering being offered, its rarely detailed. How can sophisticated investors understand then which side they are investing on, and why is it so important to understand which side your investment will be on? This will be my first ina. series of 5 emails discussing details about investments and what you need to know to make wiser, more informed investing decisions.
What is the Capital Stack: Equity vs Debt
The Capital Stack can also be described as the KEY component of an investor's “Risk Profile.” As an investor you intrinsically understand that the higher the risks = higher returns, and the lower the risk = lower returns. Since I am a believer in investors diversifying their portfolio into real estate and real estate has the unique advantage of clearly providing both sides of the capital stack to investors; let’s examine the capital stack in real estate investments.
Capital Stack: Equity
Equity is the most commonly understood side of the capital stack, even if an investor is not aware of this. You could technically break down equity into investor-provided and appreciation. Investor-provided equity is the downpayment or any capital that the investor has put into a project. This capital can be their own (preferred) or capital raised through an offering or a joint venture. If the investor has raised the capital or brought on via joint venture, just know that it's not their own personal capital but other investors' capital, typically called an “LP” or limited partner capital. Appreciation "equity” is not true equity because it’s determined by the market. In an upmarket, like what FL and TX have experienced in recent years, this is due to property values increasing. However, in a down market appreciation, equity is the first to vanish.
Capital Stack: Debt
Debt is also very well known by every investor. Most investors see debt as a way to leverage their existing equity. For example, if an investor has $1,000,000 in equity, they could generally leverage that equity 4x. So, in this case, someone could get a loan for $4,000,000, put down their $1M, and buy a $5M property. Simplistic, but the point is made. Debt is secured, equity is NOT. Equity is “Backed” by the underlying real estate, but equity is not secured. If you, as a real estate investor who is using their capital on the equity side of the capital stack, buy a property, you are still beholden to the terms and requirements of the debt investor. Most investors understand that Debt comes from banks and financial institutions. The debt investor controls the asset and shifts all risks to the equity investor. The equity investor is responsible for maintenance, taxes, insurance, and market fluctuations. However, equity investors receive appreciation for the asset the longer they hold it. The debt investor receives dependable and regular interest payments and, if structured properly, can actually reduce their risk exposure the longer they hold their asset, the loan.
Can Investors invest in either Debt or Equity?
YES! Absolutely. As a matter of fact, many real estate investors have a plan where, after a certain period of time, portfolio growth and available capital want to shift from equity investments to debt investments. In the world of real estate, when an investor moves from equity to debt, this shift in roles gives them the label of a private lender. The investor begins to take the role of the debt investor and begins thinking, analyzing, and investing like a banker by making loans secured to real estate. Honestly, it's very hard to invest in debt in any market other than the hard and tangible markets (which I will discuss in the next category, “Investment Markets”). Equity investments are numerous and plentiful. Talk to any real estate broker, and you can find opportunities to invest in equity. Suppose you know of a syndicator or an active real estate investor. In that case, you can partner with them and provide them with equitable capital for them to get started on a project and enjoy the benefits of equity investing from a more… passive role. However, investing in debt can be difficult. There has not historically been an “open” market. Now, with the advent of crowdfunding websites, this has become more available; however, the amount of control you have over which investments your capital is secured is rare and hard to determine. Also, the capital requirements to invest in debt are typically much higher than equity investments. Let’s take the previous example where you had $1M investable cash. If you invest in Debt, you can make only $1M in loans, but if you invest in equity, you can own up to a $5M property or even more when taking into consideration market and forced appreciation.
What are the risks of Debt & Equity Investing?
This is where we can really get in the weeds. I will disclose that I am not a financial advisor, nor do I play one on TV. I’ll do my best to describe the high-level risks, but at the end of the day, it is incumbent upon the investor to fully understand the risks of any investment that they choose to make. In this section, I dive into the risks of equity and debt. You will notice that I address the same primary topics from each side of the capital stack.
DEBT RISKS
No Active Control: As a debt investor someone else owns the asset. This means that they have 100% decision-making authority. You have never seen a banker show up at your house and ask why your paint the property a certain color right?
Passive Protections: While you cannot force the borrower to place adequate insurance or make pay their taxes, you can make it a default event where if the borrower has not adequately protected you or paid their taxes, you can foreclose.
Market Shifts: Market shifts can and will happen. If you have not made a well-risk mitigated loan, you could find that your loan is worth more than the property.
Assumption of Incomplete Projects: In the case of a foreclosure where the lender takes an asset from the borrower due to default, the lender may have an unfinished project. During this stage in the project, property values may be below the disbursed funding to date. A lender needs to have a team in place at the location of the asset to take over the project so that they can finish the property, or they may have to auction the property off at a potential loss of principal.
EQUITY RISKS
Debt is Called: The greatest risk (IMO) is that the lender may call the debt an equity investor places on an asset. This means that the lender requires the loan to be paid off, or they foreclose. Foreclosure is a complete wiping out of the borrower's equitable position and a black stain on their credit. It is completely unfavorable and damaging to the goal of building a portfolio.
Market Shifts: Just as in Debt market shifts will happen, but adding leverage on a deal can exacerbate the issue. Equity Investors should absolutely be keeping their ear to the proverbial “market floor” to get a sense of where the market is headed and be able to pivot when necessary.
Passive Protections: In most cases, the Debt position holder will require insurance and enough of it. Also, taxes must be paid. If neither of these is completed, then the equity investor runs the risk of defaulting on the Debt investor's requirements (i.e., Mortgage) or the government stepping in and forcing the sale of the asset to another investor.
What are the Advantages of Debt & Equity Investing?
Now that we have covered some of the general-level risks let’s examine the advantages of each side of the capital stack. The next two sections simply examine the high-level advantages and disadvantages. These items may not be an issue for you, depending upon the desired outcome or the risk tolerances you have for your portfolio. Let's say you are a young professional making a low-end to mid-level six-figure salary every year, and you're willing to take extraordinary risks so that your portfolio can grow significantly on your way to retirement. It would make sense that you focus a higher portion of your investment on equity (across all three primary markets). As you approach retirement, you may desire much lower-risk investments that are secured and in a much safer position, so you seek out debt investments. By the way, if your financial advisor/ planner is suggesting that you move over your “higher-risk” stock investments into dividend-paying stock or Bonds, you should absolutely be aware that only one of these “market” available investments is a debt, yet it’s not a secured to its more like debt collateralized by the faith in the American public and way of life. So, I’ll leave it up to you to decide whether investing in THAT type of debt is actually a secure way to invest.
DEBT ADVANTAGES
Control: When investing in debt, the investor controls the asset by means of a security instrument, a mortgage, or a deed of trust. The borrower assumes responsibility and liability for the property.
Mitigate & Shift Risks: A debt investor controls how much risk they assume as a lender. If they perceive more risks, they can reduce their risks as lenders by requiring more insurance, more downpayment, and more capital from the borrower of their loan.
Professional Services Paid For: There is no other investment method where someone else pays for all the professional services needed to keep your investment safe. When investing in debt the borrower pays for your attorney, your lender’s title policy, property insurance, taxes, inspections, appraisals, and realtor costs.
Cashflow: Debt cashflow is one of the best cashflowing vehicles. There are no complicated and variable calculations; it’s simply an annual rate on your loan amount, paid out whenever you say it should be paid. Debt cash flow is superior to all other cashflowing assets.
Dependable: Due to the security instrument, the mortgage, or the deed of trust, the lender is due periodic payments whenever they decide, monthly, quarterly, bi-annually, or even annually. If the borrower does not make their payment, the loan is in default, and the lender can take the asset from the borrower through foreclosure.
Law is on Your Side: When you invest in debt, you are playing on the side of the real estate game that banks play. And the laws of the land protect a secured lender more than any other asset class or investment method.
Deal Flow: There are more debt investment opportunities that arise because more real estate investors are looking for leverage (debt) than they are looking to give up their equity. Therefore, there are more opportunities to deploy capital into debt than equity.
EQUITY ADVANTAGES
Ownership: It’s your asset; your control. This is one of the huge benefits of ownership, the project, your plans are in your hands.
Capture Appreciation/ Depreciation: When you invest in equity, you are able to capture and participate in aspects of real estate investing that are unique to equity. Not only the appreciation of the asset but also depreciation. Depreciation is unique to the Hard/ Tangible Asset Markets.
Insurance: Unlike other markets, the asset classes of real estate allow a unique advantage, such as the ability to purchase insurance to protect your investment. If using leverage (debt) your lender may require this.
Cashflow: While cashflow for equitable investments in RE are often touted as a reason to invest in equity, equitable cashflow is not the best cashflow, yet it is still cashflow. So we will list it as a benefit.
Higher Returns: For the risks that you are taking to invest your capital in the equity position of the capital stack, your returns are rewarded accordingly. Most equitable investments in equity can generate a 25 - 50% yield.
Bar to Entry: Because investing in equity requires a lot less cash, more investors are able to invest in equity deals, than in debt deals. If you have $50,000 then that amount can easily be deployed into equity across a lot of different asset classes, and sub assets.
Taxes: Due to the nature of taxes, equity is taxed at a higher rate when realized (called “Capital Gains”) than debt income. However, with equity investments, there are many tax loopholes that investors can take advantage of that can defer and even eliminate owed taxes, such as the DST “Delaware Statutory Trusts”, 1031 & 721 Exchanges, Spend Thrift Trust, among a whole list of other tax-advantaged vehicles. It is wise to speak with your CPA about which vehicle is best suited to build, protect, and preserve your family’s generational wealth.
What are the Disadvantages of Debt & Equity Investing?
Let’s look at some of the Debt and Equity disadvantages. These will more than likely feed off each other, so it really polarizes how someone chooses to invest based on these disadvantages as well as the advantages section. Be sure you have your intended outcome clearly laid out and your expectations as far as risks and targeted returns. You do NOT want to be investing in high-risk investments with capital that is earmarked for low risks. Nor do you want to be investing your capital where you are expecting growth and high returns into a low-risk structure.
DEBT DISADVANTAGES
Lower Returns: Due to the incredible risk mitigation measures you can enforce on a borrower, this relates to a lower return than being on the equity side of the capital stack. Solid returns for a well-risk-mitigated loan can range from 6 - 10% annualized return.
No Appreciation Participation: Unfortunately, as a debt investor, you are not able to participate in the appreciation of an asset, whether forced or market. This is primarily due to the number of risks involved and the structure of becoming a lender. Only the owner of a property can enjoy the benefits of appreciation.
Depreciation Participation: Like the appreciation issue, lenders cannot enjoy the benefits of depreciation. The owner of the assets can take advantage of depreciation and spread it out over many years or hyper-depreciate the asset in a very short amount of time. A lender is not able to capture any depreciation, whether realized or paper.
Bar to Entry: Becoming a lender typically has a high bar to entry, meaning, in today’s economy, its near impossible to find a loan for $50,000. If you are considering investing in debt, then you will need a large reserve of liquid capital or join a debt fund that offers secured loans for a fractional amount, like Blue Bay Fund I.
Taxes: Alas, interest income is taxed as ordinary income. If you are a high-income earner and you then make a loan, that interest income will be taxed at your income bracket. The best way to offset this tax is by ensuring your investment capital is originating from a tax advantaged account, such as a ROTH IRA, ROTH SDIRA, or a ROTH 401K.
EQUITY DISADVANTAGES
Costs: The biggest disadvantage to equity investing is that the costs of that asset lie squarely on the shoulders of the owner. These costs can quickly eat into your cash flow and even your profit. These costs can include but not be limited to; closing costs to buy the asset, holding costs (paying for the debt), taxes, insurance, construction costs, maintenance, property management, property operational costs (typically in the commercial or multifamily asset classes), tenant turn over, and loss of rents from market changes.
Control: While equity owners OWN the asset they do not control the asset unless paid for with 100% cash. If the owner of an asset uses leverage, then the lender controls the asset by way of the mortgage or the deed of trust. Whatever the lender requires, the borrower must pay for and accomplish to gain access to the debt investor capi’s capital.
Deal Flow: Investing in equity can be challenging, especially if you are waiting for syndications to open up. Not so much on the single-family investments, but definitely if you want to invest in a commercial or multifamily property. This presents a unique challenge to equity investors called the “Time Costs of Capital”, where your investment is sitting in an account ready to be deployed into a deal. The longer your capital sits in an account, the lower your annualized return becomes.
Assumption of Liability & Responsibility: As an equity investor, you now own the property. You also have to deal with the 3 T’s: Termites, Tenants, and Toilets. You must also deal with the potential of lawsuits, construction issues, taxes, insurance, and local and state laws that may make investing in equity sour, such as New York or California rent caps and landlord laws.
Market Volatility: While the market can affect debt positions, it will drastically affect equity positions. Equity is always the first capital in the capital stack that will evaporate in a down market; first market appreciation equity, then forced equity, and then owners equity (borrowers cash into the deal). The last to be affected is the debt position.
I trust this article has been tremendously valuable and opened your eyes to a better understanding of both sides of the Capital Stack. My Investor Club Inner Circle offers capital investors unique and unheard-of investment opportunities. We offer investors the ability to CHOOSE whether they want to invest in debt or equity: 100% their decision, 100% their timing, 100% their control over returns and risks. If you are interested in learning more about my Investor Club and my Inner Circle, you can sign up below or schedule a call with me below. Here's to you and your success as you build, protect, and preserve your family’s generational wealth.
With Honor,
Edwin D. Epperson III,
Manager & CEO
