Commercial Real Estate Debt vs. Equity Financing – Advantages and Disadvantages.
The commercial real estate market continues to grow at a healthy pace, but market trends show investors are pushing for higher yields while underwriting is growing more aggressive. Within an evolving CRE landscape, it’s critical to choose wisely and know when to implement debt versus equity financing in your real estate investing activities.
Debt financing is when you as an owner/investor borrow to finance the purchase of a property. Commercial real estate financing via debt is essentially a mortgage instrument, although quite unlike one you’d get to purchase a residence.
Some forms of debt financing are:
- Acquisition financing – It may be used to purchase a commercial multi-family or retai property or hotel, etc. (also called permanent financing.)
- SBA loan – The Small Business Administration writes real property loans sometimes in concert with a bank loan (504 loan) or a government-only loan (7A).
- Private lender – This form of debt is advantageous because it can be fast to obtain, there are no set requirements, and fewer fees.
- Bridge loan – From a private equity company, this is a short-term loan you can get while working on longer-term financing options.
- Mezzanine financing – This is a blended finance option where the debt can be converted to equity under certain circumstances.
Advantages of Debt Financing
- Ownership – By borrowing to finance the property purchase, you’ll remain in control.
- Tax advantages – Interest paid on the debt is tax deductible and lowers IRS liability.
- Lower interest rate – Interest rate is fixed and may be cheaper than paying out on equity.
- Reap rewards – Since you maintain ownership, when you sell or refinance, the profit is yours.
Disadvantages of Debt Financing
- Risk – When you finance with debt, you assume the financial risk for the project.
- Prepayment penalty – You may get hit with fees if you want to pay back the loan ahead of schedule.
- Creditworthiness – There’s a higher standard for approval including credit score, asset history, and personal guarantee.
- Documentation – You must provide extensive proof of liquidity and net worth including tax returns, financial statements, and more.
Equity financing is an arrangement between the CRE owner/investor and investors that contribute cash towards the purchase of the property in exchange for equity share in the property. Equity financing can be 100% or just a portion of the financing if you combine it with debt financing or your own funds.
Advantages of Equity Financing
- Less risk – You won’t have to include a personal guarantee and can see a higher rate of return.
- Capital contributions – Equity funds bring more flexibility, liquidity, and possibly greater ROI.
- Cash flow – Unlike with debt, equity financing requires no monthly repayment obligation.
- Non-cash benefits – Your equity partners can bring a wealth of knowledge and experience to the project.
Disadvantages of Equity Financing
- Accountability – You are answerable to your investors, and this can be a hassle and a potential source of conflict.
- Loss of control – You may have to modify your plans based on investor demands as you are no longer 100% in control.
- Vetting – Potential equity partners want to know about you, will need to see your resume, and learn about your experience.
- Profit sharing – You may not realize as much profit as you could with debt financing.
How Do You Decide How Much Equity to Share with Partners?
When considering equity financing arrangements, the critical issue is how much to share with your investors. You must balance your needs and risk tolerance with the available funds and risk tolerance of each potential investor.
If you are risk-averse and would rather leverage other people’s money than commit your own or tether yourself to a debt arrangement, you may have to give up a bigger percentage to get the funds you need for the project.
There’s no ideal equity split. Instead, it will depend on the nature of the project, how much risk you want, how much your investors will agree to, and how many investors you’re considering for the project if you’re looking at more than one equity partner.
How Do You Decide Which is Best For You?
For long-term investments, equity is less desirable. Equity investors want their ROI, and if you hold a property long-term, the delayed realization is likely unacceptable. For short-term investments, equity may be better than debt. The investor realizes their ROI quickly while you have less risk. In some cases, a blend of debt and equity might be the ideal approach.
When determining whether to use debt versus equity, or a blend of both, for financing your next property purchase, ask yourself the following:
- Do you have creditworthiness issues?
- Are you prepared to share the profit?
- Would you prefer to make monthly debt payments?
- Are you comfortable sharing control of the project with partners?
- How do you feel about building a lasting business relationship with an equity partner?
When you’re ready to explore debt & equity financing and creative capital solution for your next Commercial Real Estate venture, talk to Black Collie Capital.