Two Forms of Real Estate Investment

Monopoly got it partially right.

There are two forms of real estate investment, equity (ownership) and debt (lending). Each way offers different benefits and risks for investors. Executing the right strategy at the right time or in the right way, can maximize returns for an investor.

Equity Investment

When most people think about real estate investing they think of ownership of property. There are certain rewards with equity investing and certain risks. There are three major benefits of being an equity investor: control, appreciation, and capital gains tax rates.

Control

The first benefit to being an equity investor is that of control. Because equity investors take ownership of the property, they control what goes on at the property. They can choose paint colors, tenants, repair schedules, contractors, and aspects of day-to-day management. These choices can greatly affect the value of a property over time. Good ownership can add value to a property comparative to other real estate investments around it.

Appreciation

The second  benefit equity investors reap is appreciation or growth in value of the property. Imagine a scenario where an investor buys a $350,000 property by putting $70,000 down and borrowing $280,000. In our scenarios the property appreciates to $400,000, their lender does not receive a gain from the increase in value. The owner receives the benefit of that appreciation and has grown their equity from $70,000 to $120,000.

Capital Gains Tax Treatment

The third benefit equity investors enjoy is capital gains tax treatment on appreciation for properties held longer than one year. If the value of the property goes up over time, the IRS has decided to tax this gain differently than earned income. Currently, the capital gains tax rate is lower than the earned income tax rate. As well, capital gains can be deferred by the use of a section 1031 exchange, allowing an equity investor to reap larger rewards over time.

There are risks to being an equity investor.

Equity investors are the first to suffer a loss if the value of the property falls. In our example above, the investor paid $350,000 and the bank loaned her $280,000. If the home decreases in value to $300,000, that loss is felt by the investor and not by her lender. She has suffered the first loss if she is forced to sell after a decline in value.

Variable returns are another risk that equity investors face. Cash flow for equity investors fluctuates with changes in rents, maintenance, and other expenses. An equity investor is not guaranteed a certain rate of return.

Debt Investment

The second way to invest in real estate is through loans or real estate notes.

The second investor in our scenario above is the lender or bank. The bank loaned money to the investor secured by her real estate. The lender takes a different type of risk, repayment risk.  The lender is taking a risk that the borrower can and will repay the loan.

The risks and benefits of a debt investor are almost the inverse of the equity investor. The benefits of being a debt investor are a consistent or fixed return and not being the first investor to lose money.

Fixed Return

Most debt investments offer a fixed return with little variation, essentially the interest rate. They lend their funds to the owner who pays them interest (or rent) in return for the use of the funds at a known interest rate. The interest rate is the minimum return that an investor should have on their investment.

Steady and regular income is a comfort to investors living off of the income received from these notes or debt. This is often a solid investment for retirees that need consistent income because they have ceased to earn an income.

Equity Cushion

The second benefit for the debt investor is the “cushion” from the owner’s equity in the purchase of a property. The cushion comes from the fact that most lenders do not lend 100% of the property value, the borrower must put cash down or have equity built up in the property to qualify for the loan. The equity cushion provides the debt investor with a level of comfort that not all of their investment will be lost should the borrower decide to stop repayment.

If the borrower fails to repay the loan, the lender will seek repayment through foreclosure and the sale of the real estate. Hopefully, the equity cushion will allow the debt investor to recoup all of their investment and the expenses of foreclosure. (This did not prove true in the last housing bubble and market crash.)

There are some negatives to being a debt investor in real estate, namely lack of control and being subject to ordinary income tax rates.

Lack of Control

A debt investor is generally not involved in the day-to-day activities of a property and does not have direct control over what happens to the property. They are not allowed to choose the paint color or the tenants at a property. They don’t choose who will do maintenance or how often it is done. This lack of control can mean that a property may suffer from a negligent owner threatening the owners ability to repay the loan.

Ordinary Income Tax

Because debt investors are passive investors by definition, the income they earn is subject to ordinary income tax rates. This can negatively impact after tax returns. However, some of this can be shielded by holding debt investments in tax deferral accounts such as a self-direct IRAs or in a 401k.

A savvy investor can use a combination of equity and debt to maximize their investment returns. Choosing one means of investment over another is dependent on each investors situation in life and their desired outcome.

Interested to know what form of investment might be more advantageous for you, then call or text Peter @ 925.385.8798 for further information.

photo credit: Park Place Expensive Real Estate Monopoly by PT Money