Debt and Equity: What’s the Difference?

With low-interest rate from the bank and high volatility in the stock market, many investors are seeking opportunities to achieve higher risk-adjusted returns than what their traditional investment options may offer. Here are three typical investment alternatives most investors consider.

Debt

When an investor participates in a debt offering, it means that the investor becomes a lender on the property (or properties) through a subsidiary.

The borrower of the loan that the investors provide is the property owner. Any payments to the investors are made in fixed installments. Because a debt investment is secured by a lien on the property, in the case of non-payment by the borrower, the investors may initiate legal action to take possession of the collateral to recover their investment.

Preferred Equity

When an investor participates in a preferred equity offering, it means that generally the investor purchases interests in a specially-formed limited liability company (LLC).

Preferred equity is akin to mezzanine debt. The overall return rate is divided into “current” (payable monthly) and “accrued” (payable at maturity) portions. However, when the investment involves only “current” returns (and no accrued portion), a different structure is used that is similar to the debt investments.

This presents increased risk compared to the debt offerings which have a lien on the property and seniority over preferred equity. Returns are risk adjusted and so preferred equity investors tend to demand a higher return on their invested capital than debt investors.

Common Equity

When an investor participates in a common equity offering, it means the investor becomes a shareholder in the ownership of the property.

There may also be a third-party lender on the property whose debt interest is senior to the equity. The most senior interest stakeholders get priority in the return of their investment. Common equity investing tends to be the riskiest of our three types of offerings because it is unsecured and subordinate to both debt and preferred equity investments. Consequently, common equity investors often demand a higher return on their invested capital than debt and preferred equity investors.

In the end, whatever investments you choose depends on your goal of returns and comfort level with risk. Each deal is special, as an investor you should go over the terms and details of each specific deal and pick the one that fits the best for your investment strategy.