Get In on a Real Estate Equity Investment — Here’s How
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.
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:
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 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.
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:
For Limited Members:
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.
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.