You may have heard or seen a lot in the news recently about real estate equity and debt funds but what are they and what are the differences?
Private Real Estate Funds
Both are types of Private Real Estate Funds. Private real estate funds don't show up on the NYSE or Nasdaq even though they are professionally managed. You have to know someone that knows someone, or go looking for them. In the past they were geared more toward the ultra-wealthy. Family’s with a net worth of $25,000,000 or more. Improvements in regulation have made it easier for smaller fund companies to attract investors. (Yieldstreet).
In general the way that both types of funds work is very similar. They both find potential real estate investments. They both raise money, and they both share the returns of that investment with the people or entities they raised money from. But there are a lot of differences between private real estate equity funds and private real estate debt funds.
Private Real Estate Equity Funds: Real Estate Ownership
Real Estate equity funds invest in focus on real estate ownership. That's the name of the game for the equity fund.
A general partner will take responsibility for raising capital for specific real estate projects that they see the potential in. They use the capital for down payments, renovations, full acquisition etc. of one or many properties. Once the acquisition piece is completed the fund will hold the property until the timing is right. Whether that’s after a certain amount of appreciation or changes in cash flow is up to the general partner. When the timing is right the fund will sell the property.
Private Equity funds tend to hold properties that could be described as mid-long term. 3-10 years is not unheard of. Sometimes this means a higher yield. At least that's the idea. Investors' capital is fairly illiquid due to the nature of this timeframe. While funds may choose to use rent or other property income to create dividend payments during that time cash flow can be unpredictable at times. Occupancy, leases, renovations, maintenance costs can all be factors when it comes to a properties cash flow. Which then affect investors’ returns.
When choosing a private real estate equity fund its important to consider those factors. Investors should be prepared to enter into an investment vehicle that’s fairly illiquid.
Private Real Estate Debt Funds: Real Estate Lending
This is the converse to a real estate equity fund. While equity funds focus on equity debt funds focus on debt or notes.
A general partner or managing partner raises capital to be used for real estate lending in a debt fund. Capital raised is used as a funding source alternative to traditional lending from a bank. Real estate owners, buyers that fix and flip homes, even developers are common places where capital raised inside these funds can be used.
Most of the time these funds are used as short-term debt solutions. 90 days to 18 months time frames. Annual interest rates, origination points and fees, even construction cost draws are all built-in to notes generally secured by some form of collateral. Most of the time this collateral is the property in question, but can be a related property or other personal collateral.
While some may see Private Equity fund income as inconsistent at times or even volatile private debt funds can offer a more secure form of income. Annual interest rates and pay-back time frames are agreed between borrower and lender and provide a more consistent form of income for a debt fund. This in turn could be used to create dividend payments for investors.
Debt funds that focus on short-term lending offer more liquidity than many equity funds. Short note terms would mean that fund capital is returned rather quickly from a borrower. Capital being returned to a fund within short time periods allows more liquidity of funds for the fund’s investors.
One of the bigger advantages that a debt fund has over a debt fund is the order in which a debt falls with-in a properties capital stack. If you have never heard of a capital stack you can think of it as a list on which the higher priorities are paid first. Debt comes before equity on that list. So the bank, or private debt fund will always get paid back before the property owner, or equity holder of a property.
While a debt fund may sound like the obvious choice over an equity fund it’s important to note two important issues debt funds might face: 1) Debt funds returns may not be as high compared to a similarly sized equity fund project, and 2) A borrower of the fund could default resulting in the funds ownership of a property that would require the fund to need to manage. The argument can certainly be made though that debt funds while they might not have as high of returns could definitely create a more stable return over time. Proper underwriting and due diligence can aid drastically in a fund’s default rate.
Real Estate Equity or Debt Funds?
“Investors who want consistent, dependable passive income might find private real estate debt funds are an interesting choice.” (R.C.).
When choosing real estate equity or debt funds there are a lot of things to consider:
- What are you financial goals?
- Are you looking for long-term or short-term investments?
- Is consistency or potential return more important to you?
It’s important to work with a professional that understands your financial situation and goals.
To learn more about Providence Lending Fund, visit their website.
Sources:
Yieldstreet (2023, February 22). Rules 506(c) and 506(b) Explained for Investors. Yieldstreet.com. Retrieved September 6, 2023, from https://www.yieldstreet.com/blog/article/506c-vs-506b/
R. C. (2023, May 2). Private Real Estate Funds: Understanding the Difference Between Debt and Equity. Dmagazine.com. Retrieved September 6, 2023, from https://www.dmagazine.com/sponsored/2023/05/private-real-estate-funds-understanding-the-difference-between-debt-and-equity/#:~:text=While%20private%20real%20estate%20equity,lending%20source%20to%20a%20bank.
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Real Estate: Debt Funds VS Equity Funds