Lending money to someone to buy a piece of real estate can be a complicated transaction. Investing in real estate directly is even more complicated. There are also differences in the legal rights, financial rewards and economic risks of each type of investment. Understanding them is an important step in deciding the best type of investment approach for any situation.
The Lender and Equity Investor Standing in Line
A simple analogy can be very useful in defining the differences in lending and ownership in the context of real estate. Think of everyone involved in a real estate transaction as standing in a long line in front of a window marked “Investment Return”. This window is on the building acquired through the real estate transaction and what is distributed from the window is the economic returns associated with the building.
First in the line are the lenders who lent money into the transaction. They are holding their debt instruments in their hands and expect to receive the interest and principal payments specified in those documents. There might be preferred and subordinated lenders in line with all the preferred lenders in line before the subordinate.
Standing in line behind all the lenders are the equity investors in the building. They also have their ownership interests in their hands and have expectations of what they will receive. Again, there may be different classes of equity owners with different types of ownership interests, but they are all standing in line behind the lenders.
Things Went Bad During the Real Estate Transaction
The first scenario to consider is what everyone receives if the transaction does not live up to expectations. Perhaps tenants could not be found to rent space in the building, or a buyer could not be found who would offer the anticipated sale price after the building was renovated.
The lenders approach the window and present their debt instruments. The window redeems the instruments according to the terms, assuming there is enough value in the building to do so. Every lender standing in line receives their share of the building value up to the value on the debt instrument. They walk away with what they expected to receive.
After the last lender has been paid, the first equity investor approaches the window. There may, or may not be, anything left for them. What is available after all the lenders have been paid may or may not be what the equity investors paid for their ownership interests. If there is not enough money at the window to give them what they paid, the equity investors take the loss.
Things Went Well For the Real Estate Investment
The second scenario to consider is what everyone receives if things live up to or exceed expectations. Again, the two groups are standing in line in the same order with their respective financial instruments in their hands. The lenders approach the window first.
Again, the window redeems these instruments according to the terms. The lenders see a huge pile of money at the window, but they don’t get any of it. Instead, they walk away with what they expected to receive.
The equity investors approach the window and receive their share of the money left over, again according to the terms of their ownership interests. They could each get an even cut of the pile of money. Since things went well, they certainly get more than they paid for their ownership interests.
The Lender and Equity Investor At the Bar Later
The lenders and owners meet at a bar later that evening. Regardless of how the real estate investment turned out – again, assuming there was at least enough value to repay the lenders – the lenders are a happy bunch. They got what they expected from the transaction.
The equity owners may or may not be so happy. They may have much more to show for the day than the lenders, or they may not even have what they put into the deal. Bearing the economic risk gives owners the right to the economic rewards in a capitalistic system of investing.
This is why knowing and evaluating the risks of a particular real estate transaction is so critical to deciding on if, or how, to participate. Sometimes the lenders walk away as the happy group. Other times the equity owners are buying the drinks for everyone.
This is also why it is critically important to diversify real estate investments. Unforeseen developments can derail the best plans, and owning several small interests in different properties lessens the economic risk. Of course, crowdfunding provides a great platform for assembling a properly evaluated real estate investment portfolio for either lenders or equity owners.