If you’re trying to raise money to invest in the growth of your real estate portfolio, two options that are available to you are debt financing and equity financing. Debt financing means to borrow a fixed amount that will be paid back with interest—similar to using a credit card or taking out a car loan—while equity financing is selling a percentage of ownership to an investor in exchange for their capital X. There are pros and cons to both, of course.
Depending on your situation and projections, it may be optimal to go with one option over the other.
Many would choose debt financing over equity financing. This is largely, if not primarily because this option keeps you in control of how the money is used. Besides the transactions you’ll make during the repayment period, the lender won’t have a commanding or lasting impact on your portfolio X. For the exception of variable rate loans, you are likely to reap a larger portion of the rewards than if you sold equity to investors in order to finance the growth X. Moreover, interest on the debt can be deducted from your taxes, effectively lowering the net cost of the loan. The beauty of it all is that your relationship with the lender is over after you’ve paid back your debt X.
Many others would choose equity financing over debt financing. Equity financing may come in various forms, including close partnerships, angel investors, crowdfunding platforms, venture capital firms, or even an initial public offering (IPO) X. Arguably the most appealing aspect of this option is that you get to distribute the financial risk among a larger group of people X. Not only do you not have to make repayments when you are not making a profit, but if the business venture fails, none of the money needs to be repaid X. Furthermore, you may get valuable business assistance that you otherwise would not have, depending on who your investors are X.
Specific to real estate investing, there is the additional option of preferred equity.
Preferred equity helps real estate developers finance a project with capital that is lower priority to the mortgage debt but higher priority to the remaining equity in the project X. In essence, when the property generates income from rent or profits from being is sold, preferred equity holders are paid immediately after the lenders, making the investment less risky X. Because investors with preferred equity in the portfolio are given preference relative to those with common equity in the distribution of cash flows, they are more incentivized to invest X.
Now that we’ve distinguished debt financing from equity financing in real estate, how do you choose between the two? Do the math! This is a lot easier said than done, but you must first project the performance of your investment property. Then you must calculate how the interest on the loan (annual rate times loan amount) compares to the dividends you would have to pay to investors (percent share times profit) X. This is an over simplification, of course, but projecting and calculating these figures would tell you which is more cost-effective and consequently more profitable!