Debt vs. Equity: Striking the Right Balance in Commercial Real Estate Investments

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As the commercial real estate market evolves, investors have to continually reevaluate their financing options. Borrowing has become more expensive. Underwriting has become more rigorous. And investors who might pony up some capital in return for equity have come to expect high returns and even higher ceilings. 

Commercial real estate investors have much more at stake than a homeowner deciding whether to hire a real estate broker or what neighborhood to buy in. That 40% equity stake you offered for a little operating capital could be worth millions in just a few years. Let’s touch on the differences between equity and debt and how to choose the best financing option.

The Basics of Debt and Equity Financing

A commercial real estate investment’s “capital stack” (the capital used to finance the purchase) generally consists of debt and equity. For example, if you’re targeting a multifamily commercial property that costs $10 million, you could be looking at 60% debt financing and 40% equity financing. So, what are the primary differences between the two types of financing?

Simply put, debt is money that’s borrowed and will need to be paid back, plus interest. The advantages of debt are pretty straightforward: financing an investment via debt means you’re still in complete control as long as you make your payments. Your lender has no power over you or your investments, and your payments are predictable and locked in. 

That’s not to say that debt financing doesn’t come with some clear risks. If you encounter financial adversity or broader economic headwinds, you could have trouble making your payments. And if you secured your loan with personal assets, you could lose those assets.

Even if you continue to make your debt payments on time, taking on debt changes your debt-to-equity ratio, restricting your ability to access more borrowing in the future. Debt payments are also a fixed cost that can consume a significant part of your ongoing cash flow, limiting your ability to expand or otherwise invest in your business.

Typical sources of debt financing are Small Business Association (SBA) loans, conventional business loans, bridge loans, business lines of credit or credit cards, or personal loans. 

Equity financing, on the other hand, doesn’t need to be paid back. In this scenario, you sell a chunk of your business or investment for cash. For example, you could sell a 5% interest in your business in exchange for the capital you need — but you’re also giving up some control over your business. That 5% stakeholder is now your partner, and they have the right to give input and direction on future business developments. While you could buy them out in the future, you’ll almost certainly have to pay a premium well above what you received when you sold the equity.

However, if you opt for equity financing, your cash flow is unrestricted since you don’t have any debt payments to make. And your debt-to-equity ratio is likely still low enough that you can access future debt financing if necessary. 

Typical equity financing sources are venture capital firms, crowdfunding platforms, high-net-worth angel investors, or initial public offerings (IPOs).

Debt vs. Equity: Where the Risk Falls

These two types of financing offer different risk-benefit profiles.

Debt financing is relatively low-risk. Debt holders enjoy regular, predictable payments and returns, and their investment is secured. Their debt also has a high priority for repayment, and debt holders can initiate foreclosure if payments aren’t made. Like most low-risk investments, however, returns are equally low — usually ranging from 4% on the low end up to 8%, and once the debt is repaid, the relationship is dissolved.

Equity financing has a little more risk for the capital provider since they’re essentially betting on the property’s future — that it’s something like the next Facebook and their stake will grow significantly. While equity investors have ownership stakes in the company, they’re still somewhat exposed since they can’t initiate foreclosure. Consequently, they generally receive higher returns of 10% or more and stand to make massive profits if the investment appreciates exponentially.

Weighing the Pros and Cons

If this all sounds like a tough decision, you’re right — and the decision between debt and equity financing heavily depends on your unique circumstances and expectations. But a survey of each option’s positives and negatives can clarify which is best for you.

Debt Financing Pros

Maintain ownership. Financing your commercial real estate investment through borrowing means you preserve full control instead of becoming beholden to partners. And when you sell, you don’t have to share the profits.

Potentially affordable interest rates. Although current interest rates are on the high end, historically, they could still be cheaper than equity, depending on how your equity is valued. If you’re shopping for a loan, you’ll want to shop around for the lowest interest rate, much like a home seller shops for an agent offering the lowest real estate commission.

Tax advantages. One lesser-known positive of debt financing is that the interest you pay is fully tax-deductible.

Debt Financing Cons

Approval can be difficult. Getting approved for a loan can be challenging if you don’t have a pristine credit score or can’t make the desired guarantees.

Interest and penalties. Interest rates in 2024 are relatively high, which makes borrowing very expensive. In addition, you could be charged significant prepayment penalties for paying back your loan faster than scheduled.

Concentrated risk. If you don’t take on partners, you stand to keep all the profits — but you’re also taking on all the risk.

Equity Financing Pros

Easier approval. Seeking equity financing means you won’t have to go through the potentially grueling loan approval process.

Free cash flow. Your cash flow stays completely unrestricted since you won’t be making debt payments.

Expertise sharing. While many experts focus on the downsides of taking on partners, there are also potential benefits. For example, some equity investors bring valuable expertise to the company and can help you level up.

Equity Financing Cons

Loss of autonomy. Selling a stake in your investment means giving up some control over its future and how it’s governed.

Requires salesmanship. Getting approved for a loan is a fairly straightforward and objective process while convincing an angel investor to take on a stake in your investment can require persuasion and hard selling.

Less profit on the other side. If your investment increases in value exponentially, you could lose out on the profits you would owe your equity partner.

The Bottom Line

In the end, deciding between debt and equity financing is going to depend on your specific circumstances. Can you qualify for a loan? Do you have an appetite for risk? Do you want to take on partners, and can you collaborate? What is your projected cash flow? The answers to these questions — and many others — will determine which type of financing is best for you. 

When you’re ready to act on your next investment, find the best property for you on Crexi.

Headshot of blog author Ben Mizes

Ben Mizes is the Co-Founder and CEO at Clever Real Estate, the nation’s leading real estate education platform for home buyers, sellers, and investors.

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