Debt vs. Equity:
In real estate financing world the debt method or debt financing refers to the lending process in which the development firm takes out a loan from a capital source to collect the funds needed for their targeted construction project. This makes the developer a borrower, while the capital source that issues the loan is referred to as the lender.
Lenders can have no claim to the profit that the development firm makes. The only return that concerns the lender side is the interest which the original financing agreement states. However, the interest rate, stated in the loan agreement, forms the key advantage for the lender in this relatively more straightforward methodology. Repayment of the loan is not tied to the success of the targeted project. It has to be repaid no matter what, and this is one of the most important advantages of the debt methodology from the lenders’ perspective.
In the equity methodology, the development firm, that is the sponsor/owner of the project, gives investors shares in their company’s ownership in exchange for capital. There are no documented promise made for the repayment of the investment unlike the way in which loan arrangements function.
In this method, the investors expect to earn an acceptable profit by the end of the targeted project, which would justify the risk taken during the investment period. Therefore the investor makes money in the form of a return-on-investment instead of an interest rate.
From the developer’s point-of-view, equity financing means issuing shares to an investor. Equity investors become owners of the company. This maybe a considered a potential advantage since they would be making more profit in the future in case the company further prospers in the aftermath of the initially targeted project. However, unlike the borrowers in the debt methodology, the business owners in an equity deal are usually not required to pay back their investors in case their project fails to make a profit. This also enables them to utilize the working capital freely as there are no monthly loan payments.
Debt methodology, on the other hand, comes with strict conditions and a specified date for the payment of the loan. Failure to meet these requirements result in severe consequences. This certainty should be considered an advantage for investors who collectively become lenders in a debt deal.
Comparing the two models, equity crowdfunding offers higher returns and much higher risk as a result. Equity crowdfunding platforms tend to be aimed at entry level investors with limited financial knowledge without a clear understanding of the subscription documents or risks involved. The majority of the equity crowdfunding deals set aside a significant portion of the collected capital for the down-payment the developer/borrower would make for the purchase of the property of their targeted project – that is, in most cases, a residential “fix-and-flip” project. Their goal is to re-sell that subject matter estate as quickly as possible, or get in refinanced if possible. The crowdfunding space is currently full of these type of equity deals, which are typically highly leveraged with first-trust-deed financing. On the contrary, collective lending, based on the debt methodology, provides much more predictable and higher returns with much lower risks.
A form of financing that is facilitated through a pool to fulfill a borrower’s financial request at an agreed upon sum for a specific rate. By getting a loan from a collecting lending fund, the borrower obtains the necessary amount of capital much faster and easier than in the case of traditional financing. In return, this method allows the lender to receive much higher returns in comparison to what investment instruments offered by banking institutions would provide.
In collective lending through debt methodology, the investors, instead of owning a stake in the construction project itself, they own units of membership interests in a single asset limited liability company, (LLC) that lends construction capital to the developer of the targeted project. The funds collected in the LLC are backed by a commercial real estate loan that is secured by a first position security interest in the property of the project. A debt loan is very different than an equity investment. It’s a specific amount of money repaid over a defined term by executed contacts underwritten by legal and real estate finance experts. Investors earn a return via an interest payable on the loan.
The SEC defines accredited investors as a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1million at the time of the purchase, excluding the value of the primary residence of such person; or a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
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