Equity in Real Estate
Equity in real estate means the percentage of the property you actually own. If you have 100 percent equity in a property, that means you own it outright. There’s no mortgage involved. Equity is the difference between a property’s value minus debts on the property, such as mortgages or liens. For example, if a house’s fair market value is $500,000 and there is a $250,000 mortgage outstanding, the owner’s equity is $250,000.
What is equity in real estate, and how does it pertain to investing? It depends upon the type of real estate investing you’re engaged in. If you want to purchase a rental house, it is possible to use the equity in your primary residence to make the down payment. However, receiving approval for the use of a home equity line of credit (HELOC) on an investment property for improving the dwelling or purchasing another investment property is more difficult. Because you don’t live in that home, lenders find such loans riskier. A property owner is more likely to remain current on payments for the house they live in rather than one they rent out.
Home equity is measured by a Loan-to-Value (LTV) ratio. The LTV compares the mortgage to the property’s appraised value. If you make a higher down payment, you will have a lower LTV. If you want to use a HELOC from your primary residence to purchase a rental property, you must have at least 10 to 20 percent equity in your home.
When it comes to commercial real estate investing, equity is more complicated since more players are typically involved.
Preferred Equity in Real Estate
Preferred equity in real estate is an ownership class for commercial property. This interest is not secured by the property per se, but by stock shares in the entity owning the property. For example, a real estate syndicate wants to purchase a $100 million property. A bank will lend 70 percent of the purchase price, or $70 million. The investors must then raise the remaining $30 million.
Perhaps investors will come up with $20 million. That still leaves $10 million necessary to complete the deal. The syndicate may go the mezzanine financing route. This allows them to raise money for this particular project via a combination of equity financing and debt. It’s the equivalent of a second mortgage. The downside is that rates for such financing are high, and the funds must likely come from a bank.
The syndicate’s other alternative is seeking $10 million in preferred equity. For instance, the syndicate may sell that $10 million in preferred equity by offering an 8 to 12 percent annualized return on investment. Such a return attracts institutional investors or other real estate syndicates and brings in sufficient money to purchase the property.
The Capital Stack in Real Estate
In commercial real estate investing, the capital stack refers to the mixture of equity and debt in the transaction. Overall, it’s basically a commercial real estate deal’s underlying financial structure. There are layers to a capital stack, which include capital sources, repayment priorities and, in case of default, repayment rights.
The capital stack layer consists of the following:
- Common equity –Lowest repayment priority. However, common equity investment offers a high potential reward in return for higher risk levels. These investors receive shares of the recurring cash flow and own a piece of the property. While they receive a percentage of profits after the sale, it is only after those further down the stack receive payment.
- Preferred equity –Think of preferred equity investors as those holding a first mortgage with priority over those holding a second mortgage. It is as close to a guaranteed return as possible in commercial real estate investing.
- Mezzanine debt –Mezzanine debt is akin to the second mortgage holder. This debt is generally not secured by the real estate property. The interest rate paid to these holders is usually higher. Therofore, it has the highest repayment priority. Those holding mezzanine debt may receive a small percentage of the profits upon the sale of the property.
- Senior debt – This holds the lowest risk level. Furthermore, it sits at the bottom of the capital stack. Senior debt represents the underlying financing. And it’s usually provided by a bank or other lending institution. There is less risk because if the loan is not repaid, providers can initiate a foreclosure action and become the property owner.
The property’s income and debts are outlined in the capital stack. This format allows investors to analyze the project’s equity and debt structure, as well as overall risk.
With preferred equity, investors enjoy a fixed return from a secure investment. If you want to get into commercial real estate investing with $100K or more, this is a good option for obtaining a steady passive income stream. Keep in mind that your return is limited to that fixed rate.
The downside of preferred equity in real estate is that investors do not benefit if the real estate project performs well. If the property does not perform well, preferred equity investors may lose on the investment. There is no securing of ownership should the borrower default.
Equity in Real Estate Considerations
Equity in real estate offers the potential for a high investment return. Preferred equity investors take less risk than common equity investors, but more risk than traditional lenders.
About Jane Meggitt
Jane Meggitt specializes in writing about personal finance. Besides investing and planning for retirement, she writes about insurance, real estate, credit cards, estate planning and more. Her work has appeared in dozens of publications, including Financial Advisor, Zack’s, SF Gate and Investor Junkie. A graduate of New York University, Jane lives on a small farm in New Jersey horse country.