Private Real Estate Funds: Understanding The Difference Between Debt And Equity

Many choices exist for those interested in real estate investing. There is the direct investment method. This involves purchasing the physical property and all of its attendant landlord headaches.

Then there are passive-income real estate vehicles, which eliminate the ownership hassles. Passive-income investments mean other entities buy, operate, hold and sell real estate. These entities include publicly and privately traded real estate investment trusts, or REITs. They also include real estate exchange-traded funds (EFTs), which are available via the public stock exchanges.

Then there are private real estate investment funds. These professionally managed funds don’t show up on the NYSE or Nasdaq. They’re also geared mainly toward high net-worth accredited investors.

Delving down a little further, private real estate funds deal in either debt or equity. Both fund types raise capital from investors and direct that capital toward real estate projects. Both can offer ideal passive investment and wealth-generation opportunities. But private equity and debt funds differ in two ways: how they operate and how they generate returns.

Private Equity Funds: Dedicated Ownership

Private real estate equity funds are set up and operated with one goal: real estate ownership.

Once the equity fund sponsor raises a certain amount of capital, the fund acquires a direct ownership stake in a property (or properties). The fund also takes responsibility for improving the assets (if needed) and for the day-to-day operations. Then when the time is right, the fund sells the property or properties. 

Private equity fund investors receive their returns from capital gains when the property sells. Investors might also receive cash-flow income from rents. 

A private equity fund tends to hold real estate mid-long term, typically 3-10 years. In theory, this can mean a higher yield. It also means an investors’ money is tied into an illiquid asset until the fund decides it’s time to sell.

Another issue is that the cash flow can be unpredictable. Let’s put it this way: cash flow is highly dependent on rents. This, in turn, is dependent on occupancy and rental increases. The lower a property’s occupancy, the lower the returns. In a nutshell, volatile investment returns.

In addition, any capital gains from the sale of a real estate asset are dependent on economic and market factors. Property values are in constant flux. This means an asset could sell for less than anticipated, meaning a lower return for the investor.

Private Debt Funds: Lending Sources

While private real estate equity funds focus on ownership, private real estate debt funds are focused on lending. Specifically, these vehicles provide investor-raised debt capital to real estate owners and developers, and serve as an alternative lending source to a bank. 

That capital takes the form of short-term mortgage loans which the borrower pays back during an agreed-upon term, with interest. Those interest payments generate investor returns, similar to how bonds operate. 

Private debt fund income can be less volatile and more consistent than that of private equity. This is because the short-term debt issued generally carries a set interest rate that usually is floating with the Prime Rate or SOFR.  This means a steady, anticipated cash flow during the loan’s term.

Another advantage tied to private debt funds is that the short-term loans issued are senior in a real estate project’s capital stack. Capital stack is another name for the layers of debt and equity used for purchasing and operating real estate.

Bank mortgages or other first mortgages are at the top of the stack, meaning they’re paid back first. Next on the stack is the subordinate debt – with equity falling below that. This means the borrower will pay off a short-term loan before paying back an equity commitment.

A potential downside to a private debt fund investment is that the returns might not be as high as its equity counterpart, but the debt returns are more reliable, over time.

Which is More Effective?

There is no such thing as a risk-free investment. This is the case with private equity funds and private debt funds. Both offer benefits and downsides.

But investors who want consistent, dependable passive income might find private real estate debt funds are an interesting choice. Returns can be faster – there is no longer-term hold involved. There is also less reliance on asset value and performance on returns. And because of market non-correlation, private debt funds can provide an ideal portfolio diversification strategy.

Another advantage is the growing demand for alternative financing methods. Traditional lenders that were once a main capital source are stepping back from real estate investments. But developers and owners still need capital. Private debt funds are stepping into the breach, providing capital to borrowers, while generating compelling investment opportunities. 

When considering any kind of investment, be sure to examine the fund’s sponsor, management, track record and strategy. Also be sure to understand a fund’s targeted returns and underlying real estate asset types.

There are many ways to invest in real estate. When it comes to the choice between private equity funds and private debt funds, the latter can generate more predictable yield and assist with portfolio diversification. Furthermore, the real estate sector’s ongoing need for debt will ensure that these funds remain active. This, in turn, can mean ongoing returns and stability for investors.