Commercial real estate financing is traditionally comprised of two main types of investments: equity and debt. The difference between equity and debt investments is important for real estate investors to understand prior to making their first investment.
When you make an equity investment, you become a shareholder in the ownership of a property. Benefit of an equity investment are a higher rate of return and a share in the profits of the asset, typically paid out quarterly and also in a lump sum when the asset is sold. Equity investor returns are not capped, but can increase or decrease depending on the performance of the asset. There is also no fixed-term for this type of investment.
Debt is a loan provided to the property owner or Sponsor with a fixed rate of return and term. This is typically paid out monthly and payback is secured against the property. Debt investments have a lower rate of return than equity investments, but are the first to be paid back by the borrower.
Together, debt and equity investments make up what is known as the capital stack. The capital stack depicts the relationship of each investment type in regards to the given asset arranged by the level of investment risk. The funding sources with the most risk, or equity, is positioned at the top, the position with the least risk, debt, is at the bottom. The higher the position in the stack, the higher the expected returns.