In a hot real estate market, it’s more profitable to own equity rather than debt.That’s definitely been the case throughout our most recent real estate cycle. According to the St. Louis Federal Reserve, since 2010 commercial real estate prices in the U.S. have more than doubled.
Why Equity Makes Sense in a Hot Real Estate Market
An investor buying a property for $5 million with a $1.5 million down payment back in 2010 saw its equity increase by another $5 million eight years later – in addition to the original $1.5 million down payment.
Over that time the lender’s original $3.5 million debt position stayed at $3.5 million – excluding interest income and loan servicing fees.
While the above example is simplistic it illustrates the appeal of equity investing in a market that’s going up.
But something interesting is beginning to occur. Recently investors have begun shifting money out of equity and into debt.
Why Debt Makes Sense in a Down Real Estate Market
Institutional and private equity commercial real estate investors are smart people. Which begs the question, “Why is the smart money moving into debt?”
One reason for this is that in a down market cycle owning debt is much safer than equity.
Let’s go back to our $5 million property investment. If over the same eight-year period commercial real estate values had instead decreased by 4% each year the total value of the property would be about $3.6 million.
In a down market like this, the investor’s original equity of $1.5 million is essentially wiped out while the debt investor retains all of its original $3.5 million loan.
That’s why equity investment in real estate is considered to be a ‘first loss exposure’ – equity is the first thing to disappear when a market goes south.
Real Estate Debt Funds are Growing
The National Real Estate Investor notes that fundraising for private equity real estate funds has been slowing down while capital is increasingly flowing into commercial real estate debt.
According to research firm Preqin:
North American-focused private equity real estate debt funds have seen fundraising surging higher over the past three years. Last year that segment of the private equity market raised $18.3 billion, which is nearly double the $9.9 billion raised in 2015 and marks a new 10-year high.
What Does the Smart Money Know?
In addition to debt funding being the safer investment option in a down real estate market, owning debt is an attractive alternative to buying real estate at today’s high prices.
Astute investors and smart money know that markets can go up as well as.
The shift out of equity and into debt investment is another sign that the market is beginning to top out as more and more professional investors seek safety in debt.