This post covers factors to consider when deciding between equity or debt structure for your business model.
Debt vs. Equity
Just to be clear, here's what we mean by debt and equity:
Debt: You receive capital from a lender in the form of a rehab loan and in exchange you promise to pay back the amount received plus some fixed rate of return (interest).
Equity: You receive capital from an investor and in exchange you agree to share the profits of the project.
There are “intangible” benefits of both. For example, a hard money lender will have very little interest in how you plan to execute so long as they are confident you are capable of repaying your debt. Equity investors, on the other hand, may want to have some say in the “how” which could complicate the decision making process.
That said, equity investors may bring connections or other expertise to the table that a lender generally won’t provide. These intangibles should certainly be considered.
For the purposes of this article, we’re going to only look at the tangible costs for consideration when determining whether to fund your projects with debt or equity.
At a very fundamental level this comes down to how much the capital will “cost”.
For debt structures, this is rather straight forward. You simply add up all of the costs to borrow the money such as: interest, origination fee, legal, processing fees, etc.
$100,000 loan at 12% interest, 3% points origination, $1,000 legal and $200 processing. Your total annualized cost of capital would be:
12,000 interest + $3,000 origination, $1,000 legal and $200 processing or $16,200.
On a percentage basis, your cost of capital in this example is 16.2%. ($16,200/$100,000)
If you hold the loan for more or less than 1 year it may be useful to annualize the origination, legal and processing fees. To do this, simply add these ($4,200) to the amount of interest you actually pay and divide by the number of months the loan is outstanding, then multiply that by 12 to annualize it.
Same hard money loan as above held for 9 months.
$9,000 interest + $4,200 origination = $13,200/9 = $1,466.67 per month x 12 months = $17,600.
This increases your annualized cost of capital to 17.6%. It should be noted that longer holds reduce cost of capital and shorter periods increase it on a percentage basis when there are origination fees. This is a bit counter-intuitive as the amount you pay in interest may actually be less/more. The reason for this is that the fixed origination expenses are spread over a shorter/longer amount of time.
The benefit of debt is that you usually have a pretty clear idea of what your cost of capital will be and you can price it into your analysis. The interest rate, points and other fees are established up front and the only variable that will alter the cost is how long you have the debt outstanding.
A further benefit of using a hard money loan is that the interest expenses offset your profit, giving you less of a tax burden. If you would have raised a similar amount of money from an equity partner, you would have paid taxes on the profit without an interest expense. This would leave less take home for both you and your investor. This is a benefit of debt that should always be considered.
Calculating your cost of capital for equity structures is a bit different. It typically starts with the risk adjusted return the investor wants to make and is structured backwards. For example, if an investor wants to make a 20% return by investing with you, you would structure the deal so that they earn $20,000 on a $100,000 investment. If you expect the project to net a $40,000 profit, you’d set up a 50/50 partnership.
The tricky part about structuring equity investments is that you don’t know how much profit the project will ultimately produce. If you target a return of 20% for your investor and the project is more successful, you will end up giving more of your profits away. If the projects is less successful, and the investor is guaranteed a certain return, you may end up paying all of the profits to cover their return, leaving little to no return for your efforts.
What’s interesting about equity deals is that the more successful your project is, the higher your cost of capital ends up being. For example, if you target a $40,000 profit to be split 50/50 giving your investor a 20% return (also your cost of capital) and the project makes a $50,000 profit your cost of capital goes up 5% points.
There are ways to structure the deal so the investor’s return is capped but, generally, equity investors are intrigued by these types of investments for the upside potential and will be unwilling to take a capped return.
Hard Money Loans allow you to predict what your cost of capital will be ahead of time by annualizing the total interest costs. Any profits you earn above the debt servicing costs are yours to keep. This structure also provides you with some tax benefits.
In equity deals, you won’t know the cost of capital until the project completes and the profits are split according to your partnership agreement. Any profits earned above your target return are split which will increase your cost of capital and reduce the amount you take to the bank. Also, you lose out on the opportunity to expense the cost of capital for tax purposes.
Deciding which way to go largely depends on how much risk you are taking and sharing with your capital provider. Equity deals tend to have more risk which is why they also have the potential to earn the investor a higher return. If your project is rather straight-forward, it may make more sense to price in the debt and give yourself the most opportunity to capture any upside potential the deal may present.