Understanding the Relationship Between Debt and Equity
In real estate investing there is a fundamental relationship between the money that you borrow to purchase the investment and the equity capital you invest. The money that is borrowed to purchase the investment property, whether it’s a home or an apartment or any other commercial property is called debt. It’s an obligation that requires one party, the debtor, to pay money to another party, the creditor. Usually the debt is paid back through a series of payments. The repayment process is called amortization.
Equity, on the other hand, is the money the creditor requires to be paid to purchase the asset. Some call this equity capital. In finance, equity, or “owner’s equity,” is the difference between the value of the asset and the value of the liabilities. For example, if someone is buying a real estate investment worth $300,000 and borrows $200,000, the difference of $100,000 would be considered equity, which the borrower would be obligated to pay for the privilege of borrowing the remainder of the money required to purchase the property.
When you purchase a real estate investment, the lender or creditor will usually let you borrow between 60% and 80% of the purchase price or value of the asset. Usually a lender will let you borrow a higher percentage if the property is residential than if it’s a commercial property. The ratio between the amount borrowed and the amount of equity capital invested is known as the loan-to-value (LTV) ratio.
When investing in real estate, the higher the LTV, the lower the cash flow. The lower the cash flow, the lower the cash-on-cash return to the investor. So, as a real estate investor, try to balance the percentages between debt and equity so that you have a comfortable cash flow without creating undue risk by putting too much debt on the property.
ABOUT THE AUTHOR
Ken has been in the real estate business for over 40 years and has personally overseen the development and management of over $350 million worth of assets. Ken holds a B.S. degree in Accounting from Brigham Young University, a MBA from the University of Utah. Licensed real estate broker since 1976. He holds the following designations: CCIM, CPM, CRS,CCA. Served as the president of the Utah Apartment Association.