Debt, Equity, and Real Estate: An Overview

Introduction

Whenever you think of committing your surplus capital to a product with the expectation of a regular income or creating wealth, you will have a range of options to choose from. However, these options will fall in one of these three categories: debt, equity, or real estate.

Although there are other options available like gold, cryptocurrencies, commodities, forex, and some other fancy names, those do not fall in the purview of this article.

Since you will be making a choice, it is very helpful to know the characteristics, how to compare these product categories, and what would be a fair expectation from each.

You might have some prior knowledge about these terms. Let’s first briefly review each:

Financing the Capital Requirements

Whenever an individual or a company wants to start a business, there are some capital requirements that can be financed either through debt or equity. There is also another form of financing called float. It is free money but very limited in scope and volume. Examples of float are insurance premiums and refundable security money received from the clients.

Coming back to debt and equity, while on one side is the business owner, on the other side is the individual or the company that is providing financing as an investment either in debt or equity. Both these types of investments have their own peculiarities which is the focus of this article. We will come to real estate a little later.

Debt

As the name suggests, this is a loan provided by an individual or a company to the business owner on the condition that it will be returned, in full, on expiry of the agreement and a periodic (monthly, quarterly, yearly) rent (interest, mark up) will also be paid throughout the tenure of the agreement. This will be regardless of whether the business venture is successful or not. The lender will not have any share in the success or failure of the business.

Examples

Some examples of investment in debt are bonds, fixed-income funds, bank deposits, debt mutual funds, debentures, etc.

Peculiarities

This type of investment is very safe. The safety is gauged by the credibility of the borrower instead of probablility of success of the businees.
Return is fixed. It is more or less in line with the current bank interest rates, dictated by the central bank through monetary policy.
This type of investment can, at best, be used for wealth preservation, provided accruing profits are ploughed back into the fund, in full. If this is not done, the investment will gradually depreciate due to inflation.
Wealth creation is not possible through investment into debt.
From the point of view of the borrower, debt is cheaper but riskier, when compared to equity. It is cheaper becuase what he has to give to the lender is fixed and if he earns more, it is for him to keep. It is riskier because he has to assume full risk of failure of the business, contrary to equity where he has no obligtion to pay back anything even if the business fails.

Equity

Unlike debt, equity implies a proportional share in the business. The business owner relinquishes part of the business ownership, in lieu of the funds provided, and the financier becomes part-owner of the business. If the business grows and earns profit, he gets his due share, and if it stagnates or fails, he has to own it accordingly. He cannot claim his funds from the business, as he is the business owner himself, however, he can get his money back by selling his equity in the secondary market (commonly known as the stock market) but the price at which the transaction takes place is determined by the secondary market through supply and demand. It has nothing to do with the original price at which the equity was bought from the primary market.

There are two types of equity: public equity, if the investment is made in a public listed company; and private equity, if the investment is made in a private listed company.

Examples

Some examples of investment in equity are stocks or shares of a company and equity mutual funds.

Peculiarities

The profit or loss is not fixed. It varies to the extent of success or failure of the business.
The investment is as risky as the business itself.
In case of investment in a public listed company, the investment can be traded in a secondary market in the form of shares (unit denominations of the equity). For private equity, the secondary market is non-existent.
Due to the ease with which the shares can be traded in the secondary market, there is a degree of volatility, which is often confused with risk.
Volatility is a function of the secondary market and it has nothing to do with business risk.
There are various options available with the business management (board of directors) as to how the earnings of the business will be utilized. These can be used for business expansion, paying dividends to the shareholders, or buying back their own shares from the market.

Real Estate

Real estate is a familiar term. It refers to a piece of land used as a raw material for any business e.g. some commercial or manufacturing activity, housing, or agriculture.

It is a scarce resource, as it cannot be manufactured, which is, one of the reasons, why it is so dear. Another reason for its dearness is its age-old linkage with social and political clout.

From the point of view of investment, it can be divided into various categories as under:

Rental

Residential (House or Flat)

A safe investment. An annual return of 3-5% should be expected. Capital gain can easily beat inflation.

Commercial (Shop or Office)

4-7% annual return is a fair expectation. The rest is same as residential.

Agricultural Land

3-7% annual return should be expected. A very safe investment.

Note: The annual returns given here are rough estimates. May vary significantly depending on a host of factors.

A Plot

A plot, whether residential or commercial, purchased with the intention to sell it when the price rises is a speculative undertaking and doesn’t fall in the investment category. Therefore, nothing can be said about the expected returns with any degree of certainty.

Why Real Estate is So Attractive in Developing Countries?

Although real estate is a viable investment proposition throughout the world, it is significantly more lucrative in developing countries due to a host of factors. Some of these are as follows:

The real estate sector is, so far, unregulated or, at best, semi-regulated.
The real estate transactions are not duly taxed.
The sector attracts much more money than is necessary to sustain it. A huge chunk of it consists of black money as well. It causes excessive speculation and prices shoot up within a short span.
The overall result is that the sector looks more attractive for investment, than it actually is, and many middle-class people flock to various real estate projects with their life savings in the hope of a windfall. Unfortunately, all of them do not return home with their pockets full.

What’s Wrong with this Approach from a Personal Finance Point of View?

The above approach to money-making is speculative, hence very risky. It seriously detracts from the fundamental principles of personal finance. Taking small steps while being surefooted is far better than attempting to execute big moves successfully.

There is nothing wrong with investing in finished real estate products after due diligence. In fact, it is one of the safest investments. However, buying raw real estate is entirely different and is not without pitfalls.

I will write on this subject, in detail, later.

How to Decide on Whether to Invest in Debt, Equity or Real Estate

In order to have a balanced and well-diversified portfolio, all these investment avenues should be considered. While doing so, you may keep following guidelines in mind:

Any money you may need within 5 years, should preferably be put into debt. There is a wide variety of products to choose from.
The remaining money can either be invested in equity or real estate on a long-term basis. In my view, equity should be preferred but there could be some with a preference for real estate.
There is a whole range of possibilities of how to design your portfolio, which is an entire subject in itself. I will write about it, in detail, later.
If you decide to invest in real estate, wholly or partially, real estate having a rental value should be preferred.
If you opt for equity, you can either opt for mutual funds or buy equity directly from the stock market. If you have no idea about or interest in equity, you may take the mutual fund route. In the other case, you can learn to invest in equity directly.
If you decide to buy direct equity, there are a number of investment styles. You have to keep your risk profile and temperament in mind while choosing one. However, I can say one thing that refrain from trading and prefer investment.

Conclusion

The purpose of writing this article is to give you an overview of the most common investment avenues: debt, equity, and real estate. Each of them has its own characteristics and caters to different needs. After having known their peculiarities, you can make an informed choice that is in sync with your expectations and financial goals.

How did you find this article? Please comment. Also give suggestions, if any.

My other articles, you may find useful are:

How to Make a Personal Financial Plan – Basic Considerations

Personal Finance – A Suggested Checklist

Investment vs Speculation

A Brief History of Money

Why I Started a Blog on Personal Finance

Anatomy of Financial Risk

Retirement Planning

How to Compare Equity and Real Estate as Investment Options

How Stock Market Works and How to Work in Stock Market?

Benefits and Challenges of Using a Credit Card