The financial structure (or capital structure) of a company is a combination of debt and equity used to finance business operations and growth. The levels of debt and equity can influence a company’s cash flow and potential risk exposure.
There are potential benefits and risks with both, which is why a delicate balance is optimal for business growth and the ability to survive a recession. Because of this, investors should be familiar with a company’s financial structure before investing in real estate.
Debt vs. Equity Financing
Debt financing involves borrowing money, usually in the form of a loan, and paying it back with added interest. Companies can use debt as financial leverage to potentially increase company profits. Leverage can be used as an interest tax shield under the U.S. corporate income tax law. Assets purchased with debt capital can earn more than the initial cost of debt.
What happens when there’s an economic downturn or the company doesn’t grow as quickly as projected? Debt is borrowed money, and the biggest risk of debt financing is the company’s ability to pay it back. Also, a floating rate debt structure in a rising interest rate environment creates further risk for debt financing.
Equity financing is a method of raising capital by selling a portion of a company’s equity. For example, a company decides to sell 20% of its equity to raise capital to fund a business expansion. If a single investor bought this share, they now own 20% of the company. This is also a downside to equity financing. Profits are divided between shareholders, and investors are involved in business decisions.
A big advantage of equity financing is that the company can invest more of its capital into business growth. We also want to mention that equity financing with dividend payments creates additional financial burden for the company.
The Debt-to-Equity Ratio
A company’s debt-to-equity ratio is calculated by dividing total liabilities by its shareholders’ equity and is used to dictate a company’s financial leverage. This displays stability and the company’s ability to raise capital and grow.
The debt-to-equity ratio is used by investors to determine the level of risk associated with an investment. A higher debt-to-equity ratio means higher potential risk.
Direct vs. Indirect Ownership
We mentioned investor ownership interest in a company, but we wanted to differentiate between direct and indirect investment structures.
Investors can invest directly in real estate through a Delaware Statutory Trust (DST), where investors can hold a fractional interest in the holdings and assets of a trust on a piece of property. Indirect investment is a method of buying shares in a real estate fund, such as through a real estate investment trust (REIT). Both DSTs and REITs allow investors passive ownership of real estate.
Direct ownership through a DST provides significant tax advantages to the investor over other structures. Investors can benefit from sheltered gains via a 1031 like-kind exchange and also shelter ongoing income through interest and depreciation expenses.
No two companies are alike, and each individual company needs to find the right balance or optimal structure between debt and equity financing. Before going into an investment, investors need to understand the company’s financial structure and determine whether to directly invest, like through a DST, or indirectly such as a REIT. Consult your financial advisor and a tax professional to determine if your desired investment meets your risk profile.