A real estate debt fund and an equity fund, compared

A debt fund and an equity fund can be paid out of the same building from completely different places in it. The lender is paid interest the borrower owes. The owner is paid whatever is left once every obligation above them is met. Nearly everything else follows from that.

We run one fund of each kind. Income Fund 2 lends to the projects and pays interest while the loans are outstanding; Equity Fund 2 takes ownership and participates in the outcome. Both are funds rather than single deals, so either position sits across the projects the fund holds rather than riding on the one building a syndication buys. The terms of both are published in the same rows and the same order on the two funds’ terms.

One project, one capital stack

A development project is funded from a stack, which is an order of payment.

• Senior debt. Usually a construction loan secured by the property. Paid first.
• Anything behind it. Subordinate or mezzanine debt, paid after the senior lender and ahead of the owners.
• Equity. The owners, paid last, out of what is left.

A fund that lends sits in the debt layers; a fund that takes ownership sits at the bottom. Which layer a given loan occupies is a term of that loan, worth establishing about any debt offering rather than assuming the senior position. Every step up buys priority and gives up a claim on how well the project finally does. The guide to Ohio multifamily investing describes both positions from the outside; this article starts where that one stops.

What a debt fund position buys

The useful question about a loan is not how good the project can get. It is how much worse than plan it can get before the borrower stops paying. If the building leases faster than the model assumed, the lender is paid the same interest. If it leases more slowly but still covers its payments, the lender is paid the same interest. A lender holds a floor, not a forecast.

So the work is a stress test, not a projection. What happens to the payment if lease-up runs two quarters late. What happens if the construction loan has to be refinanced into a market nobody could price when it was written. The lender carries those risks through the borrower — a real difference, and a smaller one than it sounds.

What an equity fund position buys

Equity buys the development margin: the difference between what it costs to build a building and what a finished, leased, stabilised one is worth. That margin is created by the work — entitlement, building near budget, leasing at the rents underwritten. No interest rate buys it. It is the residual.

The residual is last in line, and in development it also waits. Capital goes in before there is a building, and a building that does not exist pays nothing. An owner is paid for construction and lease-up execution, and carries it when execution goes badly. The results are on the communities map.

The two positions, side by side

No figure appears below. Figures belong to a specific offering and travel with its qualifiers. This is where the two positions differ structurally.

Question	Debt position	Equity position
What bounds the outcome	The interest rate caps it	Uncapped, against the capital committed
If a period produces no cash	Unpaid interest is a default, with remedies	An unpaid preferred return accrues
Tax character	Ordinary income, in the year received	Losses early, a mix of characters at exit
What sets the term	The life of the loans, plus any extension	The life of the projects, through to a sale or a refinancing

A preferred return is not a coupon

A preferred return is read as a coupon. It is not one.

It is an accrual — a priority claim that builds up and has to be satisfied before the sponsor or the common equity participates. In our funds it is payable from available cash flow after debt service and reserves, banded by commitment size. Those three words carry the weight: a period that produces none, once the debt is serviced and the reserves funded, pays no preferred return. It accrues.

Set that beside a lender’s interest, a contractual obligation of the borrower: missing it is a default with remedies attached. An unpaid preferred return is not a default; the balance simply grows. Two lines that look alike on a summary of terms describe obligations of completely different force, which is why a preferred return is not a guarantee of payment — a qualifier that travels with the published preferred-return bands.

What each position does in a bad outcome

Three things go wrong in development often enough to plan for. The schedule slips. The cost runs over budget. The permanent financing that replaces the construction loan prices worse than the model assumed.

The equity absorbs all three first. An overrun has to be funded, and both ways land on the owners: more equity dilutes the ones already in, more debt puts another claim ahead of them. A delay pushes lease-up into a different season and the refinancing into a different rate environment. None of it reaches the lender’s interest payment until the project can no longer make it.

At that point the lender’s protection turns out to be a process rather than a payment. Remedies take time, run against the collateral’s value in whatever market exists then, and a lender who forecloses on a partly built apartment community owns a partly built apartment community. A debt position is ahead of the equity. That is not the same as insulated from a project that does not work.

Tax treats the two differently, and it often decides the question

Comparisons often stop at risk and reward. For a taxable investor, tax is not a footnote to that comparison — it can reverse it.

Interest is ordinary income, taxed in the year received and every year the position is held — the same treatment a private credit deal or an investment-grade bond gets. Nothing defers it and nothing shelters it.

Equity is taxed differently in kind. It passes through depreciation, which in new construction is front-loaded, so the early K-1s can report losses while the building leases perfectly well. The tax is then largely deferred to the exit, and what arrives there is a mix of characters rather than a single rate: ordinary recapture on the short-lived components, unrecaptured Section 1250 gain on the building at its own federal cap, and Section 1231 gain on what remains.

Whether those losses are worth anything to you is answered by your other income, not the deal. A rental real estate loss is generally passive under Section 469, and an investor who cannot use it in the year it arrives carries it forward. Basis and at-risk limits sit ahead of that test; an excess business loss limitation can sit behind it. The whole chain, through to what comes back at sale, is in why development deals produce paper losses, and the after-tax calculator puts numbers on it under your own assumptions.

Two investors with identical money can therefore rank these positions in opposite orders and both be right.

Term, extension, and liquidity: two different clocks

Both positions are illiquid; the exit is the fund’s exit rather than a decision you make, which is the sharpest line between a private interest and a listed REIT share that trades every day the market is open. A debt position’s term follows the life of the loans it makes, and loan terms commonly include an extension provision, so the base case is not the only case. An equity position’s term follows the life of the projects: construction, lease-up, stabilisation, then a sale or a refinancing that has to actually happen. Both funds publish a targeted hold period and a liquidity row. Read them as the two clocks they are: a longer hold changes an annualised figure even when every dollar arrives as expected.

The questions that actually choose for you

Neither position is better than the other. They price different risks, and the choice is usually settled by facts about the investor rather than the deal. None of these can be answered for you by a sponsor.

• Do you need current income? If the money has a job to do each year, that is the first thing to settle — a question about your circumstances, not about either fund.
• Do you have passive income for the losses to offset? If you do, the early tax profile may be worth something in the year the loss arrives. If not, it may be worth something later, on conditions.
• How long can the capital sit untouched? Answer against the extension case, not the base case.
• What would you do if a distribution were reduced or suspended for a year? Ask it of both positions.
• Which risk do you want to be paid for? Construction and lease-up execution, or the credit of a project you have lent against.

We develop, construct, and manage what we own — the services page sets out how those teams fit together, and about the firm covers the history. Investing with us covers both routes in, to accredited investors only, and our investor relations team will take the question directly.

Private real estate is illiquid and speculative in either position. Interests are not registered, are not freely transferable, and there is no public market for them. Distributions are not guaranteed and may be reduced or suspended. A preferred return is an accrual payable from available cash flow after debt service and reserves rather than a guarantee of payment. Any offering is made only through the relevant fund’s offering documents, to accredited investors, and investors may lose some or all of their capital.