Most investors understand the importance of diversification—spreading investments across different markets, operators, and asset classes. But what happens if all your investments are equity-based? Even with geographic and operator diversification, your portfolio can still be overly exposed to risks like inflation and rising interest rates.
This is where the capital stack comes in. It’s not just about what you invest in—it’s how you invest. The capital stack represents the layers of financial structure in a real estate deal:
- Debt: The foundation of the stack. Debt investors lend money to a deal and are the first to be repaid, making this the most secure position.
- Equity: The top of the stack. Equity investors hold ownership stakes and are the last to be repaid, meaning they take on more risk, but have higher upside potential.
Whether you’re operating your own deals—like owning rental properties or flipping houses—or investing passively in someone else’s syndication or fund, balancing equity and debt is essential for long-term resilience.
Why Diversifying the Capital Stack Matters
Over the past two years, many investors assumed that diversifying across markets, operators, and deals was enough. But if all those deals were equity-based, they were still highly vulnerable to the same risks—namely, inflation and rising interest rates.
Let’s say you’ve invested in three multifamily syndications in these cities:
While these markets and operators may differ, they’re all equity deals. When inflation drove up operational costs and rising interest rates made refinancing more expensive, all three investments were impacted. This is a textbook example of why diversification must go beyond geography and operators—it has to include the capital stack.
Now, imagine you’re the operator in all three scenarios. Not only are you dealing with the same equity risks, but you’re also responsible for tenant turnover, financing challenges, and operational management. A downturn in any of these markets could significantly impact your portfolio’s performance.
Debt investments, on the other hand, can provide stability whether you’re an operator or a passive investor. During periods of economic uncertainty, debt investors are prioritized for repayment, making it a powerful tool to balance risk.
How to Balance Equity and Debt for a Resilient Portfolio
So, how do you decide the right mix of equity and debt for your portfolio? Let’s break it down step by step.
Understand equity investments
Equity represents ownership in a property, offering potential for cash flow, appreciation, and tax benefits. It’s great for long-term growth but comes with higher risk.
- Active example (operator): Buying a single-family rental or a multifamily property outright. You’re responsible for management, repairs, and performance.
- Passive example (investor): Investing in a syndication where you own a share of the deal but aren’t involved in day-to-day operations.
- Client story: Alex, a busy professional, invested in a multifamily syndication offering an 8% preferred return with upside potential. When turnover increased during a soft market, cash flow dipped, highlighting the inherent variability in equity investments.
- Key takeaway: Equity investments are ideal for those with a higher risk tolerance and longer time horizons. However, during volatile markets, a diversified portfolio requires more than just equity.
Understand debt investments
Debt involves lending money to a project and receiving fixed returns. It’s lower in the capital stack, meaning it’s less risky but has a capped upside.
- Active example (operator): Holding a private note or lending directly to another investor. For instance, an operator might finance part of a deal through seller carryback or bridge loans.
- Passive example (investor): Investing in a debt fund, where pooled capital provides loans to real estate projects.
- Client story: Sarah invested $100,000 in a debt fund offering an 8% preferred return. She reinvested her earnings to compound returns, building significant growth over time without the volatility of equity.
- Key takeaway: Debt investments are an excellent option for those seeking stability and consistent cash flow, particularly in uncertain market conditions.
Factor in market and debt cycles
The real estate market moves through four phases: recovery, expansion, hypersupply, and recession. Understanding these cycles can help you adjust your strategy:
- Expansion: Equity deals thrive as property values and rents rise.
- Hypersupply to recession: Equity becomes riskier due to oversupply and falling prices. Debt often outperforms during this phase, especially when traditional lenders pull back.
Client story: Rachel avoided equity deals as her market shifted into hyper supply. Instead, she invested in a private debt fund, taking advantage of higher interest rates while maintaining a secured position.
Key takeaway: Aligning your strategy with the current phase of the market cycle can optimize returns and minimize risk.
Ask the right questions
To determine your ideal balance of equity and debt, reflect on these questions:
- What are my short-term and long-term goals? Equity offers growth over time; debt provides steady income.
- How much risk am I comfortable with? Equity is volatile but rewarding; debt is stable but capped.
- Where are we in the market cycle? Align your strategy with the current phase.
- How diversified am I across the capital stack? Ensure your portfolio isn’t overly weighted in one area.
- Am I operating my own deals, investing passively, or both? Operators carry more hands-on risk. Passive investors should evaluate the track record of sponsors managing equity or debt.
Feeling overwhelmed by these questions? Many of my clients come to me unsure of how to balance equity and debt, especially when market conditions are shifting. Together, we create tailored strategies that align with their goals, risk tolerance, and the current market cycle.
Final Thoughts
Diversifying across the capital stack is essential for building a resilient portfolio. It’s not just about geography or operators—it’s about how you structure your investments. Balancing equity and debt can help you navigate market changes with confidence.
If your portfolio feels stuck or overly exposed, take time to reflect: Are you truly diversified, or are you relying too heavily on equity? Seeking advice could be the key to unlocking a more balanced and secure strategy.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
