An amount of money (obligation) owed by one party (the borrower) to another party (the lender), also known as a loan. Debt does not represent an ownership interest, although it is sometimes secured by a lien against property owned by the borrower, allowing the lender to foreclose on the property if the borrower is in default under the terms of the agreement. The debt (or loan) on a real estate property is in a senior position relative to the equity and is the first to receive payment from any cash flow or profits. Generally speaking, debt carries a fixed interest rate that is paid on a monthly basis.
An Example of Debt
When a development company begins a new project, they borrow money in the form of a construction loan. When you invest in real estate debt, you are in effect lending your funds to an owner or purchaser of real estate. You receive periodic interest payments from the owner and a lien against the property in the form of a mortgage. At the end of the mortgage term, you get back the balance of your principal.
Real estate debt provides leverage, increasing returns and allowing investors to buy buildings they otherwise could not access with only their own capital.
Conversely, taking on debt can increase the potential for a default and loss of investment if the value of the property decreases, or cash flows are unable to cover debt service (the amount of payments required under the loan).
The ability of a property’s cash flow (either existing or future) to service debt is one important indicator of inherent risk in the investment. Generally speaking, the greater the amount of debt (i.e. the more leverage) the riskier the investment.