There is always a key focus on diversification – spreading of assets in the markets, operators, and asset types. However, what if all forms of investments in the so called ‘third world country’ is in terms of equity? However, as geo-tailored and operator-diverse, too, your business might be exposed to inflation and increasing interest rates.

This is where understanding the capital stack comes as handy. It’s no longer a narrowed down demeanour of investment and where you put your money but how you arrange those investments. The capital stack represents the hierarchy of financial interests in a real estate deal:

Debt: Foundational and secure. Debenture holders advance money and stand first in the list of priority for repayment which minimizes risk.

Equity: Located at the upper side of stack. Equity investors own part of this firm, bear more risks, but are rewarded with more potential returns in the financial aspects.
Whether actively self-directing your own investments such as real estate, business, house flipping or simply a limited partner in syndications or funds, having an efficient mix of equity and debt is essential for long-term sustainability.

Why It is Important to Diversify Capital Stack

Over the last few years, a lot of investors thought that just diversify across different markets and operators that was enough. But if you have all your investments in equities your portfolio will still be vulnerable to inflation and increasing interest rates.

Consider an example: You are invested in three multifamily syndications based in Dallas, Phoenix, and Charlotte, North Carolina. These equity investments are also similar to each other regarding geographical distribution, escalating costs and refinancing issues. This obvious means that diversification can no longer be a simple function of geographic diversification and operators; the capital stack must form part of the model too.

So now let us consider being the operator in these cases. Not only have you got equity threats but also you are dealing with the risks linked with the tenant turnover, financing issues, and operations. A decline in any of these markets has the potential of hitting your portfolio hard.

Increased predictability is something that debt investments have over the equities. Repayment to debt investors is accorded high priority in this strategy and is thus useful on any upheavals in the economic market.

Building a Balanced Portfolio: Equity vs. Debt

Is there any way to understand how much equity and how much debt is needed in your portfolio? Let’s break it down.

Learning the Concept of Equity Investment

Equity means a stake in a property, which may include rights to revenues, a share in the property’s value increase and the right to certain deductions. Though being profitable it is more risky.

Active equity example: Employing people in your rental property or a multifamily unit in which you coordinate management, maintenance, and tenants.
Passive equity example: Joint Ventures where a person or company has invested in a business yet he or she does not manage it.

Case Study: This is Alex, a working man, invested in a multifamily syndication deal that offered a minimum preferred rate return of 8% and the hopes of making more. Nonetheless there was a decline in cash flow due to tenant turnover in the year analysing the variability of equity during a soft market.

Key takeaway: Equity is best for those with high risk taking ability and those who are looking forward to long term investment. However, when it comes to the construction of a really efficient portfolio having equity alone is not enough.

Debt investments and its classification

Debt in project finance means providing working capital and receiving a fixed rate of interest in return. Since they are positioned lower in the capital stack it is less risky but with the highest possible upside is also limited to such position.

Active debt example: Buying a promissory note or becoming the holder of an interest bearing bond or note backed by real estate.
Passive debt example: Purchasing a debt fund that collect money for Real estate loans.
Case Study: Sarah put their money into a debt fund that offered priority payback of 8%. That is how, without occasional significant fluctuations, she constantly reinvested her earnings and therefore created a rather impressive growth.

Key takeaway: Debt is preferred very much by those who would wish to avoid the volatile nature of earnings especially in volatile markets.

Adapting to Market Cycles

The real estate market goes through certain stages in its development these include recovery, expansion, hyper supply and recession. Aligning your strategy with these cycles can enhance returns and reduce risks:

Expansion: Equity investment excels when rents and property values rise, which has been a trend observed in today’s world.

Hypersupply & Recession: Equity becomes dangerous when the prices are declining and debt is more appealing as traditional funders withdraw.

Case Study: Rachel had to change her approach the moment her market supply transitioned to hypersupply. Still she sidelined equity deals and went for equity debt fund that has more interest rates but a safer bet for her.

Key takeaway: Adapting to market phases can enhance portfolio performance as a result of using a phased strategy.

Strategizing at the end of the narrative: Questions for defining your marijuana dispensary strategy.
To achieve the right equity-debt balance, consider the following:

• What are your goals? Equity is associated with long term growth; debt is related to stable income.
  What is your risk tolerance? Equity always comes with its set of risks; debt on the other hand provides stability.
• What stage is the market in at the moment? It should match the current conditions as your approach to preparing it will have changed.
• How diversified are you? This is another factor which should not be taken to a very high level by either increasing the proportion of equity or of debt.
• Are you active or passive? Operators are exposed to more risks than passive passive investors and the latter should evaluate the sponsorship abilities of the sponsor.
• What about those concerns, worried about them? In volatile markets most investors have a problem of the right balance of value investing and growth investing. Consultation with a professional always leads to development of plans and programs that meet the laid down goals as well as the prevailing economic environment.

Final Thoughts

Real diversification goes much further than location and operators to how your investments are arranged. Sustaining equity coupled with debt prepares your portfolio for new market movements.

If you need to rebalance your portfolio and it may be too much invested in equity, then consider doing this. Sometimes, it only takes the right advice to make your investment portfolio safer and more future-proof.