Financing doesn’t fix a bad property, but it can absolutely break a good one.
A real estate investment is not just the building that gets purchased. It is the set of obligations attached to that building and the cash flow available to meet them. Properties are illiquid, expenses are uneven, and revenue does not arrive on a perfectly predictable schedule. The capital used to acquire and hold the asset determines how those realities are handled over time.
Debt and equity occupy different positions in that structure. They impose different requirements and respond differently when operating results or market conditions change.
The Debt Component
Debt is capital advanced under negotiated terms. It is commonly secured by the property and may also be supported by personal guarantees, corporate guarantees, completion guarantees, carve-outs, or other forms of recourse. The presence or absence of recourse affects who ultimately bears losses, but the lender’s claim exists regardless.
Payment requirements vary by structure. Some loans amortize principal over time. Some require only interest payments for a defined period. Some allow interest to accrue rather than be paid currently. Construction and transitional loans often capitalize interest and fund it from reserves instead of operating cash flow. Despite these differences, the borrower’s obligations are set by the loan documents.
Fully amortizing, fixed-rate loans reduce exposure to interest-rate changes and refinancing timing. These structures are common in owner-occupied residential properties and stabilized commercial assets. When cash flow weakens under these loans, pressure shows up first in coverage ratios rather than in maturity risk.
Most commercial real estate loans are shorter-term and do not fully amortize. Five- to ten-year maturities, partial amortization, and balloon balances are common. These loans assume that the property will be refinanced or sold before maturity. A property can operate close to expectations and still face difficulty if refinancing occurs when rates are higher, valuations are lower, or credit standards have tightened.
Interest-only periods improve early cash flow and reduce required payments during the initial phase of a business plan. They also slow balance reduction. When valuations stagnate or decline, higher outstanding principal reduces refinance proceeds and increases the likelihood that additional equity will be required to retire the loan.
Floating-rate debt links required payments to benchmark rates rather than to property performance. Rising rates increase debt service even if rents and occupancy are unchanged. Rate caps limit this exposure temporarily, but they expire and must be replaced at prevailing market prices.
Layered debt structures introduce additional claims. Mezzanine debt, preferred debt, and similar instruments sit behind senior lenders but ahead of common equity. These positions carry higher costs and often include consent rights, cash-flow sweeps, or control provisions. While they reduce the amount of common equity required at acquisition, they increase the number of parties with enforceable rights when performance weakens.
Across all forms, debt is enforced through payment terms, covenants, and maturity provisions. Missed payments, covenant breaches, or unpaid balances at maturity trigger remedies. Control can shift without the property failing outright.
The Equity Component
Equity represents the capital remaining after debt obligations are satisfied. It does not have required payments and does not mature on a set date. Cash flow reaches equity only after senior claims are met.
Personal equity is capital contributed directly by the investor. It typically funds the down payment, transaction costs, reserves, and initial capital expenditures. This capital absorbs operating volatility and timing mismatches between income and expenses.
Partnership equity involves multiple active participants contributing capital and sharing ownership. These arrangements are common in smaller commercial deals. When operating cash flow is insufficient, capital calls, contribution requirements, and voting provisions determine how additional funds are raised and how decisions are made.
Syndicated equity consists of capital raised from passive investors. Economic rights are defined through preferred returns, distribution waterfalls, and promote structures. These arrangements increase purchasing capacity but raise the cost of capital. When cash flow is insufficient, distributions may stop entirely even though the property continues to operate and debt obligations continue to accrue.
When cash flow tightens, equity distributions are reduced or eliminated. When valuations decline, equity absorbs the loss. Debt claims remain in place unless restructured or paid off.
The Impacts of Leverage
Let’s start with a stabilized property. Nothing heroic. No turnaround story.
Gross potential rent is $120,000 per year. Vacancy and credit loss run at 5 percent, bringing effective gross income to $114,000. Operating expenses consume 40 percent of that figure, or $45,600. Net operating income (NOI) is $68,400.
That NOI is fixed for the purposes of this example. The property does not change. What changes is how much of that NOI is committed to debt service.
Leverage is not inherently reckless. It allows an investor to control a larger asset with less equity. That has real benefits.
Using more debt:
- Reduces the amount of equity required at acquisition
- Increases cash-on-cash returns when cash flow is stable
- Allows capital to be deployed across more properties rather than tied up in one
- Amplifies appreciation on the equity portion when values rise
Those benefits are real, and they are the reason leverage is used. The tradeoff is that debt service becomes a larger and less flexible claim on the same NOI.
Assume the property is financed at 65 percent loan-to-value. The loan amount is $650,000. The interest rate is 6.50 percent, amortized over 30 years. Annual debt service is approximately $49,300. After paying the loan, annual cash flow before reserves is roughly $19,100. Debt service coverage is about 1.39x.
At this leverage level, the equity contribution is larger, but the structure has room. If expenses rise or rents flatten, cash flow declines but remains positive. Returns soften, but control is not threatened.
Now finance the same property at 80 percent loan-to-value, keeping everything else the same. The loan amount increases to $800,000. The interest rate stays at 6.50 percent, with the same 30-year amortization. Annual debt service rises to approximately $60,700. Cash flow before reserves falls to about $7,700. Debt service coverage drops to roughly 1.13x.
This is where leverage starts to do visible work. The equity check at closing is meaningfully smaller, and returns on that equity look stronger as long as nothing changes. But the margin for error is now thin.
Conclusion
Debt and equity are not interchangeable sources of capital. They place different claims on the same cash flow and respond very differently when conditions change. Using more debt can make a deal more efficient and improve returns when operations are stable, but it also reduces the amount of variation the structure can tolerate. Small changes in expenses, timing, or market conditions that are manageable at lower leverage can force action at higher leverage.