In our recent posts, we looked at how real estate crowdfunding compares with more traditional real estate investments, including buying rental properties and investing in real estate investment trusts (REITs). But real estate crowdfunding itself is not homogenous – you can find several investment options, varying in terms of risk, expected return, maturity and income distribution. There are many ways to look at it – to provide the possibly fullest picture, we divide real estate crowdfunding options across three categories: position in the capital stack (the risk-return relation), investment purpose, and investment source.
Risk and Return: from senior debt to common equity
We have addressed some basic differences and pros and cons of equity-based and debt-based options in our real estate crowdfunding guide. Let’s go more into detail. A single crowdfunding project can involve several classes of investment which have different risk exposure, interest rates/expected returns and different rules regarding potential liquidation. The project’s capital structure is often called the “capital stack” and can look like this:
Capital stack: The risk and the expected returns increase going from senior debt to common equity.
Of course, some projects can only include one debt/equity class, while others might have a more complex stack. These four classes give a decent picture of possible risk/yield options though:
- Senior debt always comes first. It is the first source of money that property developers are trying to secure and, typically, the largest component of project funding. It is the safest investment option – senior debt owners are given priority in case the project goes into financial trouble, i.e. they get their money back before everyone else does. Because of this high security, it offers relatively lower interest rates – roughly between 3 and 5 per cent. Although banks are traditionally in the position of senior debt lenders, you can find senior debt projects on some real estate crowdfunding platforms as well.
- Bridge debt (or mezzanine debt) is, as the name implies, a sort of a “bridge” between senior debt and equity investments. Bridge debt lenders get paid after senior debt owners but before equity investors. This makes bridge loans riskier and potentially more profitable.
- Preferred equity is often confused with bridge debt. It tends to be quite similar in terms of risk/yield relation (although bridge debt lenders have priority before preferred equity owners) and, unlike common equity, it offers investors fixed returns (just as with debt instruments).
- Common equity is the riskiest, but the juiciest, option. Although the chance of failure is considerable, returns can often range between 12 and 18 per cent. The returns are not capped though, meaning that if a project is particularly successful, investors will get a proportional reward (whereas debt and preferred equity owners receive fixed income regardless of project performance). Equity investments have also a much longer holding period – usually between 3 and 10 years, compared to roughly 6 to 24 months in the case of debt investments.
Investment Purpose: to let, sell or construct?
Another way to look at real estate crowdfunding investments is the purpose of the project. Besides the fact that it’s good to know where your money is going, this may have an impact on your investment features, including the distribution of income and time horizon. We can identify three main real estate project types as well as one “extra”:
- Buy-to-let projects aim to generate profit by leasing the property to tenants. They are usually long-term (average of 90 months according to one study) and typically offer a monthly income for investors, deriving from monthly rents from tenants.
- Buy-to-sell projects invest in building or renovating properties for subsequent sale. They last much shorter (12 months on average) and generate no monthly income – the investor typically recovers the capital and interest after the property is sold.
- Development projects involve loans to developers for new construction. These can vary in terms and rules, but according to the above-mentioned study, they tend to be a middle ground solution between buy-to-let and buy-to-sell projects: they offer monthly interest payments, while the principal is repaid at the end of the term, and tend to be medium-term (16 months on average).
- Business/consumer loans with real estate collateral are not strictly part of the real estate crowdfunding as they do not necessarily serve to invest in properties. Nonetheless, they might be sometimes offered on real estate crowdfunding platforms and do provide another appealing and relatively safe alternative. They somewhat resemble the senior debt in real estate crowdfunding projects – the collateral guarantees that you will be the first to retrieve your money in case of trouble.
Investor involvement: From direct to syndicated debt
Finally, we can look at how the investments are found and funded. On one extreme we have a “direct debt” scenario, most often associated with the P2P and crowdfunding industries. This model leaves the whole responsibility on the investor’s shoulders – the investor needs to do the proper due diligence and pick the right investments (or those they deem right at least). The crowdfunding platform serves only as a meeting ground and a facilitator (through the handling of payments, providing space for information exchange, etc.) of the lender-borrower relationship.
On the flip side, there is a thing called the syndicated loan model. In this case, an established, experienced investor (an expert) looks for investment opportunities, identifies a “good” deal, diligences the borrower and property and then fully funds the investment. Only then does he invite other investors to participate and “shares” portions of the loan with them. The experts tend to keep a chunk of the investment, which, in a way, guarantees they are motivated to make sure everything goes smoothly (since their own money is at risk along with the “crowd’s” money). If visualisation helps you, the two models look something like this:
Of course, the real world is not black and white – you might encounter several mid-way arrangements browsing real estate crowdfunding options. Some platforms may have built experienced teams that can play the syndication role, but this is still somewhat rare. More often, they play only a part of the role – for instance, they pre-screen deals and structure the loans, providing investors with more or less “ready” investment products. Alternatively, they might syndicate loans originated by third-party lenders – experts outside the platform. As you can imagine, this involvement of experts does not come for free – the original lender (be it the platform or an individual investor) might charge relatively high fees for the expertise and work put in the deal selection.
Which is the best real estate crowdfunding investment?
As always, the answer is: it depends. Choosing the right investment for you, from a myriad of available options, will always depend on your preferences, including risk tolerance and expected returns (senior debt or common equity?), investment time horizon (buy-to-sell or buy-to-let?), your experience and expertise (direct or syndicated debt?), and so on. Just identify your priorities, be aware of the available options (hope this post helps), and then link the dots and make a well-informed choice.