The advent of real estate crowdfunding (RECF) has disrupted the real estate sector by essentially removing the high entry barriers associated with traditional means of real estate investment, making it accessible to small investors. Noteworthily, the RECF market is set to expand 58% year-on-year to reach US$869 billion before 2027. The impressive growth rate suggests that more and more retail investors capitalise on the democratisation of real estate investing. While no investor likes taking on risks per se, taking on more calculated risks can help boost investment gains, according to the risk-return trade-off principle. In fact, an academic study titled Do Principles Pay in Real Estate Crowdfunding? has shown that this may well be the case for RECF, through analysing 733 crowdfunding projects with an average annualised proposed return of 13%.
13% average annualised proposed return from projects analysed in the study
This article will show you six RECF project characteristics that can boost your returns in exchange for adopting additional risks. We do this by taking you through the key findings of the mentioned study using plain English – without you having to go through the horrendous equations!
If you are new to this investment type, a better place to start might be our in-depth guide on everything you need to know about real estate crowdfunding.
Risk factors You Can Leverage to Get the Best Real Estate Crowdfunding Returns
We have localised six risk factors that can help you increase your return from real estate crowdfunding.
The six risk factors can be translated into concrete advice that you can use when deciding which projects to invest in. We will walk you through all six, but to give you an overview, here are what we think investors looking to increase their return in real estate crowdfunding should focus on:
- Opt for investments with equity as the primary source of finance
- Keep an eye on commercial properties
- Look for projects that pay less frequently with longer investment terms
- Pay attention to sponsor type and reputation
- Find projects that involve developing or redeveloping commercial properties of below-par qualities
- Invest in projects in areas with more volatile property prices
1. Opt for investments with equity as the primary source of finance
- Equity-financed projects: 16.5% expected return
- Debt-financed projects: 10.7% expected return
Various RECF platforms provide investors with the opportunity to choose between equity- and debt-financed real estate projects. However, those who invest in equity-backed projects can expect to pocket 2.9% to 4.8% more profits than those who invest in debt-backed projects. On top of this, leverage can further increase profit margins, bringing the proposed returns for equity-backed projects to 16.5%. This is because leverage is a means by which project sponsors (more on sponsors later) transfer financial risks to investors, who anticipate larger returns as a result.
As an aside, there is a hierarchy of different types of debt in terms of proposed returns. For instance, the expected returns for projects funded by senior loans (lower risk) are 1% to 1.1% lower than those funded by junior loans (higher risk).
2. Keep an eye on commercial properties
- Commercial projects: 14.6% expected return
- Residential projects: 12.2% expected return
Here we define commercial properties as properties that are mainly or solely developed for investment or rental purposes, i.e. those generating income. Consistent with pre-existing literature, commercial projects were found to offer 0.7% to 1.8% higher proposed returns in comparison to residential projects, raising the 12.2% expected return for residential properties to 14.6% for commercial properties. As one would expect, commercial property investment comes with risk factors that differ from those associated with residential properties. In particular, sales volume, property quality, and market absorption are several risk factors specific to commercial property investment.
3. Look for projects that pay less frequently with longer investment terms
- Projects that pay less frequently: 14.7% expected return
- Projects that pay every month: 11.4% expected return
In contrast to projects that pay investors monthly, projects with more infrequent payment schedules increase proposed returns by 0.9% to 1.7% on average. Less frequent payment schedules can, for example, be schedules that pay quarterly or yearly, a lump-sum payment following the end of the holding period, or ones that pay incrementally larger sums over longer timespans. This is true regardless of whether the property is residential or commercial. We can attribute the increased return with more infrequent payments to two main risk factors described below.
Risk 1: uncertainty
The most straightforward reason is that there is a higher degree of uncertainty involved in projects spanning a longer term because investors do not receive any assurance of the performance or even existence of their investments in the form of payments. Hence investors that receive less frequent payments face more uncertainty and thus bear more risks. In fact, this is another reason to invest in equity-financed projects, as projects with equity as the source of finance tend to last longer than debt-financed projects.
Risk 2: opportunity costs
Another reason for the larger return is the time value of money. Since a dollar today is worth more than a dollar tomorrow, deferring payment receipts implies that payments cannot be reinvested in other investments for profit generation. This raises investors’ opportunity costs, why they must be compensated through higher returns. Intriguingly, the timescales of payment schedules correlate with project type (residential vs commercial). The investment periods for 73% of residential projects span under a year and make monthly payments, whereas 81% of commercial projects make less frequent payments, thereby providing further justification for investing in commercial projects rather than residential projects.
4. Pay attention to sponsor type and reputation
- Projects with institutional sponsors: 14.1% expected return
- Projects with individual sponsors: 11.3% expected return
Sponsors for real estate crowdfunding campaigns are individuals or entities who oversee the entire project development process. While measuring their reputation could be subjective, here we define reputable sponsors as those with national reputations, in contrast to merely regional presence.
Why does sponsor reputation matter?
Highly reputable sponsors tend to be endowed with more financial resources, more expertise, and a broader network that exposes them to exclusive investment opportunities inaccessible to less reputable, individual sponsors. These opportunities often lead to them selecting commercial projects that are more complicated and larger in size, thereby raising proposed returns. Sponsor type and reputation could again influence expected returns through their different tendencies towards utilising equity versus debt financing: 60% of institutional sponsors use the former, while 92% of individual sponsors use the latter.
Delving deeper: does the source of finance make any difference?
- Equity-financed projects with individual sponsors: 19.7% expected return
- Equity-financed projects with institutional sponsors: 16% expected return
If we subdivide each sponsor type according to their sources of finance, it could potentially paint a different picture as to which sponsor type to opt for. Looking only at equity-financed projects, individual sponsors seem to offer a sizably higher return than institutional sponsors to incentivise investors (19.7% vs 16.0%). However, the study’s authors were less certain about whether this represents a material difference in reality, presumably due to the small sample size.
5. Find projects that involve developing or redeveloping commercial properties of below-par qualities
Development projects: 15.2% expected return
Non-development projects: 12.2% expected return
It is easy to see that commercial properties kept in pristine conditions (think Grade A office spaces) are associated with lower investment risks. Conversely, investments involving premises of poor conditions are riskier, especially when properties show signs of physical deterioration and require renovations or even redevelopment (think derelict buildings), because of higher cost and outcome uncertainties.
Source of finance matters again
- 57% of development and redevelopment projects are equity-financed
- 71% of non-development projects are debt-financed
A more subtle underlying reason why such properties are associated with higher risks, though, actually lies in the projects’ sources of finance: 57% of projects involving development and redevelopment are equity-financed (riskier), while 71% of projects that do not are debt-financed (less risky). Therefore, the source of capital and uncertainties regarding cost and outcome both contribute to greater risks, which are compensated by significantly larger expected gains. In general, expected returns are higher when they involve redeveloping lower-quality properties with equity finance.
6. Invest in projects in areas with more volatile property prices
Commercial properties: 1% in expected return for every 10% increase in NCREIF Index return volatility for commercial properties
Residential properties: 0.1% in expected return for every 10% increase in FHFA Index return volatility for residential properties
The NCREIF Property Index (NPI) and the FHFA House Price Index are popular indicators of property market risks for commercial and residential properties, respectively. They enable the volatilities of properties to be compared and contrasted between different areas as well as between different periods. Real estate crowdfunding projects located in areas with more volatile property markets provide larger returns. Investors can expect to receive a modest 0.1% premium for every 10% increase in housing price volatility. In contrast, they can expect to receive a much higher (1%) gain in proposed return for every 10% increase in the NPI – yet another reason to invest in commercial projects.
To sum up, the source of finance, type of property (residential vs commercial), payment schedule and investment period, sponsor type and reputation, property quality and regional volatility are several project characteristics that investors could research into to evaluate risks that are worth taking on, in anticipation of higher returns and in accordance with their risk appetites. Since this is a first-of-its-kind academic study regarding RECF, the availability of additional property data will help future studies establish how other unmentioned property characteristics may contribute to investment risk hence returns, particularly when empirical results differ from theoretical predictions.
To harvest the potential benefits of leveraging risk factors to boost your return, you must pick the right platform – and one that matches your risk appetite. We have put together a list of the best real estate crowdfunding platforms in Europe that might serve as inspiration.