The Optionality of Real Estate Crowdfunding: Equity & Debt Investments

What is real estate crowdfunding and why is it so attractive?

Crowdfunding has opened up new avenues for those looking to start their own business or project, but find themselves without the funds to do so. They may not necessarily have the best credit score either, which automatically disqualifies them from getting a loan through traditional avenues. This is where crowdfunding comes in. There are many different websites offering crowdfunding options that a person can use to raise funds for their venture. These crowdfunding sites are a great way for someone to get the investors that they need, without the hassle of approaching banks or venture capitalists.

Real estate crowdfunding works similarly. If someone wants to invest in real estate but doesn't want to own or maintain a building in their own name, they can become a shareholder through a crowdfunding company. Any profits directed to the real estate venture, such as those from rental income or flipping the property, are passed onto the investor.

In a nutshell, crowdfunding pools money in order for small and mid-sized investors to use the funds to invest in the future developments and growth of a company, such as buying equipment or building a manufacturing plant.

One of the key reasons why investors are looking to real estate crowdfunding as a viable alternative to real estate investment trusts (REITs) and real estate ETFs is due to the optionality provided. With crowdfunding, investors can choose between equity or debt investments, whereas traditional non-traded REITs are usually just equity investments that are only available to accredited investors.

Real estate crowdfunding exists with its own rules, risk, and regulations. The two available offerings are debt and equity investments, each with its own benefits and drawbacks. We will break down what each of these types of crowdfunding investments involves, before delving into their advantages and disadvantages.

Real estate crowdfunding capital stack

Before we break down the pros and cons of debt versus equity investments, it is important to contextualize how each of these plays a role in the capital stack, which relates to how the property deal is structured.

The capital stack for real estate is as follows:

1. Senior debt;
2. Mezzanine debt;
3. Preferred equity;
4. Common equity.

Debt investments receive distributions first, with senior debt topping the list. Typically, borrowers must make a monthly payment to avoid defaulting on the loan. The mezzanine is secondary to senior debt but is still an obligatory repayment. Targeted returns can vary depending on the level of leverage and risk involved.

Once debt investors receive their distributions, preferred equity investors are next in line to receive their shares. Common equity is at the bottom of the capital stack, meaning these investors get paid last, following debt servicing and preferred equity investors. Common equity investors receive distributions at the sole discretion of the owner or fund manager (the sponsor).

Capital stack flipped upside down from lowest to highest risk
Source: Financial Samurai

You may be wondering: Why have equity investors at all?

The answer is leverage. A property’s leverage is the total portion of its debt financing relative to its current market value. The advantage of leverage is that it can increase the potential return on investment. Take two investment scenarios for example:

A plan sponsor has CHF 10 million in equity to invest. Let’s say they put 50% leverage on a property, allowing them to buy a CHF 20 million property (CHF 10 million in equity and 10 million in loans). Either they put up the total equity investment themselves or raise CHF 5 million from individual equity investors. The latter option lets them invest only half of their own capital into the project.

Alternatively, the sponsor could also use that CHF 10 million (5 million in investor equity and 5 million of their own funds) and might decide to use 75% leverage to buy a CHF 40 million property.

For the second example, assume both properties experience the same 10% appreciation in value before the sponsor sells. Even though the first investor has a higher split (50/50), the investment amount is half that of the second investor. Consequently, the first sponsor would make a profit of CHF 2 million, while the second sponsor would make CHF 4 million, even with a 25/75 split after the sale of the property. The result is that the second sponsor makes more from the sale because the investment amount is much higher.

But what if the deal is not successful?

Higher leverage can result in higher returns, but by the same token, it incurs higher risk. This is where sponsors need to determine how to structure the capital stack, which will vary depending on their risk tolerance and goals.

Benefits and drawbacks of debt investments

Benefits

1. Shorter holding period

Debt investments usually have a holding time in the 6-24 month range, but these periods can vary. This is advantageous for investors who do not want their assets tied up long-term and seek access to capital within a shorter time horizon.

2. Secured against the property

The property or promissory notes securing debt investments are like insurance policies for loan repayment. Remember that loans can still default, but even if this were to happen, investors can recoup some of their losses through a foreclosure action.

3. First in line for distributions

Debt investors are at the bottom of the capital stack, meaning they get paid back first when the property is sold. However, it is important to note that if there is foreclosure, debt investors will need to cover some of that cost.

4. Fixed income

Debt investments involve obligatory, steady payouts. Investors usually earn between 3-8% and beyond annually, with monthly (sometimes quarterly) payouts.

Drawbacks

1. Higher fees

Debt and equity investments tend to be the antithesis of one other: If equity has lower fees or carries higher risk, it is relative to debt which tends to be the opposite. Most real estate crowdfunding platforms do not charge investors fees for access alone, but participation almost always involves a cost, such as a platform taking a percentage off the topline. This can impact debt investment returns, in particular, due to the nature of these being fixed payments. And as mentioned earlier, there can also be a loan origination fee.

2. Capped returns

Debt investments don’t have many fluctuations regarding returns. For some investors, this is a perk because it provides a fixed income, whereas other investors may be itching to see their returns climb. That is where debt investments do not offer much in the way of variability.

3. Exposure to prepayment risk

Debt investors are susceptible to early amortization. This can happen through higher monthly payments, refinancing, or even selling the property. Any of these scenarios may interrupt cash flow for debt investors. It is essential to know that even debt investments incur risks and deviations.