With the potential to reach $300 billion in volume by 2025, real estate crowdfunding is an exciting landscape with plenty of opportunities.
But before plunging in to reap its benefits, it’s important that beginner investors learn about the different types of investment categories to best assess the diverse projects and opportunities.
Let’s venture into the real estate crowdfunding world to learn more about their differences.
Before taking a look at the main categories, we need to take a step back. Each investor needs to understand that even the same real estate project can comprise of various funding types.
This structure of each project is referred to as the capital stack. The concept serves to evaluate the risk and assess investment opportunities more accurately.
The capital stack shows different types of capital “stacked” on top of one another in a project. For example, a 30% part can be financed through equity, while 70% is funded through debt investment.
These stacks are always ordered from the least senior on the top to the most senior on the bottom in terms of priority when distributing the cash flows. This hierarchy – with equity investments on the top and debt investments on the bottom – indicates what happens to the invested capital in case a project gets into financial trouble.
Capital stacks, therefore, show the correlation between the level of risk and the amount of potential return: The higher you go in the pyramid, the higher return you can expect – but at a higher risk.
In equity investments, investors own a proportional share of the specific real estate project. The returns are based on the property rental income and change of the value of the property project.
Although not a rule, equity investors generally receive higher returns than debt investors. They also receive regular rental income on a monthly or quarterly basis, as well as earning capital gains once the property is sold.
Equity investments are generally associated with higher risk and longer holding periods. While platforms usually offer a possibility to sell the investment after five years, the periods stretch to up to ten or more years, making these investments inherently less liquid.
However, there are two different types of equity investments:
Common equity is like investing in the stock market. The investor has a lower priority to get paid but is promised higher yields. This type of investment is considered to be the riskiest in real estate crowdfunding but the one with the potential to bring the highest returns.
Our research suggests that common equity investments tend to offer around 12-18% in yields.
Preferred equity provides sponsors and developers with a higher degree of leverage at a lower cost than in common equity. In this scheme, the level of risk is generally smaller but still higher in comparison to debt investing.
This is often reflected in the average yields, which can be around 9-13%. Importantly, preferred equity investors have capped returns, which don’t always necessarily reflect the success of the project.
Debt investment is the most common type of real estate online investing. Within this arrangement, investors act as lenders to the real estate project owner, investing in a loan associated with the respective property project.
The holding periods are relatively short, stretching anything from 6 to 24 months, making the investments relatively liquid on the real estate investing scale. During this period, investors receive a fixed interest on a regular basis.
There are two different types of debt investments:
Mezzanine Debt forms a bridge between debt and equity investments. Investors stand in the payout line behind senior debt investors but have priority before equity investors.
This makes mezzanine investments riskier, so the return rate tends to vary between 9-15%. Besides higher returns associated with higher risk, mezzanine debt has short holding periods and fixed returns with monthly or quarterly interests, similar to senior debt investments.
Senior Debt is the first source of money that property developers and sponsors are reaching for when funding a project. If a project gets into financial problems, senior debt has priority over Mezzanine debt and equity investments, making it the safest investment in real estate crowdfunding.
Many senior debt investors are actually banks and financial institutions – however, they have to count on a lower return rate, usually between 3-8%.
Equity vs. Debt
When it comes to making the decision to invest, the type of investment should be one of the main guiding principles. By being able to distinguish these categories, investors can best assess which fits their portfolio the best.
If you want to learn more about the concepts surrounding real estate crowdfunding, make sure to explore more articles on our blog.