Real estate crowdfunding is a new and exciting industry. Similar to traditional real estate investment, there are different types of investments. The types of investments are varied but typically fall under two categories: debt investments and equity investments. This article will more closely examine what debt investments are, specifically related to real estate crowdfunding, and what it means for an investor.
The most common types of debt investment in this industry are providing financing for bonds or loans. In this case, investors act as lenders to the property owner, investing in a loan associated with the respective property project. This loaned capital plus interest is the total return an investor can expect to receive at the end of the project.
The holding periods for debt investments are relatively short and usually vary between 6 - 24 months. During the period, investors receive the contractual interest on a scheduled basis.
With debt investments, it is important to understand where the debt is located in the capital stack i.e. what type of debt is being financed. There are distinct risks/rewards associated with the two different types of debt: senior and mezzanine (junior).
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Senior debt is the first source of money that property developers and sponsors seek when funding a project. Senior debt is the first part of what is called the ‘capital stack’, which is a way of visualising the capital needed to fund real estate projects and their associated risks and returns. At the bottom is senior debt, with lower risk and therefore lower returns. At the top of the capital stack is common equity, with typically higher risk and therefore higher returns.
Senior debt owners have priority over the project’s cash flows over mezzanine debt owners and equity holders. This means senior debt investors are the first to have their capital paid back and are the first to receive compensation if the project encounters financial difficulties. Because of this priority, which means higher security and lower risk, senior debt offers a lower rate of return. This usually varies between 3 - 8%, hence it is the cheapest way to fund a project for developers and sponsors.
Senior debt investors desire the most security on their investment. This results in senior debt investors only providing funding up to a certain Loan-to-Value (LTV) percentage. For example, a developer may need €1,000,000 in financing for a real estate project. A bank that provides the senior debt might only provide funding for 60% (an LTV of 60% or €600,000 in funding) of the needed amount to reduce their investment risk. For this reason, senior debt usually only covers 50 - 80% of a project's funding needs, and the rest is covered by mezzanine and equity funding. In real estate crowdfunding, the funding not covered by senior debt (€400,000) is where many platforms offer their services and where retail investors are able to invest in the real estate project.
From the investor's point of view, the lower rate of return is balanced by the lower risk. In fact, senior debt is seen as the safest investment in real estate crowdfunding. This means, if something goes wrong with a project, senior debt investors will have priority and be first in line to be compensated.
Typically, banks and other institutional investors are the sources of senior debt for real estate projects. However, some real estate crowdfunding platforms offer senior debt investments as well.
Mezzanine (aka junior or unsecured) Debt
Think of mezzanine debt as a bridge between debt and equity investments. Investors stand in the payout line behind senior debt investors but still have priority over equity investors.
This makes mezzanine investments riskier relative to senior debt, so the rate of return tends to be higher to reflect this. Interest rates can vary between 9 - 15%.
Despite a higher risk and higher return, mezzanine debt holding periods and payment schedules are similar to senior debt investments.
For mezzanine debt investors, it is wise to carefully check who represents the senior lender. For example, if the senior lender is a renowned financial institution, it gives the investor a good level of security that the respective project was subjected to detailed due diligence.
Mezzanine debt can be sourced from all types of investors and this investment type is the most common in real estate crowdfunding. When investing in a bond or loan for a real estate project, it is this position in the capital stack that the investment will belong.
Debt/Loan Investments Summary
- Safe: Debt investments offer a lower risk level, with senior debts being the lowest risk investment.
- Short holding period: The holding period usually lasts between 6 - 24 months.
- Steady returns: Returns are from the contractual interest rate of the loan, so investors receive fixed timely interest payments. Short holding periods with capped interest rates generate a great steady and predictable income for investors.
- Lower returns: Lower investment risk combined with capped interest and a short holding period naturally lead to lower returns than equity investments.
- Non-ownership: Investments are funding for loans or bonds used towards real estate projects and therefore debt investors do not actually have any ownership interest in the project.