Real estate crowdfunding is a relatively new and exciting industry, with an annual forecasted compound annual growth rate (CAGR) of 33.4% from 2020 - 2028. Our current data (as of July 2021) shows the European market size as already close to €7 billion, which would make the European market size an eye-popping €93.65 billion by 2028!
As an investor, there are two main methods to access this market: debt and equity investments. This article will more closely examine what equity investments are, specifically related to real estate crowdfunding, and what it means for an investor to choose it.
Related: What Is Real Estate Crowdfunding?
Equity investments in real estate crowdfunding are typically the purchase of shares of the project, similar to owning shares in traditional investment via the stock market. Investors purchase shares of a company (SPV) that is created specifically for the property project.
A special purpose vehicle or SPV is a separate company formed by the project developer to mitigate and separate risk from real estate projects and the development company. This means the development company’s cash flows and legal obligations are separated from the cash flows and legal obligations of the project. Investors are given the opportunity to invest in the project by purchasing equity shares of the SPV - effectively purchasing ownership interest of the project.
Returns are generated from the value of any cash flows generated by the project (rental income, for example) and any capital appreciation (rise in the value of the property) of the project when it is sold. This access to capital appreciation is what gives equity investments higher potential returns than debt investments.
Equity investments also tend to have longer holding periods, as returns are derived from rental income and price appreciation - cash flows that typically take a longer time to receive than fixed interest payments from a debt investment. With equity investments, investors should be careful with the term “target holding period”, especially for common equity. It basically means that the holding period is only a projection, and therefore, there is no assurance over when the investment will be paid out or what the returns will actually be.
In real estate crowdfunding, many platforms offer secondary markets. Here, investors can buy and sell their shares of property investments to each other. In theory, a secondary market allows an investor to exit his position at any time. In practice, many platform’s secondary markets do not have enough activity and investors struggle to exit their investments early.
Investors also need to take into consideration that there are two types of equity available for investment: preferred and common.
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With preferred equity, investors still retain an ownership stake in the project, but there are some differences with common equity. Preferred equity investments have priority over the project’s cash flows over common equity investors, but are still typically subordinate to debt lenders.
Preferred equity is a portion 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 of the capital stack is senior debt with lower risk and therefore lower returns. At the top of the capital stack is common equity with typically much higher risk and therefore higher returns. As such, preferred equity has a lower level of risk than common equity, but it is still higher than debt investments.
This level of risk is reflected in preferred equity average rates of returns. Investors can expect a 9 - 13% rate of return on this type of investment.
The biggest distinction between preferred and common equity is that returns are typically capped for preferred shareholders. Returns are set at a fixed rate and derived from all revenues or cash flow earned by the project. Common equity investors typically benefit from the capital appreciation of the project, leading to potentially uncapped returns should the project drastically increase in value.
Preferred equity is also often confused with mezzanine debt investments. These two investments share some similarities. From a financial point of view, both offer a similar level of risk and the amount of expected return. The main difference is in the contractual and legal framework of the agreement. Equity investors are given an ownership interest in the project, and therefore are entitled to capital appreciation gains or project revenues, while debt investors are typically not.
Common equity investments are the riskiest investments in real estate crowdfunding. Common equity investors have the lowest priority in the capital stack, which means they are the last ones when it comes to payouts, both of cash flows and during recovery should the project have financial issues.
So if a project doesn’t meet its projected returns, the first to get paid are debt lenders (senior and then mezzanine debt investors). After debt are preferred equity investors, and then finally common equity investors receive their share from whatever is left (if anything). However, this higher level of risk means that they often also receive the highest yields out of all real estate crowdfunding investors.
Common equity investors can expect returns as high as 20% or more, depending on the success of the project. This is due to the fact that common equity has an uncapped upside on returns by being able to benefit from capital gains and increased cash flows/revenues.
Another difference is that preferred equity investors have fixed returns which don’t always reflect the success of a project.
Equity Investments Summary
- Riskier: If the property project fails to meet its return expectations, equity investors are the last ones to receive their money back, or might not receive anything at all.
- Long holding period: The duration of equity investments can be 2 - 10 years or even longer.
- Uncapped returns: Common equity can have uncapped returns that are based on capital appreciation of the project, while preferred equity usually has fixed rates, with capped returns.
- Estimated income: Returns can be hard to accurately estimate because the project’s capital appreciation and rental income can fluctuate based on numerous factors.
- Taxes: In some markets, equity investments offer certain tax benefits such as if you hold investments long-term your capital gains tax could be significantly reduced. However, it differs from country to country, so it is recommended for investors to research what benefits may be available.