If there were no difference in the risks of business transactions, there would not be a reasonable explanation for higher returns in niche investment opportunities.
Below we simplify the important issue of risk and reward when it comes to real estate investments. Online platforms are now offering opportunities for individual investors to invest in debt and equity positions in large scale real estate development projects.
To get familiar with the basics, you must first understand the capital stack in any investment project.
The capital stack below highlights the risk, reward and pay out order, for the different types of money required to complete any investment project. There are many different types of real estate projects, residential, commercial, hospitality, industrial etc. Below we attempt to simplify explanations for the capital stack by assuming a residential development that is built and sold.
Most investment projects are a combination of debt and equity and there are several different types of debt and equity. We have broadly classified them into 2 classes of debt and equity respectively.
Equity is a necessary component of a project seeking debt financing. Equity provides the lender of the debt, a form of security over the loan. The security is the land or buildings purchased with the owner’s equity. Equity holders must pledge the value of their assets to lenders who they are asking to borrow monies from.
- Equity has the highest (projected) returns, is paid out last behind debt and gets paid nothing until the project is sold. If the project does not work, there is a possibility that the equity is actually worth nothing at the end.
- Debt has lower returns, but is paid out first and secured by the equity of the asset itself. Debt usually commands monthly interest payments during the term of the loan with the principal being paid upon completion of the loan term.Debt is a lower risk investment with lower returns compared to equity.
- Senior debt, which sits in a first mortgage position, is paid out first before all other funds when a project is sold.
- Subordinate debt, may be required on a project and is paid out after senior debt. This might be a bridge loan or part of a construction loan or funds required to make up the shortfall between what the senior debt is willing to provide and the maximum equity a developer has available to invest into the project.
- Preferred equity sits above common equity and receives a preferential return in relation to the common equity. Investors should be very clear as to what the rights of preferred equity holders are and what is the difference between the distribution of dividends/returns for preferred vs common. Often preferred equity is raised as a later date and therefore receives a different return than the common equity holders. Often the developers offer a preferred return of X% and then share in the profits above this mark.
- Common equity is paid last, receives the highest(projected) returns and is also in the deal for the longest period of time. Common equity takes the highest risk on a development.
Here are sample returns on any given deal. Please note that these figures will change project to project and usually come down to negotiations as well as benchmarks set by those who are in control.
The last diagram below indicates the proportion of each type of funds for a typical real estate investment project that make up the 100% of required funds to execute the deal.
InvestaCrowd is an online real estate capital marketplace offering debt and equity investments into real estate projects in Sydney, NYC and London. Headquartered in Singapore, deals on InvestaCrowd are exclusively available to our members only. Their are limited investment positions in each deal, and investments are offered on a first come first serve basis. To see the latest offerings and begin investing today, login and create an investor account at www.investacrowd.com
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