Real estate crowdfunding is a relatively new way to invest, and it can certainly be an exciting way to put your money to work on single-property commercial real estate deals.
In the world of real estate crowdfunding, there are hundreds of possible investment variations. But they can all be divided into two main baskets: debt and equity. With that in mind, here's a primer on the differences between real estate debt versus equity investments so you can decide which is the smartest choice for you.
Real estate equity investments
The majority of crowdfunded real estate investments are of the equity variety. You can think about real estate equity investments as a similar action to buying stock in one of your favorite companies, or better yet, as buying an investment property of your own.
Once you contribute your money, you become a stakeholder. If you own an investment property and it brings in rental income and eventually sells for more than you paid for it, you get to keep the money. Similarly, when you invest in a crowdfunding opportunity as an equity investor, you are entitled to a proportional share of the potential returns and cash flows of the project.
For example, if a crowdfunded equity investment needs $5 million in total funding and you invest $50,000 (1% of the total), you'd be entitled to 1% of whatever profits the project earns, less any investment fees.
Real estate debt investments
When you invest in a real estate debt investment, you are essentially becoming one of the project's lenders. You're playing the role of the bank, lending money in exchange for the promise of being paid back with interest. Most debt investments have a fixed interest rate paid to investors and a predetermined payment schedule.
Debt investors generally have a senior claim to the proceeds of a project. In crowdfunding terms, they are toward the bottom of the capital stack. It doesn't matter how much profit a project earns (if any) -- debt investors are still entitled to their agreed-upon payments.
Which is the best choice for you?
There's no perfect answer to this question, but let's take a look at some of the advantages and disadvantages of equity versus debt investments.
Why choose a real estate equity investment?
There are a few advantages to choosing an equity real estate investment:
- Unlimited upside potential: If a crowdfunded investment doubles investors' money in five years, equity investors would be entitled to a proportional share. On the other hand, debt investors would receive only their agreed-upon rate of return even if the project is wildly successful.
- Tax advantages: Real estate owners (but not lenders) can take advantage of depreciation deductions, which can dramatically reduce their tax liability each year.
- Lower fees: In equity crowdfunding investments, the project sponsor typically gets a small upfront fee, but beyond that, they generally only get paid based on the returns they earn for investors. In other words, you'll only pay high fees in equity investments if you're making a lot of money. On the other hand, debt investments often have higher and ongoing fees.
Why choose a real estate debt investment?
On the other hand, there are some good reasons you might want to choose a debt investment instead:
- Steady and predictable income: While real estate debt investment returns aren't exactly guaranteed, they're much closer to a sure thing than returns from an equity investment. Debt investors get paid before equity investors, and most debt investments have a set rate of return, making them excellent choices for investors who rely on their portfolio for income.
- Lower risk: Real estate debt investments are backed by the properties they represent, so in the event that a crowdfunding opportunity doesn't do well, debt investors can collectively foreclose on the property and other assets of the crowdfunded project to recoup their money. In situations like these, equity investors would only see any of their money after debt investors are made whole.
- Shorter time commitment: While there are certainly exceptions, real estate crowdfunding debt investments typically have holding periods of two years or less. In contrast, equity investments often have targeted holding periods ranging from three to 10 years and therefore are better for investors who don't mind a long-term commitment.
The bottom line
So, which should you choose? Real estate debt or equity investments? In a nutshell, the best choice for you comes down to two questions:
- How comfortable are you with risk?
- How much income do you expect from your investments?
The simple answer is that if you're willing to take on some risk in the pursuit of long-term profits, an equity investment is probably the best way to go. On the other hand, if you'd prefer a steady income stream and predictable return, and have a lower risk tolerance, debt investments could be the more attractive crowdfunded real estate investment.