Equity vs. Debt Crowdfunding, which is right for me? [#tb] [from https://www.denzity.io/blog/]

Original post: https://wordpress.denzity.io/2018/09/18/equityvsdebtcrowdfundingwhichisrightforme/
Investors can participate in Real Estate Crowdfunding in two main ways: Equity Crowdfunding and Debt Crowdfunding.
Equity Crowdfunding means Investors acquire an ownership interest in a real estate project to receive a proportional share of the project’s rental income and capital appreciation. Equity Investors have the potential to achieve high returns (5–15%, for example) but face a large risk should the real estate project not work out.
Debt Crowdfunding means Investors act as a lender to the equity investor of a real estate project and would receive a fixed interest rate (7–10%, for example) generated from the project’s rental income. Debt Investors are limited to the fixed interest rate but repaid interest and principal from the Project’s rental income and sale price before Equity Investors.
It is important Investors understand where they ‘sit’ in the capital stack of a real estate project and how this can affect their investment and return.
Example of Equity vs. Debt in Real Estate Crowdfunding
A Real Estate Crowdfunding Platform acquires an office building (“Project”) for $1,000,000. The Project generates $80,000 in rent, which equates to an 8% cap rate (explained below). The Platform is given three months to perform the necessary due diligence and raise $1,000,000 from real estate crowdfunding investors to close on the Project.
Note: for simplicity, this example assumes (i) rent is equal to ‘net operating income’ (NOI), (ii) no tax is payable on NOI, dividends and capital gains, and (iii) the Platform does not charge any fees to Investors.
Equity v.s. Debt Crowdfunding
Scenario 1: 100% Equity Crowdfunding, with capital appreciation100 Equity Investors invest $10,000 each to receive 1% equity in the Project. Equity investors receive a share of the Project’s $80,000 rent in proportion to their fragmented ownership. For example, 1% of equity receives $800 in rent.
After 4 years, the Project is sold for $1,100,000 while still generating $80,000 in rent. Equity Investors receive 100% of the Project’s capital appreciation, which is $11,000 per 1% equity ownership.
How did Scenario 1 perform?
Equity Investors with 1% equity achieved a 13% annual return, calculated as:
Equity invested: $10,000
Rent received: $1,600
Equity sold: $11,000
Investor return: ($11,000 + $1,600) / $10,000–1 = 26%, which is 13% per year over 2 years
Scenario 2: 50% Equity and 50% Debt Crowdfunding, with capital appreciation50 Equity Investors invest $10,000 each to receive 1% equity in the Project and 50 Debt Investors lend $10,000 each to receive 7% interest per year. Debt Investors receive no equity ownership. Equity Investors receive a share of the Project’s $80,000 rent only after the Debt Investors are paid their 7% interest.
Each Debt Investor receives $700 in interest, while each Equity Investor receives $900, based on 1% equity ownership. The Platform would make sure all Debt Investors are first paid before paying Equity Investors the remainder of the Project’s rent. This would be calculated as:
Project rent: $80,000
Debt interest: $35,000, which is 7% on $500,000 lent by 50 Debt Investors equal to $700 each
Rent to Equity Investors: $45,000, which is paid to 50 equity Investors equal to $900 each
After 2 years, the Project is sold for $1,100,000 while still generating $80,000 in rent. Equity Investors receive 100% of the Project’s capital appreciation after each Debt Investor is repaid their original amount of $10,000. The Platform repays all 50 Debt Investors their $10,000 each before any Equity Investor receives their proportional share from the sale price, which is $12,000 for 1% equity.How did Scenario 2 perform?
Debt Investors achieved a 7% annual return, while Equity Investors achieved a 14% annual return based on 1% equity, calculated as:
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Scenario 2
Why would you be a Debt Investor instead of an Equity Investor?In the above example, the office building was purchased for $1,000,000 and sold 4 years later for $1,100,000 while still generating $80,000 in rent. The office building experienced capital appreciation and was sold at a cap rate of 7.3%, calculated as rental income divided by capital value.
The sale at $1,100,000 represents ‘cap rate compression’ which occurs when capital appreciation increases faster than rental income. In this example, the office building was originally purchased for $1,000,000 generating $80,000 in rental income, a cap rate of 8.0%. After 4 years, the office building was sold for $1,100,000 generating $80,000 in rental income, a cap rate of 7.3% or a compression of 70 basis points.
Equity Investors experience 100% of capital appreciation, which was $100,000 over 4 years. Debt investor receives no interest in capital appreciation as they are only repaid their original investment.
Scenario 3: 50% Equity and 50% Debt Crowdfunding, capital depreciation
Now let’s say the office building was rented to a single tenant and located in an area outside of the city that expecting new developments such as highways, railways, and a regional airport, but the government decided against these new developments. Two things would likely happen that affects the office building’s value:
(1) The existing tenant moves to a different office building closer to where existing infrastructure (highways, railways, airport) attracts small and large businesses. As a result, the office building would lose 100% since it relies on a single tenant. It would need to begin advertising and sourcing for new tenants. During this period, the office building would not be generating rental income to pay the Debt Investors their interest, which could be due on a monthly basis, the implications and mitigating factors of which we will discuss in a subsequent post.
(2) Prospective tenants would likely request a discount on the recent rental price of $80,000, since they may not be willing to be located in an area outside of the city with limited and undeveloped infrastructure. If prospective tenants end up paying $75,000 in rent per year (lower than $80,000), the Debt Investors would still receive their 7% interest per year of $700 each, however Equity Investors would receive lower rent, which drops to $800 (from $900) for 1% equity.
After 4 years, the office building is sold for $900,000 since prospective buyers don’t think the office building’s area will experience new developments in the future and is sold for a cap rate of 8.3%. The office building is sold for less than it was originally purchased for $1,000,000 at a cap rate of 8% with a single tenant paying $80,000 in rental income.
How does Scenario 3 perform?
Debt Investors achieved a 7% annual return, while Equity Investors achieved a 3% annual return based on 1% equity, calculated as:
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Scenario 3
In Scenario 3, Equity Investors achieved a lower return than Debt Investors since the office building’s capital value depreciated after 4 years, for the reasons highlighted above. Debt Investors achieved a 7% return in Scenario’s 2 and 3 because their returns are limited, on the upside and downside, to the fixed interest rate of 7%, assuming their principal is repaid.Equity Investors experienced 100% of the office building’s capital depreciation of $100,000 over 4 years. As a result, Equity Investors achieved a 3% return in Scenario 3, as compared with 14% in Scenario 2, primarily resulting from the office building’s capital depreciation. Equity Investors achieved a positive return since rent received over the 4 years ($3,200) was enough to recover the drop in capital value ($2,000) — this is referred to as ‘positive carry’.
Investors should decide based on risk vs. return
In conclusion, Investors should decide between Equity vs. Debt Crowdfunding opportunities based on their investment preferences. Debt Crowdfunding is typically a shorter investment horizon while Equity Crowdfunding typically provides greater upside and downside potential for investment returns.
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What’s up next? Denzity will cover valuation metrics an Investor should consider before making an investment in a Real Estate Crowdfunding project.