Audrius Visniauskas July 04, 2019
We have already previously written a guide to P2P investing, however, we understood that we want to provide a lot more value to our investors and give a more in-depth overview of the deal types as well as no-nonsense tips about to reduce the risk in crowdfunding real estate investments.
Let’s start from the basics:
First of all, with any investment, you always must diversify and do it as much as possible. I personally noticed in the investment communities that a lot of people approach this manner very simply: just investing in different kinds of returns yielding deals, but this is really not the way to go.
The way we see it diversification is about investing in different countries and different types of deals, the second is often underlooked. If you, for instance, invest only in development loans, you are betting that all the developments will be sold, which is definitely not the case in case of recession.
For example, if you invest in development projects which yield 6%, to lower the risk because you made an investment into a deal which yields 18%, it doesn’t mean that you reduce your risk by 33%, it means that you are actually making a position where you concentrate on market situations with a similar outcome, which isn’t advisable position to be in.
You should consider investing in Buy-to-let, while it is a cash-flow investment, whose yield will not change much during the time of recession.
Understanding the risks & differences between types of deals:
Usually, development projects yield higher returns than others, but they are also carrying higher risks:
- Unable to obtain a license for development- this is common if we are talking about large projects which are raising first financing through crowdfunding, which will be exited after the bank loan. This is a recent deal we have financed where we identified this as the main risk.
- No future sales contract signed- this is common with a lot of projects, you can never be sure that the property will be sold because we can never predict future economic factors. A much lower sales price than the market average could be a positive indicator of preventing such a thing happening (but you can never be 100% sure).
- No sales at the project completion- the previous risk leads us that even if the project had some sales contracts, you always have to think about liquidity and business logic. A clear example is this project, which has very limited potential buyers due to its price and potential buyers in the region.
Equity vs debt:
If we speak about development projects there’s a huge difference between investing in debt and equity deals.
Mainly debt is considered to be safer because the borrower commits to his debt and if he becomes insolvent the property could be liquidated and investors would not only receive their capital but also interest (in the best scenario).
Loan to value (LTV) expresses the ratio of a loan to the value of an asset and is used by P2P platforms and banks to evaluate the lending risk.
The lower the LTV index- it's considered that the risk is lower. This number is calculated by dividing the lending amount with the total value of the property, then turned into a percentage by multiplying by a hundred. It’s understood that this value of the property could be later recovered in case of insolvency during the liquidation process.
However, we at EVOEstate aren’t the biggest fans of it, because the number could be misleading and it captures the current value of the property. It could be misleading to numerous factors: lack of data, liquidity of the property isn’t taken into account or that it’s impossible to include business logic into the valuation. You can read more about it in this article.
Equity, on the other hand, makes you a shareholder or an investor in profit participatory loan (in Southern Europe) which is similar in the structure. Being a business owner you experience not only gains but also the downside, which means that the returns which are being stated on the project can be lower but at the same time be higher. However, the property wouldn’t be liquidated and your capital fully wouldn’t be recovered.
Lower risk options:
If you want to truly diversify and be well prepared for the times of recession, make cash-flow investments. These could be buy-to-let and buy-to-let-then-flip deals.
This name is already straightforward and your invested money will be used to acquire the property, maybe do a small renovation and then rent it. It’s also divided into long-term and short-term rentals, which will generate a stable net income to the investors of 4-6% annually, which is very good if you would be comparing it to REITs. The only problem with these deals is that they have long durations and they are illiquid, however, it will be very soon possible to liquidate your investments on the secondary market. Until then- if you want to cash-out if this deal has our skin in the game, we’ll buy it back for 90% of the principal value at any given time.
It works the same as buy-to-let, but it’s intended to be sold in a period of 2-5 years. They have higher returns, but also they carry more risk due to market fluctuations because the platform would not be able to sell it at the level of the price they have expected. The best way to prevent this is to already have future sales contracts signed as in this project.
Worst case: the sale will not happen and you will be generating lower but stable rent income from the rent as there's a tenant.
PS: one thing platforms never tell about buy-to-let projects is that they always are planning to sell the property, it’s just a matter for how much, so in a sense, these two types are similar.
Never underestimate capital growth:
At first glance, 4.5-6% annual returns could seem small for a typical P2P investor, however, with buy-to-let projects you are typically participating in the profits of property value increase. The capital growth of the last years was extremely evident in Spain, where in Valencia property value in 2018 grew 14% on average and 6% in Barcelona. The real estate prices in Spain, still haven’t reached the level before the Economic Crisis. When these numbers and rental income add up, you might be receiving similar or even higher returns than the typical development deals.
Don’t lose capital:
As Warren Buffet suggests, investing has 2 rules:
- Never lose capital.
- Remember the first rule.
Therefore, we highly encourage you to find the right balance between rental & development projects and follow your guidelines. This number for everyone is different, just be honest to yourself with how much risk are you willing to take. And finally remember, that lower returns are a lot better than defaults.