Denzity on Real Estate Crowdfunding (Part 1 of 3)

Here at Denzity, we are passionate about effecting change in an asset class and primary tool for capital appreciation and wealth preservation maintained through generations. Real Estate Crowdfunding (“RECF”) utilizes technology as a medium by which property ownership can be spread and diversified among a wide demographic of investors from different places.

Real estate has traditionally been an asset class that only available to wealthy individuals. Real estate platforms, such as private equity funds, have therefore only been able to seek investment from accredited investors. Accredited investors are individuals with USD $200,000 annual income or USD $1,000,000 net worth.

RECF is a new medium made possible since 2012 with the introduction of Jumpstart Our Business Startups Act (also known as the JOBS Act). The JOBS Act means real estate platforms can access a wider demographic of potential investors. However, there are several key issues which arise as a result.

In this article, we will highlight the technical knowledge investors need before investing.

Real estate investment requires technical knowledge. This is why Platforms hire real estate and investment professionals to perform due diligence and benchmarking before making an investment. As an investor, you will usually be provided with an information package, primarily containing an investment memorandum (“IM”) and limited partnership agreement (“LPA”).

The investor would read the IM, which contains details on the real estate property and its market (geographic and type), along with cash flow projections based on the platforms forecasts. Platforms will explain what capital expenditures are needed to improve the building’s marketability and the tenancy schedule to achieve a certain return to investors — one of the key metrics used by investors to decide on investment opportunities.

As an investor, you would need to understand the terms and conditions of the LPA, a document which details the legal manner by which you participate in the project. An investor who subscribes for shares in an investment fund, the vehicle used to hold the project, would be subject to certain rights and obligations under the LPA. These obligations can present itself in the form of a legal and commercial obligation.

The point is that understanding these documents require specific knowledge predominantly held by investment professionals who are typically employed by investment funds. These investment professionals accumulated their specific knowledge and skillset having worked in the finance (e.g. banker) and/or legal (e.g. lawyer) fields.

For example, a real estate project purchased for USD $10,000,000 obtains a USD $6,000,000 loan from a bank. The bank provides the loan subject to a facility agreement (“FA”). The FA is a legal document which defines the project’s legal obligations, which are primarily to (i) pay interest to the bank, (ii) repay principal ($6,000,000) to the bank, and (iii) maintain certain metrics referred to as covenants, such as a specified loan-to-value (“LTV”).

As an investor, you should understand the FA which highlights one the key risks associated with the project and your investment. In the event, the project is unable to satisfy the covenants (e.g. unable to repay the bank loan principal), the project would be in default and your investment would become at risk.

Therefore, investors without the technical knowledge stand at a disadvantage to investment funds which hire investment professionals. So what’s the good news?

Denzity is backed by a team of real estate and investment professionals here to guide you along the way of searching and filtering RECF investment opportunities, and here to help you understand the key metrics and provide insights.

We hope these articles provide you with insight into the real estate investment process and journey!

If you’re not already signed up with Denzity, make sure to sign up to receive the latest updates!

Asia PropTech, our Community Partner

Asia PropTech

Denzity is proud to announce a partnership with Asia PropTech, a PropTech ecosystem operator focused on building and connecting PropTech startups in Asia. We would like to introduce Asia PropTech to you as the newest member of Denzity’s community. https://www.asiaprop.tech/

Asia PropTech holds regular events and hackathons to build awareness and participation in Asia’s PropTech developments. Based in Hong Kong, Asia PropTech was founded by Leo Lo, a surveyor turned serial entrepreneur in high demand as a speaker for his thought leadership at real estate conferences in Asia.

Leo Lo, Asia PropTech Founder

Leo is the founder of PropSeed, a Real Estate Crowdfunding Platform, founder of PropBLK, a company providing real estate blockchain solutions, and co-founder of Fonto Real Estate, a boutique real estate advisory firm in Hong Kong. Leo will soon launch a dedicated PropTech accelerator and we are excited to share its ongoing developments with you.

Asia PropTech provides an ecosystem for real estate startups and incumbents, government, and academia to collaborate on achieving technological improvements to their real estate business model. The ecosystem supports PropTech startups with sound business expertise, acceleration methods, and funding with a goal towards value creation in the real estate industry.

Denzity is pleased to announce our partnership with Asia PropTech and will be sharing details of their upcoming events, new ideas and recent developments to help them build the Asia PropTech community.

Propteq Asia 2018 [October 30 2018]

Asia PropTech is holding Propteq Asia 2018 on October 30 2018 at Cyberport, Hong Kong’s incubator of startups. Propteq Asia is where the world’s leading real estate innovators will come together and talk about the challenges and opportunities in PropTech.

You can find more details on Propteq Asia 2018: https://us18.campaign-archive.com/?e=[UNIQID]&u=2a0989df9d93dfc233cdb6e79&id=7cf4ab66a9

What you need to understand about real estate capitalization rate (Part 1 of 4)

Real estate investment is an opportunity to generate regular income and achieve capital appreciation in a stable asset held over a 5–15 year period. Real estate investors typically compare investment opportunities start by using one key metrics: Capitalization Rate, aka Cap rate.

In this article, we highlight how you should understand how to compute the cap rate and how to use cap rate when comparing different real estate crowdfunding investment opportunities.

This is part 1 of 4 articles covering the real estate cap rate:

  1. What is the real estate cap rate?
  2. What you need to understand about the real estate cap rate?
  3. How does the real estate cap rate form part of your investment analysis?
  4. How leverage helps you achieve your investment goal in real estate.

Part 1: What is the real estate cap rate?

Cap rate is the rate of return on a real estate investment property based on the income that the property is expected to generate. It is calculated by dividing the property’s net operating income (“NOI”) by the current market value or acquisition price of a property.

Capitalization rate = Net Operating Income / Current Market Value (Source: Investopedia)

Once an investor knows a property’s cap rate in a specific market, the cap rate can be used to compare with other types of real estate cap rates located in different markets around the world to understand which is more suitable to their investment preference. We have made a quick guide for you below:

Understand the Real Estate Cap Rate

That’s it!

Let’s use an example: an investor (Bill) wants to achieve a 12% annual return over 5 years by investing in real estate.

Bill decides to purchase an office building for $600,000 that generates $60,000 of net operating income (NOI), which represents a 10% cap rate. This means the property value would need to increase by at least 2% per year to meet Bill’s goal of 12% annual return.

Bill decides to achieve his investment goal by being more dependent on the cash flow (net operating income) generated as rent by the office building’s tenants, rather than a strong capital appreciation.

In this example, Bill is characterised as a defensive, income-based real estate investor seeking real estate investments that require minimal out of pocket expenses (e.g. refurbishments). In case you are wondering: yes, we will cover different investing style and types of investment play in future blog posts.

In Bill’s case, the cap rate is a key metric to begin his initial screen to compare real estate investment opportunities. For example, a shopping mall being sold at an 8% cap rate means that Bill would rely on (i) strong capital appreciation and/or (ii) leverage in order to achieve Bill’s goal of 12% annual return.

Cap rates are an important way to screen investments and narrow down a list of investment opportunities which suit your individual preference. Once you’ve decided on which investment opportunity to pursue, you will need to gain a better understanding of the real estate’s location and market conditions to form your investment analysis.

An important aspect here is timing — something which Denzity wants to clarify with ‘cap rate compression’, explained below.

What will we cover in Part 2?

We have just scratched the surface when it comes to cap rates! There are more metrics you should take into account when making an investment decision.

In our next article, we will discuss how you should understand and compare the cap rates of different types of real estate located in different places around the world to decide on which best suits your investment preference.

We at Denzity are here to help you understand the key metrics and provide insights. We hope these articles provide you with insight into the real estate investment process and journey!

If you’re not already signed up with Denzity, make sure to sign up to receive the latest updates!

Equity vs. Debt Crowdfunding, which is right for me?

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 appreciation

100 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% 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 appreciation

50 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:

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 the 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:

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.

Denzity is built to continuously learn user preferences and interests so that our metasearch algorithm provides you with the most suitable investment opportunities every time users search.

If you’re not already signed up with Denzity, make sure to sign up to receive the latest updates!

What’s up next? Denzity will cover valuation metrics an Investor should consider before making an investment in a Real Estate Crowdfunding project.

Types of Real Estate Investment

Real Estate Crowdfunding provides Investors with the opportunity to invest and receive passive income from various types of real estate located in different parts of the world. Real estate consists mainly of residential, office, retail and shopping malls, industrial and warehousing, and hotels.

Investors should understand the real estate market’s underlying dynamic and outlook before investing in a particular type real estate matching their investment preference. In this article, we highlight the various types of real estate and key considerations before investing in a particular type of real estate.

Why office buildings are the backbone of real estate investment

Office buildings are generally located in cities and towns, the center of economic hubs with retail shops and hotels located in this area as they benefit from pedestrian foot traffic. Office buildings are the core of economic hubs as they provide citizens with jobs, which in turn fuels the economy as employees spend money at retail shops and restaurants.

Office buildings usually have a mix of tenants consisting of small and large companies to ensure stable rental income is generated over a 3 to 5-year time horizon or weighted average lease expiry (WALT), which is explained further in a subsequent post. As a result, rental income is consistently generated each month, even as office tenants move in and out of the office building, which results in what real estate professionals refer to as an occupancy rate.

Office rents are usually the highest among all types of real estate given their central location and function in the economic hub. During periods of economic growth, office buildings can generate high rental income and lead to strong capital appreciation, depending on other factors such as economic condition and supply of office building space in the city.

Office building typically forms the core of a real estate investment portfolio since the investment size is generally larger than others (residential, industrial) with potential for high and stable income generation making it an attractive investment.

Why invest in residential property as a landlord

Residential properties range from a small apartment to large housing complex generally located in close proximity to cities and towns. Residential property is the core type of real estate investment since it provides individuals with accommodation, a fundamental necessity, which makes it easiest to understand from an investment perspective.

Residential properties generally have a single tenant, small house or large housing complex with individual apartments, providing investors with greater accessibility in terms of investment size and tenant management. Single tenant means rental income can be ‘choppy’ as tenants move in and out of different homes, especially as their social behaviors change (e.g. starts a family, needs a larger space).

Residential property located within or close proximity to economic hubs generally carry the greatest value as individuals seek the convenience of a shorter commute to and from their office. Residential properties located close to hospitals and schools is also an important consideration, especially for residential homes suitable for families.

Residential property typically represents the highest yield among its peers in the real estate market. Real Estate Crowdfunding means Investors can obtain fragmented ownership in the residential property while holding other types of real estate.

Why invest in retail with the rising popularity of e-commerce

Retail property range from small shop fronts to large-scale shopping malls. Retail property is generally located within cities and towns to leverage on pedestrian foot traffic paying for products (groceries) and services (hairdressers).

Retail property generally has a single tenant (e.g. hairdresser, restaurant) seeking a shop where similar types of retail businesses are located to capture [like-minded] pedestrian foot traffic. Retail property is important to the makeup of a city or town but faces a key question as a type of real estate investment.

The popularity of online shopping, such as Amazon, questions whether retail property, especially large-scale shopping malls, will survive e-commerce retail. Retail shops located in city centers will attract higher-income consumers, especially tourists, with companies justifying retail rent as (physical) advertising and brand awareness expense alternative to digital marketing.

What the investment rationale is for an industrial property

Industrial property is generally storage warehousing that provides companies with the space to store products sold at retail shops in the city or online. Industrial property is usually located outside of cities and towns as it requires access to transportation networks, such as highways and airports.

Industrial property generally has several tenants sharing sections of a storage warehouse with different access to loading bays for trucking access. Industrial tenants leverage the cheaper cost of real estate in the outskirts since it primarily functions as a storage unit. Rental income generated from the industrial property is usually ‘smoother’ than residential as turnover within the industrial property is lower.

Industrial property benefits from retail consumption of products, whether at retail shops in city centers or through e-commerce. For example:

  • A retail shop located in the city center that sells music instruments would typically store large instruments (pianos, for example) in a warehouse on the outskirts. Once a customer orders a piano, for example, the store would package and deliver from the warehouse to the customer.
  • An e-commerce company selling books online would typically store books in a warehouse on the outskirts and once a customer orders a book, a shipping company would pick up from the warehouse and deliver to the customer.

As you can tell, both retail and e-commerce sales create demand for warehousing storage, whether it be the production or consumption of goods.

How do you invest in a hotel?

Hotel property generally ranges from small (50 rooms) to large hotels (500 rooms) located in cities and towns as temporary accommodation for travelers visiting the particular city or town for two key purposes: business travel and tourism. In addition to the size of the hotel (number of rooms), hotel guests usually seek a particular class of hotel (Holiday Inn vs. Four Seasons) during their stay.

Hotels generally have a single tenant, who manages hotel operations (a Hotel Management Agreement), with various retail shops and restaurants as other tenants within the hotel premises. An investor would enter a Hotel Management Agreement with a service provider and separately manage the retail shop and restaurant tenants, which leverage the capabilities of the hotel service provider.

In general, hotel property investment is considered a ‘trophy asset’ whereby it forms the ‘missing piece’ to complete a real estate investment portfolio. Real Estate Crowdfunding means an Investor could acquire a fragmented ownership in a hotel as part of their portfolio.

What other real estate investments are available

Other types of real estate investors would commonly acquire would be land, agriculture, schools, hospitals, docks, golf courses, to name a few.

Investors require a certain level of expertise in the particular type of ‘other’ real estate, for example, zoning requirements of land, operational needs of a hospital, or topography design of a golf course. This is where Real Estate Crowdfunding Platforms hire real estate professionals to provide relevant expertise, for example analyzing the market dynamics of land that is freehold or leasehold, which is explained further in a subsequent post.

In conclusion, Investors benefit from being able to identify the characteristics of different types of real estate (highlighted above) to make a comparison and decide on which opportunity best matches their investment preferences (size and time horizon of investment).

What’s up next? Denzity will cover the key considerations an Investor should make before making an investment in a Real Estate Crowdfunding project.

Introduction to Real Estate Crowdfunding

Real Estate Crowdfunding provides individuals with the opportunity to invest and receive passive income in real estate, one of the oldest forms of investment that has demonstrated a long history of consistent capital growth.

Crowdfunding in real estate means a number of individuals (“Investors”) combine their money to purchase a real estate property with a Real Estate Crowdfunding Platform (“Platforms”) that hire real estate professionals (“Sponsors”) to achieve the goals of income generation and/or capital growth. Investors have a lot of factors to consider when investing in real estate, let’s walk through step-by-step.

This article’s purpose is to explain the key considerations of Real Estate Crowdfunding so that Denzity users understand how to decide on a Real Estate Crowdfunding investment (“Project”).

How much to invest in Real Estate Crowdfunding?

Investors decide exactly how much they invest into a Project, regardless of the underlying real estate property’s value. Each Investor receives an ownership (in the form of shares) proportional to how much they invest — this is fragmented ownership.

For example, an Investor commits US$50,000 to a Project where the underlying property is valued at US$1,000,000 and generates net income of US$100,000 per year. The Investor’s fragmented ownership is 5% of the Project and would receive US$5,000 in passive income (5% of the property’s US$100,000 net income). In comparison, traditional real estate investment would have required the Investor to commit around US$200,000 and be liable to pay a mortgage payment every month, as a mortgagor.

Where to invest in Real Estate Crowdfunding?

Investors decide which real estate market to invest, usually based on the Platform’s expertise and investment objectives. Each property type (e.g. residential versus hotel versus office) requires specific knowledge held by real estate professionals to match the property’s net income and value with the Investor’s investment objectives.

Investors would typically select a developed real estate market (New York or London, for example) where rent is generated in a commonly held currency (United States dollar, British pound) to generate stable passive income and capital appreciation. In contrast, Investors seeking large capital appreciation would seek an emerging real estate market for long distance real estate investing like Vietnam, for example.

Which type of real estate property to invest in?

Investors decide which type of real estate property to invest and obtain fragmented ownership in a Project, for example, a residential home, office building, or industrial warehouse.* Each real estate property has different characteristics and Investors should decide based on their individual investment preference for risk and return.

*We will talk more in-depth about the various real estate property types in the future.

Which Platform should I invest in Real Estate Crowdfunding?

Platforms will typically be focused on a certain real estate market geography and type of property. As a result, Platforms will hire a team of real estate professionals with specialized knowledge in its focus areas. As an Investor in a Project, the Platform provides you with fragmented ownership but has sole discretion in operating and managing the Project.

Investors should decide whether to proceed with a given Project having made careful consideration of the Platform’s track record and reputation. Denzity provides users with the relevant information to make an informed investment decision on Projects and Platforms.

How long should I invest in a Real Estate Crowdfunding Project?

Each Project will have a different investment (time) horizon. While equity crowdfunding (usually 3–5 years) is typically longer than debt crowdfunding (usually 2–4 years) it can provide a higher return to investors (around 5–15% for equity vs. 7–10% for debt crowdfunding). Based on the investment horizon, Investors can decide how much to invest in any given Project.

In conclusion, each Investor can decide exactly how much to invest in any given Project with consideration to the Platform’s track record and reputation towards achieving passive income and capital appreciation through fragmented ownership in Real Estate Crowdfunding.

What’s up next? Denzity will cover the various types of real estate properties available for investment and highlight the considerations each investor should make before investing.

Stay tuned!

Denzity Team