Equity vs. Debt Investments for Real Estate Crowdfunding (2024)

Investing in real estate through a crowdfunding platform has some advantages over real estate investment trusts (REITs) or directly owning property. One is the ability to choose between debt and equity investments. Before plunging into real estate crowdfunding and choosing one or the other, it's best to understand how they differ and what the risks with each are.

Real estate crowdfunding took off after the passage of the Jumpstart Our Business Startups (JOBS) Act in 2012, and the market continues to expand.In 2015, theSecurities and Exchange Commission (SEC) allowed non-accredited investors to participate in crowdfunded real estate deals alongside accredited investors. The best real estate crowdfunding sites can help diversify investors’ portfolios and offer opportunities for competitive returns, but such investments can be risky. It’s always prudent to do full due diligence before going ahead with any investments of this type.

Equity Investment Basics

Most real estate crowdfunding deals involve equity investments. In these ventures, you become a shareholder in aspecific property, and your stake is proportionate to whatever you invested. Returns are realized as a share of the property’s rental income minus any servicefees paid to the crowdfunding platform. You may also receive funds from appreciation in the property’s value when sold.

Pros:​

• No cap on returns: Equity investments offer greaterearning potential.It'spossible to have annualized returns ranging from 18% to 25%. Since there's no cap, however,there is no set limit from an investor's perspective.
• Tax benefits: Oneperk of owning an investment propertyis the ability to deduct the expenses associated with ownership, such as depreciation and the cost of repairs. With equity crowdfunding,deals are normallystructuredthrough a limited liability corporation, which is treated as a flow-through entity for tax purposes. This means you can deduct depreciation.
  
• Lower fees: Equity investments ordinarily have fewer fees. Rather than paying fees upfront or monthly, you will likely pay a single annual fee to maintain your position in the property. The fee is calculated as a percentage of the total amount invested,typicallybetween 1%and 2%.

Cons:​

• More risk: Equity crowdfunding can put more money in your pocket, but you are taking a greater risk in the first place. You are second in line to receive your earnings on the investment. If the property fails to live up to its performance expectations, that can easily translate to a loss.
• Less regulated: Crowdfunding is still not as regulated as securities issued in public listings. Therefore, projects and management teams may not have been vetted thoroughly enough to ensure that the best teams with only solid projects are raising capital for their projects on the platforms.
• Longer hold period: As an equity investor, you must have a much longer time frame for the investment than debt investors. Hold times can stretch to five or even 10 years, which is important if you need liquidity in your portfolio.

How Debt Investments Work

When investing in real estate debt instruments, you are acting as a lender to theproperty owner or the deal’s sponsor. The loan is secured by the property, and you receive a fixed rate of return determined by the interest rate on the loan and how much you invested. You are at the bottom of the capital stack in a debt deal, meaning you get priority when claiming a payout from the property.

Pros:

• ​Shorter holding period: Debt investments most often involve development projects. As a result, they typically have a shorter holding period than equity investments. Depending on the nature of the deal, the holding period may last between six and 24 months. That’s a plus if you aren’t comfortable tying up assets for the long term.
• Lower risk: Because of the waydebt investments arestructured, you take on less risk. The loan is secured by the property, which acts as an insurance policy for repayment of the loan. If the property owner or sponsor defaults, you can recoup all or some of your losses through foreclosure.
• Steadyincome:Debt investments are more predictable regarding the amount and frequency of returns. While every deal is different, it’s not unusual for investors to earn yields from 8% to 12% annually. These returns are typically paid on a monthly or quarterly basis.
• Higher fees: While most real estate crowdfunding platforms don’t charge investors to create an account and research debt investments, there’s usually a fee involved to take part. The crowdfunding platform typically receives a percentage off the top before any interest is paid, which can eat into your returns. There may also be a separate loan origination fee that’spassed toyou.
  

Cons:

• Lower potential returns: As with other investments, you are exchanging lower risk for a lower expected return.
• Capped returns: Another downside is that returns are limited by the interest rate on the loan. You have to be clear about whether you’re willing to sacrifice opportunity cost and the potential to earnhigher yields in exchange for a safer bet.
• Exposure to prepayment risk: Mortgagees sometimes pay off their loans early, either by selling or refinancing. Doing so can interrupt the cash flows on your debt investments and shorten the duration of your loan portfolio.

The Bottom Line

Crowdfunding can be an attractive option for investors who wantto invest in real estate in a less capital-intensive manner.The minimum investment with many platforms ranges from $5,000 to $10,000, a comparatively small price to gain access to this asset class.Both equity and debt investments have their upsides and drawbacks, which you should take the time to weigh carefully. Understanding what you stand to gain versus what you're risking can help you decide whether one or both types of investments are a good fit for your portfolio.