Risk levels of real estate crowdfunding

With the (arguably) impending crisis, many people have started to look into the risk levels of their investments with a bit more diligence. I asked Loit Linnupõld (Crowdestate) and Marek Pärtel (Estateguru) a few questions about how risk is managed in their investment portals.


How to assess the risk of crowd funding real estate?

The problem with many hybrid ways of investing is that evaluating the levels of risk associated with it becomes difficult due to how some risks may help balance out others while some may actually compound and create additional risk. Some things to keep in mind:

  • All real estate projects, crowd funded or no, follow the ups and downs of the market. If the market falls out from underneath you, then this will influence you whether you are in rental real estate, business real estate or crowd funding projects.
  • Crowd funding adds both a level of certainty (wisdom of the crowds) and a level of unreasonable enthusiasm (others are investing, so it must be good). You should still base your decisions on your own analysis, not on what others are doing.
  • (Real estate) crowd funding is still a new enough investment that we don’t have significant historical returns to base our thoughts on. Then again, past returns don’t predict future returns anyways. We can however ‘ballpark’ based on existing data in similar fields.

What do the portals do to manage risk?

I asked both Loit (CE) and Marek (EG) about how they manage risks, and how they hope to prevent problems from happening in their portfolios.

In case of a real estate crisis do you feel that crowd funding real estate & real estate loans are overall more or less risky to own than individual pieces of real estate? (Let’s assume a reasonably diversified portfolio).

Loit (CE): It really depends on a specific property, it’s cash flows and financial leverage. Technically, property is property regardless of whether it has been acquired directly or through crowdfunding. Nevertheless, I believe crowdfunding adds a new layer of common knowledge and if we combine that with crowdfunding platform’s due diligence (if they do it), that can significantly reduce the risk of picking wrong assets. Crowd is much smarter than any single individual alone and it is quite remarkable, that the wisdom can be shared and spread digitally between crowdfunders.

Marek (EG): To be prepared for a potential real-estate crises, smart investors should watch out not only for high returns but also for low and diversified risks. Every investment is a risk and once you accept this fact, then next thing that comes into play – it is how well you understand those risks and what measures you take to control them.  One of the best things to control risks is diversification. Individual investors can’t typically buy several pieces of land or properties, to diversify their risks. If you bought a flat you still depend on developments in vicinity of your property. Its price may go down even without a crisis.

EstateGuru p2p lending platform gives you the possibility to significantly diversify your portfolio, splitting your money into smaller pieces between different types of loans (flip, bridge, buy to let, mezzanine, commercial, land, residential etc), in  different locations by different borrowers and in the future also even in different countries.

One should understand the difference between investing in property crowdfunding (investment into equity and no security to investors given) and crowdlending platforms (investment secured by mortgage). We would suggest investors to do always their own stress tests- what happens to their investment if market goes down 20% (predicted m2 price of  is not 2000 but 1600). In case of, say a 20% market decline, do investors  earn some profit still, do they get back their invested money in some portion or lose it all- it largely depends on the capital structure of the project – what obligations the Borrower or Developer needs to fullfill before paying to platform investors.

Today we see clearly from UK, Europe and US statistics (altfi.com, Lendit.co) that institutional investors prefer lending platforms over crowdfunding ones as safer bet when making their capital allocations.

How has Crowdestate/Estateguru prepared for potential economic downturn scenarios? What kind of defences are in place to keep oversight of the projects and protect the investors’ money?

Marek (EG): First of all, all investments on EstateGuru platform are protected with 1st or in some cases 2nd charge mortgage. Not all Crowdfunding platforms have this security in the first place and with any fluctuations in Economy, their investors will be hit first. Smart looking business plans and fancy projects are not sufficient when property prices go down. But at EstateGuru we implemented second level protection – LTV at our projects is never higher than 75%, normally its around 60-69%, which means that even if property prices go down 25% we would still be able to recover our investors’ funds in case the borrower fails to repay the loan. In addition to the mortgage EstateGuru often asks the Borrower for a personal guarantee as extra security in order to make his EstateGuru loan repayment the top priority.In addition our partners have years of experience in Real Estate and we are able to foresee bad signs much in advance, so we will start working with Borrowers (refinancing, sale of assets etc.) much earlier to prevent Investors from litigation process and from potential partial loss.

Loit (CE): We continue to do our proper due diligence, picking only the best and business wise reasonable investment opportunities. Someone has pointed out, that most of the profits are earned at the moment of purchase and a our due diligence is focused on eliminating the odds of opening a bad project for crowdfunding.

Regular meetings with Sponsors (i.e. developers) and pre-agreed reporting formats ensure we have adequate information on project’s progress.
As the real estate related bank lending becomes less and less available, there will probably be a decrease in new projects started and we might see some of its effects in next 12 – 18 months.
What is the absolute worst case scenario of what can happen to the projects in your portfolio?

Loit (CE): There are several absolute worst case scenarios, that might happen, and they all end up with real estate becoming worthless (Russian tanks invading Estonia) or completely illiquid (like in the end of 2008 to mid 2009, requiring the major global economic crisis hitting employment and income).  Both scenarios might probably lead to partial or complete loss of the investment, depending on the specifics of the project (location, timing, leverage, demand etc). Its all about project’s cash flow – if you are able to generate cash either through even slow sales or leasing the property out, you will probably survive. Collateral is not the replacement of cash flow.

Marek (EG): A sharp decline in property prices (say 50%) lack of overall demand for property and in case of default longer than expected litigation time could be the worst case scenarios. Since our projects are diversified between residential and commercial, in different locations and are on top of that protected with 1st Charge Mortgage (this means our investors  will have 1st claim on the money received from property sale) and LTV of no higher than 75 (currently average is 60% at EstateGuru) – we feel that all above mentioned measures make our investments one of the best protected on the market and give best risk/return ratio.

As you can see, both portals have given significant thought to what might happen in case of an economic downturn. I do agree fundamentally that a retail investor can never diversify to the extent that is possible with crowdfunding. However, it is important to keep in mind that you don’t stop analysing projects even while you are still diversifying – it’s better to not take in a bad project even when you aren’t really diversified yet.
In addition to that, I like that Loit also pointed out the wisdom of the crowd and Marek emphasised that all investors should stress test their own portfolios to make sure they are making correct investment decisions for their own risk levels.
Thanks to Marek (Estateguru) & Loit (Crowdestate) for answering!

Is there a wrong way to invest?

One of the fears that plagues beginners after taking a first look into most investment opportunities is the fear of doing something wrong. This is of course closely related to fears of losing money, making errors with taxes and other technical issues, but at heart, a large part of this fear can be attributed to the fear of making mistakes.


What is the definition of  a mistake?

1. an error in action, calculation, opinion, or judgment caused by poor reasoning, carelessness, insufficient knowledge, etc.

If you look at the dictionary definition then you can clearly see what causes mistakes – lack of knowledge that leads to poor reasoning or leads to careless decisions. This means that mistakes are relatively easy to learn from – if you have done something wrong, then gaining extra knowledge is the way to make better decisions in the future.

The bigger problem is, how do you know that you have made a mistake? If you’re working on your portfolio, then no one will helpfully point out mistakes in your strategy, nor are bad returns a good indicator of having made mistakes since even perfect decisions can lead to temporary losses in bad market situations.

How do I know that I have made a mistake?

I get asked quite often to give my assessment of a person’s portfolio so they’d know if they’re doing the right thing. Other than the inherent problems that accompany such a broad question, assessing whether you’re doing something right is mostly based on one fundamental question:

How well is your portfolio doing compared to market averages?

If you are a real estate investor and your objects are returning an average of 3% per year then it’s likely that something might be problematic. Taking a look into overall investment returns for real estate you should probably assume a 5-7% return on lower risk projects and 9-12% for higher risk projects. If you’re not earning that then it’s time to look into your own portfolio – are the objects rented for under market price? Are your expenses too high? Is the location undesirable? Is the vacancy rate too high? Could you get better loan terms? Is the risk and returns level reasonably tied? If your object is super safe, has had the same renter for 6 years who hasn’t caused any issues, then 3% might even be an OK return when it comes to keeping property value.

If you are investing into crowdfunding based instruments then comparing yourself to market averages becomes more difficult. There isn’t really a set standard and a lot of comparisons are actually historically done compared to stock indexes. A good benchmark here might be the 11-12% generally used for SP500, if you have a more risky portfolio, then a higher target might be reasonable. Quite often people end up thinking their portfolio is underperforming because they have read from some forum that someone is making 30% returns on their social lending portfolio and are disappointed that they aren’t doing that well, without knowing anything about the truth of the issue or the risk profile of that person’s investment portfolio.

For a stock market based investor assessing returns is highly dependent on which part of the market cycle we’re at. If the global market is dropping, then your portfolio is likely to drop as well, and if you have stocks in your portfolio that make your portfolio allocation differ from indexes, for example you’re more focused on different industries, then it can become problematic to tell if you’re doing “well”. The same problem arises with a bear market, some stocks might be flying high, while your portfolio is slowly lagging behind, but you won’t be able to tell how big of an issue that is unless you balance your moderate turns to what are likely to be more moderate losses as well. Unless you’re using some very generic strategy, then it takes a full cycle to assess your returns, since then you will have lived through both a rise and a drop in the market.

Is it possible to avoid mistakes?

Let’s go with a resounding “no” on that question. We’re all only people, and making a perfect decision in all situations is virtually impossible. You will never have enough time, enough information and enough knowledge to make a fully informed decision. The more important issue is, to think about what the potential consequences of mistakes are.

When it comes to investing the cost is generally paid in effectiveness. If you make a bad call, then you will likely receive lower returns. If you make a fundamental error somewhere, then you will have to accept a loss of some size. This is where probability comes to play – if you constantly educate yourself, read up on what’s happening and don’t start testing out some obscure investment logics, then are you likely go make more reasonable decisions or more terrible decisions?

I’d say unless you are phenomenally unlucky at life, then you are likely to make more good decisions then bad ones, especially if you start reasonably conservatively (as in, not with high risk instruments like Forex, bitcoin etc.). While the loss in returns might be a hit (especially once you figure out what you managed to mess up), then even a low return of a couple of per cent is always better than no returns since you didn’t gather up the courage to do anything.

Building a portfolio strategy

When you’re just getting started with investing, then your portfolio strategy is pretty much aggressive growth all the way. After a while though the issue of balance starts coming to play, which is what I’m starting to struggle with right now.

How much of what should you have in your portfolio?

There are about as many rules as you can imagine about this. One thing that people generally agree on is that your portfolio should have more than one asset class included. For me, I have three – social lending/crowdfunding, stocks and real estate. Beyond that though things get complicated – how much of what should you have? When to rebalance? How to rebalance before a crisis? How to take into account cash flow vs capital growth?

correctportfolioIf I visualize the more actively managed part of my portfolio this is the result. The equity I own in the Sõle apartment is worth just about as much as most of my other investments combined. This sets my portfolio to something like 50% real estate equity/20% stock market/30% social lending.

Is that a good or a bad balance? On paper it seems fine since no asset class is above others, and real estate is a capital heavy type of investments. However, if I purchased another apartment then real estate equity would take up almost 70% of the whole portfolio balance – not a good way to go in my opinion. Also, whole social lending grows organically quite quickly due to money being reinvested then with stocks you need to contribute actively, especially for Baltic stock.

So, in a way I’m currently trying to figure out a strategy for how to balance my portfolio better. I’m fine with taking larger risks since I’m still young, which would mean contributing more to social lending. However in terms of a potential crisis real estate might be better in terms of steady cash flow, even if it does eclipse other types of investments in terms of capital value. I’m leaning towards not letting any asset class climb above 50% of portfolio value but that might be a tricky balancing act if I want to get further into real estate. What’s your strategy on this?



I purchased my first piece of rental real estate

Even though, it’s not the first time I had to sign off on a real estate purchase, then it’s still scary enough to get started with rental real estate. However, this puts me more than half way to filling one of my goals for this year.

What did I buy?

I ended up buying a very typical starter apartment for a lot of real estate investors – a small 12 m2 apartment in a dorm style house in Põhja-Tallinn. I’ve been looking for a piece of rental real estate for quite a while now, and several that caught my eye sold very quickly, so I was unsurprised when this apartment was already booked.

However, I ended up being a part of those lucky few people who found a motivated seller – a person who had planned to start with rental real estate himself, but was moving due to switching jobs and the person who had wanted to purchase the apartment failed to pay the deposit, so the deal had failed and he was in a bit of a rush.

Why did I buy this specific apartment?

I’m going to be completely honest here, that my knowledge about real estate is not good enough to claim that my analysis was by any means perfect. The sale ended up being under market price, especially considering the state of the apartment – it had been freshly renovated. The house itself is old but ok outside, the hallways are ugly as sin though, so that can be problematic when it comes to actually renting it out. I’m taking this as a serious learning experience. The apartment itself looks like this:

korter1 korter2 korter3

How did I finance the purchase?

Essentially I didn’t get too creative with the financing. About 60% of the purchase was my own financing, the money of the company that my husband and I own. The money has been gathered through years of living below our means, and aggressively gathering money for investments. The other 40% was financed with FFF money (in this case friends, who were willing to lend out money at a low %). Currently the loans are relatively short deadlined, but I’ve tried to do my best to balance out the risks.

What are the next steps?

Well, there’s actually quite a few small things that I’ve already done. Such as finalizing everything about the sale, getting extra keys, exchanging all kinds of contact information, looking for furniture etc.

Essentially what I have to do now, is finish with getting in furniture (hopefully done next week), and then find & edit a proper rental contract & then it’s time to start looking for someone to live there!

I’m currently hovering between mad excitement and small slivers of panic, let’s see how it goes!


Peeter Pärtel’s real estate course, part 2

Last weekend I had a chance to take part of the 9th real estate course that Peeter Pärtel organizes. The 10th, which will take place in autumn is almost sold out, if you happen to want to grab a ticket. It was a very intensive 2-day course that firstly gave me a lot of inspiration for blog posts and secondly it was a very high quality look into what is happening on the real estate market. This is why I wanted to give an overview of how the days went.


Presenting your projects

The second day started with people presenting their projects that they had picked out the previous day. It was interesting to see what people had come up with, since some were clearly very realistic and had done a lot of overnight work, while some were very optimistic both in terms of returns and investor interest towards the project.

The key idea behind this part is obviously the fact that to find deals it’s not just enough to look at the ads and surf mindlessly. You have to actually go through the numbers to figure out what works out, and if it doesn’t then you’ll have a chance to figure out which part of the project should be altered to make that project work. (And to realise that some projects won’t work whatever you try to do.)

Recovery of debt

Lately there has been a lot of media attention on various cases of tenants refusing to leave apartments and the hassle that this brings. The laws in Estonia are quite strongly in favour of the tenant, which means that as a property owner you’re pretty screwed if something happens to not work out, since getting the person evicted or even getting the debt they owe you recovered is barely possible.

This section introduced an actual case of attempting to get a debt recovered by going the whole way – to suing the tenant. While this topic was quite familiar to me because I’ve researched it because it’s relevant to social lending as well, then it was really an eye opener in terms of just how depressingly slow and incapable the legal system can be at times.

Impromptu panel

Since the room was clearly full of many experienced people to whom you could talk during breaks and whatnot, it was reasonable to give them some time to discuss their thoughts on stage as well.

They gathered up the most experienced investors with the biggest portfolios to share some thoughts about what has worked out well for them and what kind of advice they wish they would have had when they were starting.

The main learning point was that to grow that big, you have to be aggressive. To be aggressive in growth however you need extra financing from somewhere, it’s not easy to just start growing a portfolio and end up with 50 apartments.

Bizarre happenings

The final, stress relieving, section of the day had a visitor who spoke about the two tiny apartments that got a lot of media attention a while ago. (The apartments are 5 & 6 square metres respectively.)

It offered a chance to think about just how static the Estonian market really is, and what a long way we have to go in terms of alternative housing methods. Plus, it was a quite funny retelling of the events that surrounded the media attention.

Summary of second day

Clearly everyone’s brains were quite overloaded with the information from day one, so the pace was a bit slower and the topics were a bit more lecture-like. This wasn’t necessarily a bad thing, since I don’t think people would’ve been clearheaded enough to listen to the taxes section on the second day.

Overall I’d say I was deeply impressed by the quality of the event and I can see why they have been organizing it for years already. I will probably not attend the next event, but I’m likely to attend one in the not so distant future if things go well with my plans of real estate investing.