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.

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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!

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:

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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!

 

Of portfolio balance

There are many different portfolio balance theories out there in the world of personal finance. Some are based on risk management, some based on diversification, and some have a logic so complex that it takes a while to even figure it out. Whichever portfolio strategy you use, one idea is constantly emphasised – you must diversify between different asset classes and markets.

Why diversify across asset classes?

The somewhat classical theories focus on three main asset classes – stocks, real estate and loans. Other options include metals, entrepreneurship etc. The idea behind diversifying asset classes is that they behave differently in different market situations. While stocks can be quick to drop, they can also generate incredible short term returns and are considered relatively stable long term.

With real estate the main value is the idea that you own a physical asset – while a company may go bankrupt then you still own an apartment or a house and while it may drop in value, it won’t completely drop to zero. Real estate and loans also help generate cash flow in a way that stocks generally don’t.

This means that to reduce risk levels you should have different asset classes in your portfolio because in case one asset loses value the others may keep theirs for longer. In the case of a big economic crisis of course all parts of the market drop, but different asset classes recover at different speeds and being able to generate cash flow while you wait for capital growth recovery is valuable.

Why diversify across markets/geographically?

In the case of social lending diversifying across hundreds of loans helps you manage risks by betting on the fact that not all regions of the country lose jobs at the same rate. In case of a crisis it’s clear that the less wealthy regions of Estonia will be hit harder while the bigger cities are likely to have more job opportunities therefore people will be more likely to pay back their loans.

For stock markets geographical diversification in its broadest sense means picking different markets. I invest both into the Baltic market and into the US market. Maybe soon I’ll add in general European markets as well. The benefit of this is easy to see – if you take side by side the growth charts of Europe and USA, then you can clearly see that they don’t always move in a similar direction, which means more stability for your portfolio.

Why diversify across different risk classes?

Everyone who invests wants high returns. It is however important to keep in mind that higher returns are linked to higher risks as well. This means that while you may enjoy higher returns when the market is climbing upwards then higher risk investments also mean a much bigger hit when the market takes a steep downwards turn.

Generally stock indexes are considered much safer than individual stocks due to the lowered risk provided by higher diversification rates. Social lending is inherently riskier than real estate backed loans where you have less of a chance of walking away empty handed.  The same way smaller apartments close to city centres are generally considered lower risk since they’re likely to maintain renters’ interest even in the case of an economic downfall.

How to assess your portfolio?

The easiest way to look at whether your portfolio is balanced is to either write it down in numbers or have a visual outline of your portfolio. Taavi I. wrote a nice piece of code that allows you to visualise your portfolio and I must say I quite like the visual aspect of it.

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For example the image above is the balance of my current portfolio. It lists all social lending, stocks, indexes and crowdfunding. As you can see, my portfolio is very heavily influenced by whether or not Bondora does well (Bondora used to be 75% of my portfolio) so I’ve been working hard to push it down to 50% overall portfolio value.

Ideally your portfolio should be close the 1/3 in each asset class. In my case what is arguably missing is real estate (since Crowdestate is not pure real estate), which is why I set the goal of getting into rental real estate this year. Overall though, you can see that my portfolio is getting better in terms of overall balance. While my portfolio isn’t all that big yet, then getting into the habit of it being balanced will help a lot in the long run.