A reputable real estate crowdfunding opportunity should present a wealth of information enabling prospective investors to perform proper due diligence. For novice real estate investors this can be refreshing, albeit perhaps overwhelming. Here’s our take on some of the most important metrics to look at when screening an online real estate investment opportunity.
Local Demographics/Market Trends
You know how the saying goes. Location, location, location. When evaluating an investment opportunity it is important to understand all the local factors at play. Is the population growing? Is the job market growing? Is the job market diversified? If it is a residential property, how many units are being built it the local pipeline? Are rents trending upward? Hoes does the opportunity fit in with recent sales and rent comparables? You’ll want to know the answers to these questions and more.
Crowdfunding business plans should include a market report, but you can do further research by reading up on local business journals, looking at U.S. Census data and signing up for local real estate market reports. Maybe even create a Google News alert for the neighborhood.
A hold period is the estimated time between when a crowdfunding deal closes and when the real estate sponsor plans to sell, recapitalize or otherwise end the investment period for the investor. Simply put, a hold period is the estimated time it will take to earn your projected distributions from an investment.
Unlike the stock market, investing in real estate is relatively illiquid, with crowdfunding deals typically seeing a hold period in the 3 – 5 year range. That’s because there is no secondary market to buy/sell/trade interests in a deal. This is starting to change as some crowdfunding portals begin to explore giving investors the ability to transfer their investment interest to another qualified investor.
Net Cash Flow
Equity investment crowdfunding relies on positive cash flow to pay out returns. This cash flow can come from rental income, refinancing proceeds, or sales proceeds. Real estate crowdfunding business plans show the expected schedule of income and expenses on a Projected Pro Forma. The bottom line is Net Cash Flow — the difference between income and expense over a given period. Once you familiarize yourself with the Projected Pro Forma layout, you’ll find it a quick and easy way to understand how the business plan relates to your return on investment.
Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is one of the most common metrics used in real estate crowdfunding and is typically one of the first you’ll encounter when examining a potential deal.
Typically expressed in a percent range (i.e. 13%-15%), the IRR is the annual rate of earnings on an investment. We will present a simple illustration below:
You purchase a piece of land today that for $1,000,000. You sell that land in four years for $2,000,000. Your IRR is 19% because:
Year 1 — ($1,000,000)*(1.19%) = ($1,190,000)
Year 2 — ($1,190,000)*(1.19%) = ($1,416,100)
Year 3 — ($1,416,100)*(1.19%) = ($1,685,159)
Year 4 — ($1,685,159)*(1.19%) = ($2,005,339)
Now, this example does not factor in that net cash flow from income-producing real estate varies from year to year. Because IRR looks at the rate of return over time, the actual return on equity (ROE) between two opportunities with the exact same IRR can vary depending on when investors receive their return on equity. Here is an article that examines three scenarios with the same IRR and hold period, but different ROE results.
Equity Multiple (EM)
Also known as the Realization Multiple, the Equity Multiple is simply a ratio of your returns to paid-in capital. It is another common real estate crowdfunding metric you are likely to encounter early in a deal. Like IRR, the higher the Equity Multiple, the greater the return on your initial capital contribution. The calculation for Equity Multiple is as follows:
Equity Multiple = Cumulative Distributed Returns / Paid-In Capital
So if you invest $25,000 into a deal and earn a net profit of $20,000, your Equity Multiple is 1.8x.
1.8x = (25,000 + $20,000)/($25,000)