Commercial and residential real estate investors are quickly realizing that equity crowdfunding offers a simple and effective way to find potential investments by providing them access to more deals, connecting them directly with developers, and enabling them to conduct thorough due diligence. In the past few months, many investors who have joined EquityNet have expressed a singular interest in real estate investments, signaling that equity crowdfunding has the potential to produce a positive economic impact on local real estate markets across North America.
Like any private investment offering, however, real estate investments have their share of risks. We’ve highlighted some of the most important factors to consider prior to committing to a real estate investment.
1) Tenant Risk
When assessing a potential real estate investment (or any investment opportunity for that matter), a prime consideration should be the investment’s ability to generate sustainable returns. A vacant property is unlikely to generate any sort of revenue; therefore, finding quality tenants and maintaining an acceptable occupancy rate are paramount concerns to a real estate investor.
Quality tenants are those who are capable of paying rent even during times of economic downturn and are unlikely to cause any damage to the property. They generally have a good credit score and are able to commit to a long-term lease agreement. If a property is maintained and managed properly, it is doubtful that quality tenants will engage in any sort of negative behavior like refusing to move after their lease term has expired, failing to pay rent, or causing damage to the property that goes beyond normal wear and tear that comes naturally as someone occupies a space.
An acceptable occupancy rate is the percentage of occupancy that will generate a positive return for an investor. Prior to an investment, research should be conducted on past occupancy trends, both of the property and surrounding area. An investor should conclude that the neighborhood is not experiencing any changes that could have a negative impact on the property.
Determining the quality of a piece of property’s location depends on a variety of factors and is often reflected in the price of the property. For example, surrounding properties could have a negative impact on your investment property if they are vacant or in disrepair. Areas that generally abandoned also invite all sorts of criminal behavior, thereby lessoning the value of a property’s location. Zone planning and development are two other considerations. Plans for hospitals, schools, public transportation, or other centralized amenities can greatly improve property values. Accessibility is yet another factor to determine quality of location. A property that is close to major thoroughfares and is accessible by more than one route will typically be valued more than one that isn’t. Finally, centrality is considered to be a top factor in location. Properties in downtown or core areas in strong urban markets typically have higher occupancy rates and prices than those in rural or emerging real estate markets.
3) The Loan-To-Cost Ratio
The loan-to-cost ratio is used in commercial real estate to compare the amount of the loan used to finance a project to the actual cost of building the project. It’s used to assess the risk of making a construction loan. For example, if a project costs $1 million and a borrower asks for $700,000, then the loan-to-cost ratio is 70 percent, making it a fairly risky investment as the borrower has a high probability of defaulting on the loan during an economic downturn. As the ratio increases, so does the risk. Real estate investors should recognize their tolerance to risk and not dive into an investment that falls outside of their comfort zones. Typically, however, if an investor can accept a high level of risk, then he or she has the potential to receive much higher returns.
4) Issuer Track Records
An investor should research the total value of real estate developed by an issuer prior to committing to an investment. A large developer who has properties valued at over $200 million presents an investment opportunity with much less risk than one who is smaller scale, or is just beginning to participate in the real estate market. Learning more about an issuer’s track record can also aid the investor in many instances, such as if a property is currently under development. The investor can look at the developer’s past projects to determine the value and potential risks of the investment.