Education Archives - Page 3 of 3

A social return on investment is a methodology that businesses, organizations, and high net-worth individuals can use to account for the value they generate that can’t be accurately displayed with financial statements, which includes environmental and social value. By using the SROI measurement method, companies have the ability to identify how effectively they are using their resources to produce value for the surrounding community.

It’s important to understand the SROI of your investments or the projects you’re funding because this information will allow you to maximize the returns on your initial investment. When companies know how to calculate the SROI of various social, economic, and environmental developments, they can improve project management for these creations. Having a clearer understanding of how the business affects the surrounding community will allow the company to more effectively communicate the value of their work to the members of this community. This information can also be relayed to internal or external stakeholders.

This type of measurement is commonly used by venture capitalists, non-profits, and philanthropists to monetize the social impact that they have. If you invest significant amounts of money into social projects and developments, you may want to use the SROI methodology to determine what effect you are having on the greater community. When you’re looking to expand your social return on investment, there are seven principles that you should consider following if you want to arrive at an accurate measurement of the social change that you have created. The following will provide a closer look at what a social return on investment is and why you should consider using it.

What is Social Return on Investment?

A social return on investment is a kind of methodology that allows businesses and individuals to determine how much social change has occurred because of their investment or similar activity. If the brunt of your investments go into philanthropic institutions or are used to develop programs and projects that are aimed at helping the greater community, it can be difficult to know whether or not you’re making a difference. The SROI methodology provides you with the ability to measure how much your investment affected the outcome.

If you find that your investments aren’t as impactful as you hoped that they would be, you can use this information to make better decisions in the future that should improve your overall impact. If you want to communicate with the stakeholders involved in your investment, an SROI will allow you to do so with tangible information. Before you start using the SROI methodology, you should know that there are two separate SROI types, which include a forecast SROI and an evaluative SROI. No matter which SROI type you use, there are seven guiding principles that comprise an SROI. These principles include:

Involve stakeholders
Understand what changes
Value the things that matter
Only include what is material
Do not overclaim
Be transparent
Verify the result

1. Involve Stakeholders

The stakeholders in this situation are individuals or groups that are directly affected by the activity or program that you’re currently implementing. The economic, social, or environmental changes that you or your company are creating will affect a stakeholder. When you’re looking to use the SROI methodology, it’s important that you properly identify any stakeholders and consider them to be active participants throughout the entirety of the SROI process.

2. Understand What Changes

In order for the SROI methodology to work as intended, you will need to understand more about the changes that have occurred and whether they were negative or positive. Regardless of whether you expected these changes or didn’t even consider them, knowing what changes have occurred from your investment will allow you to better understand what the return on your investment is.

3. Value the Things That Matter

This principle involves placing monetary value on the outcomes that have resulted from the change you’ve generated. By assigning monetary value to the social, economic, or environmental changes that you’ve influenced, you can more effectively identify how much return has been generated from your initial investment.

4. Only Include What is Material

It’s important that the information you include when performing your SROI methodology is relevant to the interests of the stakeholders. For instance, you should include the outcomes of a specific activity as well as the parties involved in affecting change or being the recipient of this change.

5. Do Not Overclaim

While you’ll want your investments to enact significant social, economic, or environmental change, it’s essential that you don’t overclaim by making it appear as though you created more positive change than you actually did. The SROI accounting process involves asking questions about what would have occurred without your activities, how much your activities contributed to the eventual outcomes, and how much other entities may have contributed to the generated outcomes. Answering these questions allows you to provide your stakeholders with a wholly accurate representation of the value you provided.

6. Be Transparent

Every facet of the SROI methodology calls for transparency, which involves everything from conducting an analysis on your activities to communicating with your stakeholders about the results of your SROI. Your transparency can play a significant role in how your stakeholders react.

7. Verify the Result

Once you’ve completed your SROI analysis, you should verify the results via an extensive process known as independent assurance. By performing an external validation of your SROI results, your stakeholders can more accurately measure the outcomes of the change that you’ve created.

Forecast SROI vs. Evaluative SROI

If you’re interested in expanding your social return on investment, there are two SROI types that you can use, which include a forecast SROI and an evaluative SROI.

Forecast SROI

A forecast SROI is one that you can use before the activity or program has occurred. This form of analysis is beneficial when you want to gauge and predict how an investment by yourself or your company will perform in regards to social change in the surrounding community. If you’re getting ready to fund a project that you expect will result in a certain amount of social, environmental, or economic change, a forecast SROI is a great way to determine if you’re making a sound investment.

Along with being able to predict the amount of social value that a project will have, a forecast SROI is also a great way for organizations and individuals to implement the infrastructure that’s necessary for precisely measuring change. This infrastructure includes data collection processes and relevant indicators. With this infrastructure in place, you can continue to perform SROI analyses with ease throughout the duration of the project. Obtaining an SROI analysis before the project occurs should also help you leverage your capital for the highest impact.

Evaluative SROI

An evaluative SROI is designed to be held once an activity or program has had a reasonable amount of time to properly affect change. While a forecast SROI may not always be precise because of how it relies on predictive information, an evaluative SROI is only used when there are already some outcomes that can be measured with this methodology.

You should consider using an evaluative SROI in situations where you’re already tracking data related to the outcomes of the activity or project. You need this data in order to perform an evaluative SROI. If the program that you invested in involved donations of money and time, an evaluative SROI can be performed as long as you measure the amount of time and money that’s being donated. With the results that you obtain, you should be able to determine if your initial investment provided you with the results you wanted.

How Can SROI Help You?

There are a myriad of benefits that are provided to you when you perform an SROI, the primary of which is that this analysis allows you to know if you’re actually making a difference. Unless your investment is a one-time deal, an SROI can also provide many additional benefits. If you perform a forecast SROI, you should be able to identify how much social change your investment or project will cause. If the analysis doesn’t provide you with the results you wanted, the information from this SROI can be used to make better investment decisions in the future. If you want to make sound investment decisions that make an economic, environmental, or social difference, an SROI should provide you with a useful calculation.

Along with using an SROI to plan your investments and help you determine what to spend your money on, you might also want to perform an SROI to better communicate the social impact of your investment to your stakeholders. Without conducting an SROI, it’s practically impossible to provide concrete data about how you or your company is affecting the community around you. When you perform an SROI, you will be generating value for your stakeholders, obtaining the information needed to improve the social impact of your investments, and increasing your overall transparency with stakeholders. When your stakeholders are provided with this information, they will be able to hold you accountable while also involving themselves meaningfully in the project at hand.

Resources to Carry Out an SROI Analysis

If you’re ready to carry out an SROI analysis, there are many excellent resources that you can take advantage of. For instance, if you navigate to the Social Value Self-assessment Tool, you will be able to use this tool to determine how well you are currently measuring your social value and reporting on it in accordance with the seven principles of an SROI. Some of the establish calculators in the industry include the Social Impact Calculator, the Inclusionary Housing Calculator, and the Social Value Bank Calculator.

If you’re interested in joining a wider network that aims to improve the way social value is measured, you could become a member of Social Value International. To better understand how outcomes are generated, you can view outcome reports for home ownership, SMEs, vehicles, and women employment. A great guide that can help you measure your SROI can be found at this NEF Consulting page, which offers extensive tools and resources. With these resources in hand, it should be relatively simple for you to accurately measure the social impact of your investments.

*Disclaimer: The statements and opinions expressed in this article are solely those of AB Capital. AB Capital makes no representations, warranties or guaranties as to the accuracy or completeness of any information contained in this article. AB Capital is licensed by the Financial Division of the California Department of Business Oversight as a California finance lender and broker (DBO Lic. No. 60DBO-69427). AB Capital makes money from providing bridge loans. Nothing stated in this article should be interpreted, construed or used as legal, financial, investment or tax planning advice, or a substitute for thorough due diligence and the exercise of sound independent judgment. If you are considering obtaining a bridge loan, it is recommended that you consult with persons that you trust including but not limited to real estate brokers, attorneys, accountants or financial advisors.

Real estate crowdfunding is a method of funding a real estate project using a small amount of funds from a large number of investors.

From the developer’s perspective, crowdfunding gives developers access to networks of colleagues, friends, family, and even the general public, through such social media sites as LinkedIn, Facebook, and Twitter and various crowdfunding platforms available online. These efforts allow the real estate developers to widen their potential investor base and capitalize projects they may have had difficulty funding through more traditional channels.

From the investor perspective, crowdfunding provides investors access to significantly more investment opportunities, and allows them to spread their investor dollars in smaller amounts across more investments, and thereby achieve greater diversification.

Though real estate crowdfunding has been around in some form for many years, it has recently begun to increase in popularity, primarily because of the proliferation of online crowdfunding opportunities and platforms.

As an investor, to be successful with real estate crowdfunding, it’s essential that you select the right crowdfunding platform. By using crowdfunding to make a real estate investment, you’ll be able to gain access to the wider real estate market with only small amounts of money. While there are dozens of crowdfunding platforms available to you, some of the more popular platforms include Fundrise, Origin Investments, and RealtyMogul.

The real estate industry is becoming more active with crowdfunding, which has facilitated the refinement of the process in recent years and the increase in viable platforms. While crowdfunding is a great way to engage in real estate investment without needing to spend a significant sum of money, there are advantages and disadvantages to the process that you should be aware of before you give it a try. The following takes a look at some of the pros and cons of real estate crowdfunding, which may help you decide if this investment vehicle is right for you.

How is Real Estate Crowdfunding Advantageous?

1. Portfolio Diversification

Among the most notable benefits of real estate crowdfunding is that it allows you to engage in portfolio diversification. By diversifying your portfolio, you are essentially minimizing the risk that comes with making a singular investment by spreading that risk across numerous investments. If one of your investments happens to fail, your investment portfolio will be spread across numerous investments. To illustrate the benefit, you could make one investment of $100,000 into investment A, or invest that same amount equally in $20,000 increments across investments A, B, C, D & E. If you only invested in investment A and that investment failed entirely, you would lose $100,000. But if you had invested that amount across five investments, and one failed, you would only lose $20,000.

2. Accessibility

Engaging in real estate investing has been made much more accessible with crowdfunding. Private real estate investments were once only available to high net-worth investors who had the capital and connections that were needed to access the investments. With changes in the law and the proliferation of online crowdfunding platforms, those are no longer barriers to entry. The entry point for the real estate investment market is now much lower than it’s ever been.

3. Geographic Diversification

While portfolio diversification is among the top advantages of making real estate investments with crowdfunding, another similar and notable benefit is that you can obtain geographic diversification with your investments. The reason that geographic diversification is important is that multiple areas of the real estate market can perform very differently from one another.

While the real estate market in one city may be healthy, it’s possible that the market in another location could experience a significant downturn. If you invest all of your money into one location, it’s possible that you could obtain a negative ROI solely because of issues specific to that market that don’t impact the broader market. When you make real estate investments via crowdfunding, you’ll have the option to choose where you invest.

4. Passive Investment Vehicle

Another attractive aspect of investing in real estate through crowdfunding is that it is a passive investment vehicle, as contrasted to more traditional real estate investment vehicles, such as direct ownership. For people who make traditional investments, they generally will need to spend considerable time managing the property to make sure that it’s developed on time and according to specifications, and bear all of the associated risks. With crowdfunded real estate investments, you are investing with a third-party real estate developer or operator who does all that work. You are trusting that the developer or operator will do all of the required work on time and on budget. As such, you don’t need to deal with the frustration of managing the property. This, in turn, frees you up to focus on your other investment ventures.

5. Small Investment Size

If you’ve never before been able to invest in real estate because of how much money is typically required with a traditional real estate investment, crowdfunding provides you with the opportunity to become a real estate investor because of the small investment size requirements. In fact, some crowdfunding platforms allow potential investors to make an investment of as little as $500. You no longer have to have the tens or hundreds of thousands of dollars that would more typically be required to purchase a property to invest in real estate. The smaller investment amount also allows you to “tip your toe in the water” if you are new to real estate investing, or achieve greater diversification.

How is Real Estate Crowdfunding Disadvantageous?

1. Lower Relative Returns

While real estate crowdfunding can be highly advantageous, there are also some disadvantages that you should be aware of before you start to invest. One potential disadvantage is that your return will typically be lower than what you would receive if you directly invested in the real estate through ownership. That is because the developer or operator with whom you are investing needs to make money too. Your investment return typically accounts for that fact. The return you do receive, however, will depend on numerous factors including, without limitation, whether it is a debt investment, equity investment, and the ultimate success of the investment. If your real estate investment proves to be a successful one, you can typically expect a return of 8-10 percent for a debt investment and 18-23 percent for an equity investment.

2. Illiquid Investments

Another disadvantage of investing with crowdfunding is that this type of investment is considered to be an illiquid investment. These investments are ones that cannot be easily sold for cash if the need arises. A buyer will need to be lined up for the property that you’ve invested in, which can take a significant amount of time and may cause the value of the property to drop over time. If ever an emergency occurs, it could be nearly impossible to cash out on the investment.

3. Lack of Control

If you want to have control over your investments, real estate crowdfunding may not be for you. Once you make the investment with crowdfunding, the development of the property will be managed by someone else entirely. However, more traditional forms of investment provide investors with the ability to manage the project.

If you have managed sizable projects before and believe that you could effectively manage a real estate project, a traditional form of investment will allow you to have more control over the development process, which can typically make it easier to get the returns you’re looking for.

How to Get Started with Real Estate Crowdfunding

If you want to start investing in real estate through crowdfunding, you will first need to select a crowdfunding platform to join, of which there are many. Each crowdfunding platform comes with different requirements and different areas of focus. One principal requirement that you need to consider when choosing from among the many crowdfunding platforms is the minimum investment amount. While some platforms come with a minimum investment amount of just $500, others require minimum investments of $100,000. The average is usually around $5,000.

Most of these platforms provide you with the ability to put your money into an equity investment or a debt investment. When making an equity investment, you will receive a direct stake in the property. Returns occur in the form of an equity share of the total rental income or profit if the project is sold. As for debt investments, you will be placing your investment directly into a loan. These loans are typically secured by the underlying real estate serving as collateral and will be repaid with interest on a monthly or quarterly basis, after which a percentage will be provided to each investor.

Once you’ve found the right platform, it’s important to understand that each works differently. You will first be required to start an account, after which you can make your investment. With a platform like Fundrise, an investment of $500-$1,000 will allow you to invest in 5-10 projects, each of which you will be able to select on your own. You can get started with most of these platforms in a matter of minutes. Keep in mind that the length of these investments can be anywhere from 1-10 years.

The Bottom Line

While real estate crowdfunding and investing may not be for everyone, it can be a great way for you to start investing in real estate without needing to spend a substantial amount of money. Placing less money into the investment means that the risk will often be lower. Before you begin to invest in real estate with crowdfunding, it’s important that you understand the many advantages and disadvantages that come with crowdfunding. With this information in hand, you’ll be able to create a risk assessment for your investment.

Construction or rehabilitation of real estate for investment purposes can be a complex and timely process involving a number of considerations that need to be managed appropriately to ensure a project is completed on time, within budget, and is ultimately profitable. One critical and difficult aspect of the process if you don’t have the funds needed to complete the project on your own is securing the necessary financing.

There are a number of ways that you can finance the construction of your real estate investment project including through equity, debt, or a combination of the two. Equity will typically come in the form of unsecured financing from investors, but at a significant cost that requires you to give up a share of your profits. Whereas debt is typically provided in the form of a loan secured against your interest in the property, but at a lower cost that pays a stated interest rate pursuant to negotiated terms.

If you are considering a construction loan and believe that you can meet the terms of the loan, there are numerous types of loans available to you. These loans include construction-to-permanent loans, renovation loans, construction-only loans, owner-builder construction loans, and end or permanent loans. While the terms of each of these forms of loan can vary significantly depending on the project and lender, there are some common characteristics that, if understood, should help you evaluate whether and which loan is right for you.

What are Construction Loans?

Unless you have a significant amount of money saved up for a construction project, you’ll almost certainly need to obtain a loan to finance the development of the property. And even if you do have the money necessary to finance your development project, a construction loan might still make sense because it provides leverage that allows you to deploy your excess capital toward other projects or investment opportunities.

Very generally, a construction loan is a loan secured by your property that provides you the capital needed to complete all or some of the desired improvements to your property.

Construction loans are oftentimes not offered by traditional banks, and if so on very limited terms, therefore requiring that you work with private lenders who specialize in construction loans. While the terms will certainly vary, typical characteristics of construction loans include shorter terms typically from 12 to 24 months, higher interest rates given the additional risk involved, and the establishment of a construction reserve account that you draw against and only can access upon passing certain benchmarks as construction progresses.

Perhaps one the most notable difference between a construction loan and a traditional real estate or personal loan is in how the loan proceeds are disbursed and paid out. When you obtain a traditional real estate or personal loan a lump-sum payment will typically be made (to you, or the seller of the home or car you are acquiring) when the loan funds. On the other hand, construction loans are more typically funded and paid out by the lender in stages, also known as tranches.

For example, you may secure a construction loan for $500,000, but only a portion of that amount is funded initially, and the remainder is funded and disbursed to you as construction progresses. Because the lender is often lending to you based on the value of the project once it is completed, the lender will only want to disburse the proceeds to you as the project progresses pursuant to the plans and budget. Otherwise, if the lender funds the entire amount of the loan to you upfront and that money does not go into completing the improvements pursuant to the budget, the lender would be left under-secured.

Another key difference with construction loans is the documentation required to secure approval. Because these loans are riskier and depend on certain assumptions, including the future value of the property and that the property will be completed on time and within budget, more documentation is typically required. The lender is likely going to require detailed information about the construction including plans, budgets, city approvals, contracts, etc. The lender is also likely going to require a detailed appraisal that takes all of that into consideration in arriving at a future value of the property. The reason that you need to provide this much documentation is that the underwriting process extends to you, the builder, and the actual project.

Applying for a Construction Loan

If you’re looking to build a new property and want to obtain a construction loan that will allow you to do so, the first step of the process involves filling out and sending in the application for the loan to one or more potential lenders that you have identified. You’ll typically need to provide the lender a certain amount of more limited information about your loan request and the development project, so that the lender can provide you an initial letter of interest with proposed terms.

If you decide to proceed further, the lender will then request more detailed information and further documentation about your loan request and the project to further underwrite the loan. Once the lender has all of the information that they need to evaluate your loan and proceed, your loan will be been approved and ultimately funded, and you’ll be able to begin construction of your development project.

credit card and lock representing strong credit score

It is important to understand that the loan funds are intended to cover the budgeted cost of labor and materials for the property. You want to make sure that your loan budget is accurate, includes an adequate amount to account for unexpected contingencies, and that the loan provides you sufficient funds to complete the project.

For example, if your construction budget is $500,000, including appropriate contingencies, you will likely need a construction loan of more than $500,000 to account for the escrow, title and lender fees that are typically paid from the loan amount. Therefore, it is important to understand the “net” amount that you are to receive for construction from the loan. If you don’t adequately fund your project, you face the risk of running out of money before it is done, and potentially having the lender foreclose.

Types of Construction Loans

There are generally five primary types of construction loans, though the terms of each may vary significantly by a lender. The five types are construction-to-permanent loans, construction-only loans, renovation loans, owner-builder construction loans, and end loans. Different loans are necessary for different types of projects, which is why it’s important that you know what each loan does and what it should be used for.

1. Construction-to-Permanent Loan

A construction-to-permanent loan is likely the best loan available to you if you want to live in the property once built. It provides all of the funds that you will need to develop the home and then live in it with a more traditional mortgage. The money that you borrow will first be used for the construction of your home. Once the property has been developed and you’re ready to move in, this loan will be converted directly into a permanent mortgage, which means that you don’t need to obtain two separate loans.

The closing process on the loan occurs only once, which allows you to keep your costs down. When the loan is converted into a permanent mortgage, it can come with a term of 15-30 years. While a construction-to-permanent loan may save you in closing costs and provide you more certainty, the interest may also be higher because of the increased risk and uncertainty. It also limits your ability to explore the market for the most competitive permanent loan once construction is complete. If you are considering this type of loan, you should carefully weigh the costs and benefits against other alternatives before proceeding.

2. Construction-Only Loan

A construction-only loan just provides you with the funds that you need to construct a property. However, these funds will typically need to be paid back once the property has actually been built, which means that you can’t convert the loan into a permanent mortgage. This type of loan is most commonly used by professional real estate developers who intend to sell the property once it is complete.

Interest rates for these types of loan are typically higher than traditional mortgage loans because of all of the additional risk. Some lenders have set rates depending on various criteria, other lenders will analyze each loan request individually and negotiate an appropriate rate, and others will base their rate on the prime rate set by the Federal Reserve as well as an additional margin. Regardless of how lenders determine their rates, you can expect an annual interest rate typically ranging from 9% to 12% depending on the lender and the specifics of the loan request. The stronger you are as a sponsor, the lower leverage that you seek, and the better the location and quality of the project are all factors likely to help you secure a lower rate.

While these loans are beneficial when you’re developing a project for a profit, building the home of your dreams or moving your business into a new property, they usually cost more than construction-to-permanent loans since you will need to pay two sets of closing costs. It’s also important to note that a worsened financial situation while the home is being developed may cause you to have issues when you try to apply for a permanent mortgage. The term of this type loan is typically 12 to 18 months, though that can also vary depending on the scope of the project.

3. Renovation/Rehab Loan

A renovation or rehab loan is a type of construction loan that provides you the money that you need to remodel or renovate a property and does not involve ground-up construction. It could provide money to a professional real estate developer who is buying a property to do a light rehab and then sell it, or to a homeowner simply seeking to remodel a kitchen. Options for this type of financing can include a government-backed home renovation loan, a home equity line of credit (HELOC), a cash-out refinance where you refinance the property with a new loan and receive cash for a certain amount of the existing equity, or a loan from a private lender that that is treated much like a construction loan but without as many of the requirements.

Because of the many varying options, the cost and requirements for each of these options will also vary significantly. You should assess and compare all potential options before making a decision.

4. Owner-Builder Construction Loans

An owner-builder construction loan is a type of construction loan where you will act as both the borrower of the loan as well as the home builder. These loans are rarely every issued because of how complicated it is to develop a home and the conflicts of interest inherent when the borrower is also the builder. However, you can consider this option if you’re a licensed builder. These are short-term loans, much like a standard construction loan, that will last until you complete construction of the building, which means that the loan terms will likely be 12 to 18 months.

5. End Loans

An end loan is essentially the long-term mortgage loan that you obtain after you’ve developed your home to pay off your construction loan. Whereas construction financing typically bears a higher interest rate and is short term by nature, end loans typically bear a lower interest rate and are long term by nature. They are also referred to as permanent loans. These types of loans aren’t typically available until construction is fully complete and you have a certificate of occupancy for the property. However, if you know that you will need an end loan once construction is complete, you should start exploring your options and speaking to potential lenders well before construction is done so that you can secure the end loan as soon as possible once construction is complete. Loan terms will typically be 15 or 30 years.

Choosing the Best Construction Loan for Your Project

If you’ve made the decision to apply for a construction loan for the development of a property, you need to select the best loan for your project. To do so, you first need to find a lender that offers these types of loans and evaluate that lender to make sure they are reputable and their terms are competitive. Many lenders don’t offer construction loan financing, which means that you likely need to do some research.

Since construction loans are relatively complicated, you should consider working with a lender that specializes in this type of loan. During your search, it is highly recommended that you obtain multiple quotes from different lenders to determine which lender offers the best terms, down payment requirements, and rates.

Securing traditional bank financing to buy a property may be difficult when you need to close quickly, your finances are difficult to document, or you want to make improvements to a property. The same may be true if you own a business and need to pay the expenses related to your commercial property while you search for a new property, or need to stabilize a commercial property after you buy it in order to qualify for traditional financing. If any of these circumstances apply to you, you might want to consider obtaining a bridge loan.

Bridge loans are loans designed specifically to “bridge” a short-term funding need until more permanent financing can be secured. They offer borrowers the opportunity to “bridge” two separate financial transactions.

Why Might I Need a Bridge Loan?

There are a number of circumstances when you might want to consider a bridge loan. While bridge loans can be beneficial for traditional home buyers, they are more commonly used by real estate professionals and investors. One of the more common situations where a bridge loan is needed is when a real estate investor needs to close quickly on the purchase of a property that he/she intends to remodel and sell. The need to close quickly and remodel may make securing a traditional bank loan less feasible or desirable. Accordingly, the real estate investor may go to a private lender for a bridge loan that will allow him/her to close quickly and cover the expenses of remodeling. Once the remodeling has been completed, the real estate investor may sell the property to pay back the lender of the bridge loan, or at that time refinance with traditional bank debt in order to keep the property.

Another common situation where a bridge loan is needed is if you are in the process of selling your current property, but have the desire or need to purchase a new property before you can close the sale. In such situation where you would be carrying the debt on both properties for a short period, your finances may not be strong enough to secure approval of a traditional bank loan. A bridge lender, however, will look primarily to the value of the new property to provide a bridge loan for the purchase of the new property. Once your previous property has sold, you can use the money that you earn from it to pay off the bridge loan, or at that point secure more permanent financing through a bank. A bridge loan is beneficial in this situation because it allows you to purchase a new property before your current property has sold. Not being able to purchase a new property because your current property is still on the market is a problem that could cause you to miss out on a great opportunity which a bridge loan can remedy.

There are many other circumstances where a bridge loan may be right for you, and the above are just two common examples. Generally, if you ever need a short term financing solution to bridge two financial transactions, and traditional bank financing is not feasible or desirable, you might want to consider a bridge loan.

What are Typical Bridge Loan Terms?

The terms of a bridge loan may vary significantly from lender to lender, and also be contingent upon your particular needs, however, there are some general common characteristics of many bridge loans. One common characteristic is the short-term duration of the loan. Because the purpose of a bridge loan is to bridge two financial transactions, they off are written for periods ranging from 6 months to 24 months.

Interest Payments on a Bridge Loan

Another common characteristic is the way that interest is paid. Because bridge loans are typically short-term and necessitated where the borrower may have cash flow constraints (such as during a remodel or when buying two properties), a bridge loan often requires interest only payments with a balloon payment due when the loan matures. This is different than a traditional bank loan where payments are typically amortized over a period of time to include payments of principal and interest. While you typically will need to make monthly payments on a bridge loan during its duration, the principal balance and vast majority of the loan will likely not be due until the loan matures, or you are able to pay back the loan through a sale or refinance.

Bridge loans also often require the payment of an interest rate higher than a bank loan (typically 7% to 10%), and the payment of a fee to the lender or broker arranging the loan (typically 1.5% to 3%). This is the byproduct of many factors including, but not limited to, the limited market of lenders willing to make such loans, the costs of their funds, the short-term duration of the loan, and the perceived additional risk.

Where Can I Get a Bridge Loan?

Unlike standard mortgage lenders, bridge loans aren’t typically provided by standard institutional lenders like credit unions and banks. Most bridge loans are offered by private money lenders, who are non-institutional lenders that typically make real estate loans secured by a promissory note and a deed of trust. Some of these lenders also often limit these loans to real estate professionals or companies who are using the proceeds for investment, and not consumer, purposes.

Finding the Best Bridge Loan Lender for You

To determine which bridge loan lenders are the best for your situation, use common sense. Just like researching any service provider, it is recommended that you solicit referrals from people that you trust and perform due diligence on the company and its track record. Visit their website, read reviews, analyze other loans that they have funded. And, if possible, it is highly recommended that you visit their office in person to get a first-hand look at their operations or, at the least, speak to someone at the company in a position of authority. Often times bridge lenders are smaller and less-hierarchical than banks, and you may be able to establish a direct relationship with a principal of the company.

Once you’ve identified some possible bridge lenders, it is also recommended that you obtain several quotes to identify which lender offers the best interest rates and terms. While you shouldn’t necessarily choose the lender that offers the lowest interest rates and origination fees, this is a good barometer to use when conducting your search.

In our opinion, if you’re trying to choose between several reputable bridge lenders with similar terms, the most important characteristics to look for include a great reputation, a significant amount of experience, and personalized attention throughout the lending process.

How Do I Apply for a Bridge Loan?

Once you’ve selected a bridge lender or perhaps during the selection process, you’ll need to apply for the loan. One of the more favorable aspects of bridge loans, when compared to traditional loans, is that they typically come with a much faster application and approval process. After you’ve filled out the application, the lender will typically take a short period of time to review the application and request additional information necessary to preliminary evaluate the loan, which will likely include pertinent information about the subject property, your credit score, and a personal financial statement. Assuming the lender has enough preliminary information, the lender may then provide a Letter of Intent or term sheet detailing the proposed terms of the loan based on certain stated conditions and the completion of underwriting, for you to review and approve.

The Approval Process

Once approved, the lender will proceed to gather additional information needed to complete the loan file and fully underwrite the loan. Such additional steps often entail opening escrow, generating a title report, securing an appraisal or other opinion of value. Once the lender is fully satisfied with the loan file, loan documents will then be drawn, and the loan will be moved to closing. The duration and complexity of this process will vary based on the scope and complexity of the subject loan, but can at times be completed within as little as 2 business days.

Will I Qualify for a Bridge Loan?

If you’re wondering how to qualify for a bridge loan, the standards are typically leaner and less robust than the standards employed by traditional banks. While the criteria will vary from lender to lender, most bridge lenders are “asset-based” lenders, meaning that the primary qualifying factor is the value of the property securing the loan. Private money bridge lenders typically lend an amount based on a percentage of the property value. The amount of your loan as a percentage of the property value is known as the loan-to-value ratio.

While private money lenders will also typically evaluate the financial strength, credit, and quality of the borrower, these are often secondary factors. Accordingly, unlike a traditional bank, you can typically qualify for a private money bridge loan without having to provide as many financial data, such as numerous years of tax returns, and without the same financial strength that may be required for a traditional bank loan.

However, because private money lenders focus less on the borrower’s financial strength and ability to repay the loan, they typically lend at a lower loan-to-value ratios than traditional banks. Where a traditional bank lending on a traditional mortgage may lend up to 80% of the property value, private money bridge lenders often times lend in the 60% to 70% range. However, the loan-to-value ratio will, of course, depend on a number of other factors involved.

If you’re looking to invest and set yourself up for long term financial success, one type of investment that you may want to consider is investing in real estate. There are many ways to invest in real estate including by owning rental properties, buying properties to rehab or develop for resale, investing with other persons who buy or develop property, investing in a real estate investment fund or real estate investment trust which aims to diversify risk by pooling your investment with others to make numerous real estate investments and generate a stable return, or investing in individual trust deeds where you essentially act as the lender to a third party real estate developer, to name a few.

Before one selects the proper real estate investment for his/her particular needs, it is essential that he/she identifies the risk associated with the investment in question. One important term you will often here which relates to the risk assessment is the “capital stack.” When it comes to real estate investments, the capital stack refers to the various layers of funding that are required to finance a real estate investment.

Where your investment falls within the capital stack and the priority it has in relation to other positions in the capital stack directly bears on the risk of the investment in question. If everything goes according to plan, all positions in the capital stack will be paid the targeted return. Unfortunately, however, things don’t always go as planned, and you want to make sure you understand your position in the capital stack so that you can make an informed decision before you decide to invest. By identifying where your investment is situated within the capital stack, you will be able to understand more about when you get paid and the amount of underlying risk associated with the investment.

Though the capital stack will likely be structured differently based on the particular investment, the most common four layers of the capital stack in real estate investments are common equity, preferred equity, mezzanine debt, and senior debt. Some capital stack structures have fewer layers, such as, just debt and equity, and others have more.

The capital stack generally tells you the order of priority of payout with respect to other positions within the capital stack. Starting at the bottom of the capital stack, the senior debt will be paid out first, then the mezzanine debt, then the preferred equity and finally the common equity. If the real estate investment doesn’t perform as projected, there may not be enough money to repay all money invested along with returns. The bottom layers will be repaid first, and the top layers will incur losses before anyone else.

Thus, your position in the capital stack directly relates to your risk. If you happen to be towards the top of a capital stack, you will inherently have more risk than the lower layers. If you are in the bottom of the capital stack, your investment will be safer relative to the other positions in the capital stack.

The projected return, however, is generally structured to correspond to the amount of risk. While investing in the bottom of the capital stack is typically more secure, it also typically generates lower returns. While investing in the top of the capital stack is less secure, there tends to be more upside potential. Keep in mind you can also vary your risk and returns by investing in multiple layers of the capital stack at the same time depending on your investment goals.

The specific terms and structure of any particular investment will certainly involve many more complexities, but having a basic understanding of the capital stack can provide a solid foundation to build from. This article endeavors to provide you that foundation.

Common Components of the Capital Stack

As touched on above, the four most common components of a real estate capital stack include common equity, preferred equity, mezzanine debt, and senior debt. We’ll start our discussion from the top and work our way down.

Common Equity

The common equity of an investment is considered to be the top layer of a capital stack. This portion of a real estate stack is considered to be the riskiest, yet potentially most rewarding, layer.

It is risky for numerous reasons. First, when you’re involved in this layer of the investment, every other layer of capital that was invested into the project will receive repayment before you do. In other words, you’ll get paid last. Second, the common equity layer typically does not have a recorded secured interest in the property, nor is it typically entitled to reoccurring payments. Rather, the return of the entire investment, principal and potential returns, typically will not be realized until the property is sold or there is another liquidity event. If the investment does not perform as projected, you are potentially at risk of losing some or all of your initial investment.

On the other hand, investing in the common equity layer of the capital stack can be the most lucrative. Potential returns typically aren’t capped for common equity investors. Thus, in the event that the investment is largely successful, common equity investors could realize very sizable returns.

If you are investing in the common equity layer, you will typically be standing side by side with the sponsors of the real estate investment. The sponsors are often relegated to the highest position in the capital stack. This incentivizes the sponsor to maximize the returns for every position in the capital stack, because the sponsor will only realize its returns if every position below is first paid. Once everyone below is paid, the sponsor, along with other investors in the common equity layer, also capture any remaining upside.

Preferred Equity

The preferred equity for a real estate investment is the layer of a capital stack that falls just below the common equity layer. It is a malleable layer that comes with a significant amount of flexibility in regards to how it is structured, but typically entails a preferred rate of return that must be paid, and therefore provides more certainty than the common equity layer. The preferred equity layer will also have the right to repayment before the common equity investors, which lowers the amount of associated risk.

The preferred equity layer is commonly structured as a hybrid to share characteristics of the common equity and mezzanine debt layers. Like the common equity layer, the preferred equity layer will typically share in some (though less) of the upside of the investment. Like the mezzanine debt layer, the common equity layer may also have a right to regular recurring payments.

While there are many potential ways to structure the preferred equity layer, investments in this layer are often differentiated as either “hard” or “soft.” A “hard” preferred equity investment tends to be less risky. It typically requires that the preferred return must be paid regardless of cashflow or the performance of the investment, and involves varying remedies if payments are not made, including the right to take control of the investment or force its sale. In this way, it operates much like the mezzanine debt layer described next.

In contrast, a “soft” preferred equity investment typically only requires payments if there is sufficient cash-flow, and may or may not entail remedies if those payments are not made. In this way, a “soft” preferred equity investment is more similar to the common equity layer.

Mezzanine Debt

The mezzanine debt layer sits just above senior debt in the capital stack, which means that payment priority will come immediately after any senior debt investors, and before the equity layers. Mezzanine debt typically involves characteristics of senior debt and equity. Like senior debt, mezzanine debt investors will typically have a right to receive regular payments at a stated rate not tied to the performance of the investment, and that rate will typically be higher than the senior debt rate because of the increased risk. Like equity, mezzanine debt investors will typically have a right to share in a portion of the potential profits, but a much lower portion than the equity layers.

Unlike senior debt, however, mezzanine debt is not typically secured by a recorded interest in the property itself. While mezzanine debt investors may have limited foreclosure rights, those are typically governed by the terms of agreements among the parties. Unlike equity, mezzanine debt is debt. The right to repayment attaches regardless of the performance of the investment.

The mezzanine debt layer can be attractive if you want to share in some of the potential upside, while also securing a guaranteed right to payment at a lower position in the capital stack.

Senior Debt

Senior debt for real estate investment is the very foundation of the capital stack. It is typically the largest, least risky, and least expensive portion of the capital stack. As an investor, if you want your investment to come with the least amount of risk attached to it, you should consider a senior debt investment.

Senior debt is secured by a deed of trust or a mortgage recorded against the property, which means that you will be able to claim the title of the property in the event that the borrower defaults on making its regular payments through the foreclosure process. It is also structured to require regular monthly interest payments at a stated rate, that is not tied to the ultimate performance or success of the investment.

Because of its lower relative risk, returns for senior debt investments are also lower. As a senior debt investor, you will not have the right to share in any of the potential upside or profits of the venture. Whatever rate is negotiated and stated in the loan documents, is the return that you can expect to receive.

What Your Position in the Capital Stack Means for You

It’s important to understand that different positions in the capital stack will affect the investment in different ways. The position that one should take in a real estate investment all depends on one’s broader portfolio strategy and risk appetite. If the intent is to make risky investments that could provide the highest ROI, the focus is usually on the common equity and preferred equity layers of the capital stack. If, on the other hand, one wants a risk-averse investment with a lower rate of return, it’s much better to be positioned at the senior debt or mezzanine debt layers of the capital stack. One can also consider being in different positions of the capital stack at the same time, which helps to spread out risk and obtain higher blended returns.

Understanding the capital stack is, however, only one small, albeit important, piece of information necessary to assess the risk and evaluate if a real estate investment is right for you. For example, you can invest in the senior debt portion of the capital stack, but if the underlying investment is not otherwise sound, it still could be a bad investment. Conversely, a common equity investment could be well worth the associated risk if other factors exist to mitigate the risk and provide the opportunity for significant upside.

Expanding Your Social Return on Investment (SROI)