“Skin in the game” is a common business and finance term used to describe the Project Owners’ significant equity stake in the investment project, which has solicited external investors to invest. “Skin in the game” is directly related to the Project Owners’ confidence in the investment project as well as to the stability of the venture.
Nassim Nicholas Taleb has written an excellent book on the subject (unsurprisingly named “Skin in the Game”), stating the importance of balancing incentives and disincentives. In other words, people who want to share the benefits (e.g. the profit) of an investment should also share some of the risks (e.g. potential loss) associated with that investment.
“Skin in the game” in real estate crowdfunding
The majority of real estate projects are straightforward and transparent, allowing the analysts to determine the true capital structure of the project and, thus, clearly outlining the amount of Project Owners’ equity investment. The requirements for owners’ equity vary from country to country and are mostly determined by the local market practices and commercial banks’ lending appetite.
Typically, the banks would finance about 65-75% of the real estate project’s costs, resulting in a need for about 25-35% equity contribution. A more recent approach allows the real estate developers to split the 25-35% equity contribution into mezzanine capital and pure equity investment.
In some Central European real estate markets, it is not uncommon to see the Project Owners providing only a minor 5% equity stake (often even in the form of soft costs or sweat equity) and funding the remaining capital needed via mezzanine loans or preferred equity.
The real estate project’s equity stake equals the Project Owner’s actual skin in the game. The larger the equity stake, the more motivated the Project Owner is to avoid the failure of his project. The larger the equity stake, the less risky the lenders’ or external investors’ position.
As different real estate crowdfunding platforms are having quite different funding criteria, the investors should pay attention to the Project Owner’s actual equity contribution to the project. If the Project Owner’s equity contribution is unclear, small or missing, or the equity return offered to the crowdfunding investors is not balanced with their investment, this is a clear sign of the Project Owner’s unwillingness to take necessary risks, and such real estate projects should be approached with caution.
There are a few well-known tricks to reduce or eliminate the Project Owner’s actual skin in the game in real estate projects. With mortgage-secured bridge and construction finance loans, the typical way of bluffing is the overvaluation of the collateral, including the case where the acquisition of the collateral takes place below the value stated in the appraisal document. This results in the Project Owner actually not investing the disclosed amount into the project. In real estate equity projects, the typical way of demonstrating a large amount of skin in the game is happening via the inflation of the development costs and assigning them to be financed by owner’s equity.
Crowdestate requires the Project Owner to clearly demonstrate a reasonable amount of equity contribution, the overall equity stake in the real estate project should not be less than 20% of the full capital stack. Failure to demonstrate the necessary equity contribution will result in the immediate disqualification of a crowdfunding project.
The fallacy of the “skin in the game” on the P2P marketplaces
The alternative finance industry and specifically its P2P unsecured consumer lending sector, is using the term “skin in the game” to market the safeness of the unsecured and highly risky consumer loan instruments.
A typical example of the “skin in the game” from the consumer lending industry is the marketplace’s requirement for the loan originator to keep a certain percentage of each loan on the originator’s books. If the marketplace requires the loan originator to have a 10% skin in the game, the originator can sell only 90% of the originally issued loan on the marketplace. For example, if the originator has issued its borrower a EUR 1,000 loan, only EUR 900 of that can be listed on the marketplace.
The principle seems to be fair, and the loan originator seems to take some risk as long as the principles of financial mathematics are ignored. Unfortunately, the truth is quite far from reality.
Let’s continue with the previous example of a EUR 1,000 consumer loan to calculate the originator’s actual “skin in the game”. In order to do that, one should pay attention to the term of the loan, the interest rate of the original loan and the return that the P2P investors are getting when investing in that loan in the marketplace.
The interest rate of a typical unsecured, high-risk consumer or payday loan issued by the originator can be anywhere from low 20% to high 100% per annum. For the sake of simplicity, let’s assume this unsecured consumer loan has an annuity-based monthly repayment schedule, the loan is originally issued at a 36% per annum interest rate, and the term of the loan is 3 years. By issuing this EUR 1,000 loan, the borrower is committing to making the originator 36 equal payments of EUR 45,80 per month. The total amount repaid by the borrower will be EUR 1 648,80.
If the originator would sell the loan on the marketplace with the same yield (36% per annum), the Net Present Value (NPV) of that loan would be the same for both the originators as well as for the P2P investors. Instead, the originator sells this loan to the P2P investors at a 10% per annum interest rate. The difference in the original and marketplace return becomes the source of financial magic.
As soon as the loan is repriced to a 10% interest rate, the NPV of the cash flow generated by this loan becomes EUR 1 419,52, allowing the loan originator to book an immediate EUR 419,52 net profit. As only 90% of the original loan can be sold on the marketplace, the originator receives EUR 1 277,84 for the sales of 90% of its claim (and will receive an additional EUR 141,68 over the next 3 years).
What becomes of the originally marketed 10% “skin in the game” statement?
Formally, the loan originator still retains 10% of the original loan amount (EUR 100) and collects it with accrued interest along with all other P2P investors during the next 3 years. In reality, when selling the loan on the marketplace, the loan originator will immediately receive back EUR 1 277,84 (EUR 277,84 more than the full amount of the original loan), thus totally eliminating all his original credit risk and skin in the game.
- All investments soliciting external investors’ funds should have a strong and experienced Project Owner with significant skin in the game via his equity contribution;
- As a rule of thumb, real estate projects should have at least 20% of common equity to be considered as reasonably leveraged projects;
- The Project Owner’s unwillingness to provide a reasonable amount of common equity is a clear sign of a weak project and such projects should be approached with caution;
- When investing in unsecured, high-risk consumer loans, the originator’s “Skin in the game” is worth less than the paper those words are printed on. When the consumer loan is sold to the P2P investors, the originator is hedging its original credit risk by collecting both the full initial loan amount as well as most of the deal’s profit.