What is real estate crowdfunding?
Crowdfunding refers to a group of people who pool their money together in order to achieve a common goal. Some crowdfunding activities are charitable in nature -- for example, if a person is facing medical bills they can't afford, they may attempt to crowdfund the expenses. Crowdfunding can also apply to investment situations, and real estate is one of the latest applications that has gained popularity.
Real estate crowdfunding involves a group of investors who each contribute money to a specific real estate deal. For example, if an experienced real estate investor identifies a lucrative opportunity to renovate an apartment building and then sell it at a profit but doesn't have the necessary capital, they might turn the investment into a crowdfunding opportunity and attempt to raise the rest of the necessary funding from investors like you.
How does real estate crowdfunding work?
The general idea behind real estate crowdfunding is that when a developer or experienced real estate professional identifies an investment opportunity, they don't always have the ability (or desire) to completely fund the investment on their own. So, they'll allow individual investors to contribute some of the project's capital in order to raise enough money to execute their plan.
There are three key players in any crowdfunded real estate investment opportunity.
First, the sponsor is the individual or company that identifies, plans, and oversees the investment itself. The deal's sponsor will facilitate the purchase of the asset, arrange for any contractors or other needed work, arrange financing, and take responsibility for the eventual sale of the property. Deal sponsors generally contribute some of the project's funding themselves and are also entitled to a certain share of any profits they earn for the deal's investors.
Second, the crowdfunding platform is where the sponsor finds investors to raise the necessary capital for a project. Think of the platform as the middleman between investors and sponsors. The platform will ensure a deal meets certain standards, advertise deals to potential investors, guarantee that investors meet the requirements for investment, and deal with regulatory issues. The platform will also collect investors' funds on behalf of the sponsor.
Finally, the investor (that's where you come in) contributes some of the deal's required capital in exchange for a share of any profits the deal produces. An investor may get some sort of income distributions and/or be entitled to a proportional payout from an eventual profitable sale.
Here's a simplified example of how this might work: Let's say that an experienced real estate developer -- the sponsor -- identifies an office building that is outdated and lacking modern amenities -- and is only 50% occupied -- for sale at a price of $5 million. After a thorough analysis, the sponsor determines that they can invest $3 million in renovations and improvements, lease up the vacant space, and triple the property's rental income. Not only that, but once occupancy is stabilized in three or four years, the building will also have a market value of $12 million, at which time the sponsor will sell the property.
However, although the opportunity requires $8 million in capital between the purchase and the renovations, the sponsor can only obtain bank financing for $5 million, and only has $1 million of their own capital to contribute. So, they choose to list the deal on a crowdfunding platform and offer the other $2 million as equity in the project to investors like you.
Why has real estate crowdfunding become so popular?
The short answer is that there is a lot of money to be made on successful crowdfunding deals. As I'm writing this, there are five single-asset investment opportunities listed on popular platform CrowdStreet, all of which are targeting annualized internal rate of return (IRR) ranging from 12.7% to 18%.
To be sure, we don't have a ton of data on actual investor returns because the industry is so young, but the numbers so far look quite promising. As of July 2019, CrowdStreet had published 352 crowdfunded investment opportunities throughout its five-year history, and just 17 of them had been "realized," or fully completed, meaning that the property in question has been sold or investors have otherwise cashed out.
Of those 17 realized investments, only one has lost money for investors. The majority have met or exceeded their target returns, and 14 of the 17 (82%) have generated IRR in excess of 14%. With returns like that, it's no wonder that real estate crowdfunding has attracted the attention of many investors.
Advantages of crowdfunded real estate investing
Like any investment opportunity, real estate crowdfunding isn't a perfect fit for everyone. There are several potential pros and cons of real estate crowdfunding that should be taken into account before deciding whether it's right for you. We'll start with the reasons you may want to consider an investment in a crowdfunding deal:
- First, there's the potential for higher returns than you'd get from any other major asset class. I mentioned in the last section that most crowdfunded deals that have completed have produced annualized returns in excess of 14%. It isn't uncommon to see an IRR of 20% or even more from a successful deal.
- Crowdfunded real estate investing can provide an element of diversification to your portfolio. This is especially true if most of your assets are currently invested in stocks and bonds, as these don't generally move in a correlated manner with real estate.
- Crowdfunding allows you to benefit from the potential of single-property investments without the headaches of actually becoming a landlord or dealing with renovations.
- Crowdfunded real estate allows you to invest in assets that may otherwise be inaccessible to you. Could you really go out and buy an office tower or high-rise apartment building? Even if you could, would you know how to go about adding value to the property in a cost-effective manner? Crowdfunding allows you to leverage the expertise of others in assets that have historically been the realm of wealthy developers.
- Most crowdfunding deals focus on a specific property, as opposed to real estate investment trusts (REITs), which typically own a portfolio of many properties.
- Crowdfunded real estate investments often have an income component as well as a targeted lump-sum return at the end of the investment timeframe.
Potential drawbacks of crowdfunded real estate investing
As I said, there's no such thing as a perfect investment. It's always important to weigh the pros and cons before making any investment decision, so here's what you should consider before deciding whether crowdfunded real estate investing is right for you.
- No investment that is capable of double-digit rates of return is without risk, and crowdfunded real estate is certainly no exception. To be perfectly clear, this is a high-risk, high-reward type of investment. There's a lot of execution risk involved with most crowdfunding deals, and there's also the inherent risk that comes with investing in a single real estate asset (as opposed to a portfolio of properties).
- Crowdfunded real estate investments are highly illiquid. Once you put your money in, you're pretty much committed for the duration. Unlike when you own an investment property, you can't just decide to sell your investment whenever you want.
How to find crowdfunded real estate opportunities
I mentioned earlier that the crowdfunding platform serves as the middleman between deal sponsors and real estate investors. One of the major functions of the crowdfunding platform is vetting deals before posting them to its site for investors. So, it's fair to say that it's extremely important to use a reputable platform that takes appropriate measures when it comes to evaluating the opportunities it is willing to present to investors.
Make sure you understand the platforms vetting process, both for the developers it allows to sponsor deals on its platform, and how it vets those deals before they are allowed in its marketplace. The top real estate crowdfunding platforms all apply a high level of due diligence at both the sponsor and deal level. Additionally, make sure you understand where your investment dollars actually go. In most cases, you’ll invest directly in the real estate asset, or in a legal entity (such as an LLC or limited partnership) that owns a stake in the property, something that can protect your assets if the platform were to fail. If your money is an investment in the platform itself, not the real estate asset, then your investment is at a much higher risk if the platform has financial trouble.
Lastly, look for a platform with the kinds of real estate investments you’re interested in, whether it’s individual properties, a handful of properties, or a highly-diversified fund that owns a stake in dozens of properties. If you plan to pick individual properties and choose how much to invest in each one, then a platform that only offers funds doesn’t make sense, and vice-versa.
How to evaluate crowdfunded real estate investments
I've written a thorough guide that can help you evaluate crowdfunded real estate investment opportunities, but here's a rundown of some of the key things to look at:
How risky is the project?
It's rare to find a crowdfunded real estate opportunity that could be considered a "low-risk" investment. However, different types of commercial real estate projects come with different levels of risk.
There are a few factors to consider when evaluating risk. Just to name some of the most significant:
- How cyclical is the property type? If you invest in a fully occupied Class A office property and a recession hits, the damage probably won't be catastrophic. Most office tenants are on long-term leases, and businesses need space to operate from. On the other hand, if you invest in a hotel and a recession hits, profitability could plunge.
- How much execution risk is there? Most crowdfunding investments have some type of value-adding strategy. Now, this can be as simple as refinancing an existing loan in order to save money on interest expenses. Or, it could be as complex as effectively tearing down the existing property and building a new one.
- How much of investor returns is dependent on the sale of the property? A property that has a great income stream from Day One can be a much lower-risk investment than one whose investor return is mostly dependent on the sponsor's ability to sell the property at a profit.
What is the investment category?
For the most part, when we're discussing real estate crowdfunding, we're talking about equity investments. In other words, you contribute some of your money and in exchange, you own an interest in the profits generated by the property.
However, there are two other possible types of crowdfunding investment structures -- debt investments and preferred equity. If you choose a debt investment, you are essentially acting as a mortgage lender. You provide some of the deal's financing, and in return you get an agreed-upon series of interest payments. However, you won't get to share in any profits generated by the investment.
Preferred equity is something of a hybrid. It generally has some type of guaranteed return, but preferred equity holders in crowdfunding deals often get some sort of performance-based return as well.
How much debt is the project taking on?
It's important to thoroughly read any investment's prospectus, and one area that's especially important to pay attention to is the capital stack. This tells you the financial structure of a deal -- how much money is coming from which sources, and who holds the most senior claims to the deal's assets in the event that something goes wrong. This can also tell you how leveraged (debt-dependent) an investment is.
Here's a simplified example of a capital stack you might see: