Does Crowd Sourced Real Estate Investing Reduce Risk?

Crowdsourced real estate investments can help diversify your investment risk, but they aren’t exactly low-risk investments.

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Crowdsourced (or crowdfunded) real estate investment entails a group of investors pooling their money together to invest in a single-property real estate opportunity. This can help investors diversify their portfolios and become less reliant on the returns of their stock and bond investments, but to say that investing in real estate deals of this nature reduces risk would be misleading.

With that in mind, here’s a rundown of why crowdfunded real estate could help you reduce risk, as well as the crowdfunding-specific risk factors that you need to be aware of before considering such investments for your own portfolio.

What is crowdsourced real estate investing?

Crowdsourced real estate investing, more commonly referred to as crowdfunded real estate investing, is a relatively new way to invest in real estate.

Here’s how it works: A developer or real estate company, known as a "sponsor," designs a commercial real estate opportunity. For example, the sponsor may identify a hotel property that is in need of renovation, or an opportunity to develop and build a new self-storage facility.

The sponsor then advertises the opportunity to prospective investors through a crowdfunding platform. CrowdStreet and Realty Mogul are reputable examples of these, and they essentially act as middlemen between a potential deal’s sponsor and real estate investors. Investors can choose to contribute some of the project’s required financing in exchange for a share of the income and profits generated.

The point of crowdfunding is to allow everyday investors the opportunity to put their money to work in commercial real estate, or CRE. This has historically been a lucrative type of investment that for obvious financial reasons has been largely out of reach for most investors. For example, not many people reading this could go out and buy a high-rise office tower and then proceed to renovate it. However, crowdfunding can allow you to invest your money in exactly that way.

How crowdfunded real estate investments can help reduce risk

Unfortunately, there’s no easy answer to the question of whether crowdfunded real estate reduces risk. In some ways, participating in a crowdfunded real estate deal can certainly lower your risk level, but in other ways, it adds to your risk. We’ll look at both sides of the story, starting with the ways it can help you reduce risk.

For starters, crowdfunded real estate can help you diversify your investment portfolio. This is the No. 1 way crowdfunded real estate investments can help you reduce your investment risk.

If you currently invest in stocks, bonds, or mutual funds, for example, adding a crowdfunded real estate opportunity to your investment strategy can add diversification, and help insulate you from stock market fluctuations. Even if you already invest in real estate -- let’s say that you own a rental property -- investing in a crowdfunded real estate deal is an entirely different type of investment.

From a real estate investment standpoint, crowdfunded real estate has the advantage of professional management. Most deal sponsors who list on major crowdfunding platforms are very good at what they do, so it can be less risky than, say, trying to buy a property, fix it up, and flip it yourself.

How crowdfunded real estate investing can add risk

Crowdfunded real estate deals often target internal rates of return (IRR) of 12–18%. Let’s be perfectly clear -- no investment that is capable of that type of annualized return is without risk, and crowdfunded real estate is certainly not an exception.

With that in mind, although crowdfunded real estate can certainly help reduce your investment risk in certain ways, these aren’t risk-free investments by any definition of the term. In fact, there are some big risk factors you should know about before you commit to your first crowdfunded real estate investment.

One major risk is that crowdfunded real estate deals typically involve only one property, as opposed to stock mutual funds or real estate investment trusts (REITs), which can involve more. Investing in a single asset obviously carries more risk than a REIT that owns hundreds of buildings, or a stock mutual fund with 1,000 different stocks in its portfolio. Think about it this way -- if a company owns 100 office buildings and there is a major problem with one, it isn’t likely to be devastating to the company’s profits. On the other hand, if a company owns one office building and it has an issue -- say, it sits vacant for longer than expected -- it can crush that company’s returns.

There’s also an element of execution risk when it comes to these types of investments. In other words, a crowdfunded real estate deal typically doesn’t aim to simply acquire a property and rent it out as is. There’s usually some type of value-adding strategy, such as a renovation project. So, the targeted return is predicated on the company’s ability to execute its plans as expected.

But here’s an example of how this can go wrong. Let’s say that a crowdfunded real estate deal aims to acquire an apartment complex, spend the next year renovating it, lease it up and collect rental revenue for another four years, and then sell it at a profit at the end of the five-year holding period. Well, if it ends up taking longer than expected to renovate it, or the renovations end up costing more than expected, or it takes an unusually long time to lease up the units, it can be a serious drag on investor returns.

Furthermore, crowdfunded real estate investments are highly illiquid, even more so than typical real estate investments. If you own a stock, you can sell it at full market value, immediately, at the click of a mouse. If you own a rental property, selling it at an acceptable price might take a few months. And, if you invest in a crowdfunded real estate deal, you’re likely to be locked in for several years. Deal sponsors generally provide a target holding period (three to seven years is common), but there’s no guarantee that it won’t take even longer.

Finally, there’s also the economic risk. This varies based on the specifics of each deal, but it always exists to one extent or another. For example, if your crowdfunding deal involves buying a hotel (a highly cyclical type of real estate), a recession can be devastating to your projected returns.

The bottom line

Crowdfunded real estate investments can help you reduce your risk in the sense that they can help you diversify your investment strategy and become less reliant on returns from stocks, bonds, and other common investments.

However, it’s also important to realize that crowdfunded real estate is not a low-risk investment by any means, and investors should be well aware of the risk factors before deciding if crowdfunded real estate is right for them.

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