Crowdfunding lets investors pool their money to finance investment opportunities.
For example, many startups raise capital through crowdfunding. They ask investors to commit a relatively small amount of capital instead of seeking massive investments from angel investors or venture capital firms.
Real estate crowdfunding lets a group of investors, also known as a syndicate, pool their money to invest in one or more real estate deals.
Here’s how commercial real estate crowdfunding works and why it can be a smart way to invest. We'll also take a look at the risks and drawbacks investors should be aware of.
Why is commercial real estate a great fit for crowdfunding?
Because it's historically been inaccessible to non-wealthy investors. For example, few people could afford to buy and renovate a 500-unit apartment community. But crowdfunding lets you do just that.
How does commercial real estate crowdfunding work?
Here’s an overview of how the process works. A commercial real estate crowdfunding deal involves three main parties:
- Sponsor: The company that intends to acquire the property and carry out an investment strategy. The sponsor negotiates the deal, hires contractors, and manages and oversees the project on behalf of investors. The sponsor also typically contributes some of the project’s equity capital so they have skin in the game.
- Crowdfunding platform: There are several reputable real estate crowdfunding platforms. The platform acts as the middleman between a deal’s sponsor and investors. The platform advertises the deal to prospective investors, deals with the regulatory and paperwork aspects of the project, and collects investor capital.
- Investor: This is where you come in. Investors search crowdfunding platforms for deals and, when they find a good fit, commit to investing capital in a deal.
How commercial real estate crowdfunding deals make money
There are two main ways commercial real estate crowdfunding deals make money for investors: Rental income and the eventual sale of the property.
In most commercial real estate crowdfunding deals, investors get regular rental income distributions. But, in some cases, it can be delayed.
Imagine a commercial real estate crowdfunding deal that aims to develop an apartment complex from the ground up, fill it with tenants, and sell it once it hits a high level of occupancy. There won’t be any rental income to distribute until tenants start moving in.
The second way to make money from commercial real estate crowdfunding deals is when the property is sold. Commercial real estate crowdfunding deals generally give investors a target holding period. Three to seven years is most common, but these aren’t set in stone.
For example, if a deal has a five-year target investment period, that doesn’t mean the property will be sold and profits distributed in exactly five years. It’s possible that an opportunity to exit will come up sooner. Or the sponsor could decide that it’s in the best interest of investors to hang on for longer than initially planned.
How does a deal’s sponsor get paid?
It’s important to know the fees and expenses you'll pay before getting involved in any investment. Let’s take a quick look at how this works in commercial real estate crowdfunding.
There are two main ways sponsors make money. First, they collect an acquisition fee when a deal closes. This is generally in the 1–2% range. In other words, if a deal to buy a $50 million office tower closes and the sponsor gets a 1% acquisition fee, they’ll get paid $500,000 when the deal closes.
Beyond that, sponsors can get a pretty nice cut of the profit after investors get a minimum return. Investors get what’s known as a preferred return. This is an annual percentage return plus the return of their initial investment. Those are paid out before the deal’s sponsor gets anything at all. This is typically between 6% and 10%. It’s common for the sponsor to get 25–30% of any profits after this preferred return has been met.
For a simplified example, let’s say you invest $25,000 in a deal with a 10% preferred return and an 80%/20% investor/sponsor split beyond that. If the investment generates a 15% return in a given year, you’d get a 10% return ($2,500). The remaining 5% ($1,250) would be divided, with 80% ($1,000) going to you and 20% ($250) going to the deal’s sponsor.
Some deals have increasing sponsor splits as returns rise. For example, a possible profit structure could look like this:
- 8% preferred return, so 100% of the first 8% annualized return would be paid to investors.
- From 8–16% annualized returns, 80% of the profits goes to investors and 20% goes to the sponsor.
- From 16–20%, 70% of the profits goes to investors and 30% goes to the sponsor.
- Beyond 20% returns, 60% of the profits goes to investors and 40% goes to the sponsor.
The idea here is that the sponsor’s interests are aligned with those of investors. In other words, the sponsor doesn’t make any money until they produce at least a minimum amount of profit for investors. And if a deal is highly successful, the sponsor can really cash in.
Also, keep in mind that commercial real estate crowdfunding deal sponsors typically contribute some of the deal’s capital themselves. So they also get paid as an investor on this portion. For example, if a sponsor contributed 10% of the equity capital to a deal, they’ll be entitled to a 10% share of the payout just as an ordinary investor would. That includes preferred return.
Can I invest in crowdfunded real estate deals?
It depends on how much money you make, your investable assets, and the platform you want to invest through. Historically, investment opportunities like this have only been available to accredited investors with $1 million in assets or income over $200,000. But the JOBS (Jumpstart Our Business Startups) Act opened up private equity to non-accredited investors.
Many crowdfunding platforms still require investors to be accredited. It’s significantly easier from a regulatory perspective to market private investment opportunities to accredited investors. Plus, many platforms don’t want to deal with investors who don’t understand what they’re getting into.
To make a long story short, you’ll need to check with each commercial real estate crowdfunding platform to see who their deals are available to. CrowdStreet, for example, is generally restricted to accredited investors only. Fundrise and Groundfloor offer some real estate investments to non-accredited investors.
Types of commercial real estate crowdfunding investments
There are three main types of crowdfunded real estate investments from a capital structure standpoint:
This is what most people think of when it comes to real estate investment. When you invest in a common equity deal, you hold an interest in the underlying property’s profits.
Say you contribute 10% of a deal’s funding and it’s structured as common equity. You’d get 10% of the income distributed to investors and 10% of the profit upon the sale of the property (minus fees). The main thing to know is that common equity investments don’t have a set, guaranteed return. Their performance depends on how well the underlying property does.
If you invest in a debt financing deal for commercial real estate crowdfunding, you’re essentially acting as the project’s mortgage lender. You’re financing the property and receiving regular, predetermined interest payments.
This is the least risky way to invest in crowdfunded real estate deals but also has the lowest return potential.
Think of preferred equity as a combination of debt and common equity.
Like debt, preferred equity generally has some type of fixed distribution to investors. So investors’ income doesn’t depend on how well the property is performing.
However, like common equity, preferred equity holders are subordinate to debt holders when it comes to getting paid if a real estate deal loses money. Preferred equity holders generally get a better payout than debt holders, but they also take on more risk. Not quite as much risk as common equity, holders, though.
Where will your money go?
Investments can be allocated to a single deal or to several.
Direct investing is when you invest in a single property through crowdfunding. You give a project sponsor a certain amount of money to invest in a specified asset. From here on out, if I refer to real estate crowdfunding, this is what I’m talking about unless I specify otherwise.
On the other hand, many of the major crowdfunding platforms offer some type of pooled investment funds. This allows investors to write a single check that will be invested in a variety of crowdfunded real estate opportunities. This offers diversification without the need to analyze and select individual deals.
Benefits of commercial real estate crowdfunding
Crowdfunded commercial real estate deals can have some pretty impressive benefits:
- They let you invest in properties that you can't otherwise afford. Most people can't buy a shopping mall. But real estate crowdfunding lets you buy part of one. You can find crowdfunding deals that will allow you to invest $25,000 or less per deal -- much less than non-crowdfunded options.
- Unlike real estate investment trusts (REITs), crowdfunded real estate deals let you invest in one property. You can evaluate property investments and the sponsor’s strategy on a single-asset basis.
- Crowdfunded real estate deals have lots of reward potential. There are many crowdfunded deals that achieve annualized returns of 15%, 18%, 20% or even more.
- Not only do crowdfunded real estate deals have high reward potential, but many offer a combination of steady income and equity appreciation. They're true total return investments.
- Crowdfunded real estate deals diversify your portfolio. Real estate returns haven't historically been heavily correlated to the stock market. So crowdfunding can be a good way to diversify while focusing on high-reward-potential asset classes.
- Unlike investing in individual properties on your own, crowdfunded real estate deals eliminate the hassles of property ownership. If you buy a house to rent, you have to find tenants, handle maintenance issues, and more. When you participate in a crowdfunding deal, the deal’s sponsor handles all of that.
Drawbacks of commercial real estate crowdfunding
There’s no such thing as a perfect investment, and commercial real estate crowdfunding isn't an exception. I believe that the pros outweigh the cons in most cases, but commercial real estate crowdfunding isn't a good fit for everyone. There are some things you should know before throwing your own money into the mix.
- Commercial real estate crowdfunding can be a risky investment, even for real estate. Unlike with a REIT, your returns depend on a single property’s performance. And most crowdfunded deals aren’t as simple as buying a property and holding it for income. There’s generally some type of value-add strategy, such as a full-scale renovation, further complicating things.
- Crowdfunded real estate deals aren't liquid investments. In fact, they're some of the most illiquid investments you can choose. One of the most popular crowdfunding platforms shows that the shortest target investment period for a common equity deal is three years. And some target an investment period of as long as 10 years.
- It could be quite a while before you start receiving income from your crowdfunding investments. When you invest through a REIT or by acquiring an investment property, you can start generating cash flow right away. Many crowdfunding deals don’t start paying out for a while.
- Most single-property crowdfunding deals are only open to accredited investors. Some platforms allow non-accredited investors to participate in deals. But, for the most part, these deals are multi-property funds or debt investments.
Evaluating commercial real estate crowdfunding deals
I won’t get too deep into evaluating commercial real estate crowdfunding here, as we have an entire page dedicated to analyzing crowdfunding deals. But here are some things to keep in mind when you're looking at crowdfunding deals:
First, consider a few things about the property itself.
Is the property type highly dependent on a strong economy, like a hotel? Or is it fairly recession-resistant, like an office building? Also, how “involved” is the project? A light renovation of a highly-occupied apartment building is one thing, but a complete down-to-the-studs renovation is quite another. The latter comes with more execution risk.
Second, a commercial real estate crowdfunding deal is only as good as the sponsor.
Take a look at the sponsor’s track record before considering an investment, especially when it comes to the particular property type. I like to see that the sponsor has put a bit of their own money at risk by contributing a substantial portion of the project’s equity capital.
Of course, you also want to make sure that the sponsor’s fee structure is reasonable and incentivizes them to generate high returns for you.
Finally, consider the projected rate of return and distribution yield.
It may surprise you that I’m mentioning these factors last. To be sure, they're important. After all, other factors being equal, a 17% internal rate of return is obviously better than 15%. But the return needs to be realistic. And that depends on the project and the sponsor’s record of delivering results. That's why I mentioned those things first.
Tax treatment of commercial real estate crowdfunding profits
Unless you’re planning to invest in commercial real estate crowdfunding deals through a retirement account, it’s important to know the tax implications of crowdfunded real estate investing before you get started.
In a nutshell, there are three ways you could be taxed:
Your share of rental income distributions will be taxed. But not all the money you receive will be considered.
You’ll receive a form K-1 after the end of the year that reports your income or loss for tax purposes. This will likely be lower than the amount you actually received thanks to the real estate tax benefit of depreciation. If your K-1 shows income for the year, it's generally taxable at your ordinary income tax rate.
When the property you invest in is sold, you pay capital gains tax on your part of the property. If the property was owned for more than a year, this income is taxable as a long-term capital gain, which means lower tax rates than ordinary income.
Any depreciation expenses used to reduce your taxable distribution income are taxable upon the sale of the property. Unfortunately, this is taxed as ordinary income.
These three types of taxes mean you could face a hefty tax bill if you invest in a profitable commercial real estate crowdfunding deal. Especially after the property is sold.
You can defer taxes you owe by completing a 1031 exchange to reinvest your profits into another commercial real estate crowdfunding deal. But there are many rules and regulations to know before attempting this. Be sure to check out our 1031 exchange homepage if you’re interested.
Is commercial real estate crowdfunding right for you?
It depends on your particular risk tolerance and investment goals.
If you want the ability to cash out whenever you want, for example, crowdfunded real estate is not a good fit for you. Or if you don’t like taking on higher-risk investments, you’re better off looking to REITs for your real estate allocation.