Real estate crowdfunding hasn’t been a “thing” for very long compared to other ways to invest in real estate. It’s a great example of how technology creates new opportunities—opportunities that are essentially new ways of doing something that we’ve been doing all along.
Kent Ritter is an experienced multifamily syndicator and operator helping you to build real wealth through real estate investments. Learn More
What Is Real Estate Crowdfunding?
Most of us first became aware of crowdfunding in the context of raising money for individuals in difficult circumstances or for nonprofit organizations helping large numbers of people in the aftermath of natural disasters. Since its advent only a couple of decades ago, crowdfunding has become a common way to raise money for any number of purposes, including raising capital for real estate deals.
Real estate crowdfunding provides an alternative to relying on a traditional lender for financing. It also creates opportunities for investors to participate in the real estate market on a scale far greater than they could achieve on their own.
Does Real Estate Crowdfunding Really Work?
Yes, it works. Does that mean it is without risk? Of course not. There is always an element of risk with any investment. But the concept has proven to be solid, and the returns can be impressive. The better question would be, “Does it work for me?” And that’s something that you’ll have a better sense of once you have a clear understanding of how real estate crowdfunding works.
Who Are the Parties to a Real Estate Crowdfunding Deal?
There are three parties to a crowdfunding real estate deal: the sponsor, the crowdfunding platform, and the investors.
It all starts with the sponsor, typically a sophisticated investor (or firm) with enough real estate experience to put together a deal, negotiate with the seller, acquire the property, oversee improvements, perhaps hire a property manager, make any distributions to investors, and eventually sell the property at a profit.
The Crowdfunding Platform
There are several reputable crowdfunding platforms dedicated to facilitating investing in real estate. They list the deals put together by sponsors and make sure that all regulatory requirements for marketing the deal are met. The platform serves as the intermediary between the sponsor and investors by advertising the deal, collecting funds from investors, and transferring those funds to the sponsor.
Investors buy into the deal, providing capital for purchasing, improving, and managing the asset until it is sold. They function as limited partners who receive current income and share in future profits when the property is sold, but are passive participants in the deal once they have made their investment.
How Are Deals Created?
Every deal begins with the sponsor’s recognition of a compelling real estate investment opportunity, typically one with the potential for a return much greater than the average return on a real estate investment. Often, that is a large, income-producing value add asset that with some improvement could, within a few years, sell for much more than the acquisition price. Crowdfunding real estate deals typically are multimillion dollar deals involving hotels, industrial parks, large apartment buildings and the like, that generate revenue and can be expected to appreciate significantly within a few years. A lot of due diligence is required on the part of the sponsor to ensure that the deal makes good financial sense.
Once a property that will be attractive to investors has been identified, the sponsor structures the deal. The major decision to be made is what type of capital is being sought: debt or equity. A debt investment gives investors periodic interest payments at a predetermined interest rate. An equity investment gives them an ownership interest in the property.
The sponsor must specify the terms of the deal in writing so that crowdfunding investors can evaluate the deal and determine whether it’s right for them. It’s crucial to create an ironclad agreement to ensure that investors understand exactly what they will get in return for their money. Very large crowdfunding deals, those with more than 100 investors, could be regarded as a real estate investment trust (REIT), which is an entirely different animal and requires compliance with SEC regulations governing such offerings.
The sponsor must also choose an appropriate crowdfunding platform, which involves another type of due diligence. The terms of the agreement with the platform can influence the details of the deal itself in terms of whether investors must be accredited, the size of the fees charged by the platform, whether funds collected from investors will be released to the sponsor before the funding goal has been met, and so on.
How Do Investors Make Money on a Crowdfunding Real Estate Deal?
Many equity deals are structured in a way that gives investors periodic cash distributions of income from rent plus a portion of the proceeds when the property is sold. This is common with deals involving the purchase of properties that already are occupied. Other equity deals, such as those involving unoccupied structures or ground-up construction on undeveloped land, offer only a share of the profit from the sale of the asset at a given point in the future with no cash distributions in the interim. In all cases, the amount that investors receive in the form of income or profit is proportional to the size of their investment.
Deals structured as debt investments often are development deals. The interest rate is known and fixed, and the sponsors make regular (usually quarterly) interest payments to investors and return their principal when the property is sold.
Often, sponsors invest their own funds in the deals they offer on a crowdfunding platform. For passive investors, that’s a good thing. Having skin in the game gives sponsors an added incentive to make smart decisions that will maximize the return on investment for everyone participating in the deal.
What Is the Return Potential?
The metric most often used to evaluate a deal’s potential return and to compare the potential returns of multiple deals is the Internal Rate of Return (IRR). Unlike cash on cash (COC) return, which is simply a deal’s pre-tax net profit divided by the initial investment amount, the IRR takes into account the role played by money and time. Although calculating IRR is complicated enough that it’s not usually done by hand, the result is an annualized return that smooths out the uneven cash flow from fluctuating rental revenue.
Because crowdfunding real estate investment is a relatively recent development, there is less historical data upon which to base return expectations than is available for other investment vehicles. Double-digit annualized returns are common, and can be more than 20%.
Would Investing in Real Estate Crowdfunding Work for You?
As with any other type of investing, determining the suitability of real estate crowdfunding must consider your investment objective, appetite for risk, and time horizon, as well as your understanding of the advantages and drawbacks associated with this way of investing in real estate.
There are crowdfunding deals designed for those seeking income, growth, or some combination of the two, with income deals at the low end of the risk continuum, growth deals at the high end, and everything else somewhere in between. However, the length of time that you can tie up your funds in what is an undeniably illiquid investment is a major concern. Additionally, unless you meet the SEC criteria for accredited investor status, you’ll be limited to deals that are offered through crowdfunding platforms that allow non-accredited investors.
Advantages of Real Estate Crowdfunding
With real estate crowdfunding, investors now can build wealth and diversify your portfolio through real estate without the capital requirements and hassle of owning individual income-producing properties. You can acquire an equity interest that produces regular cash flow and an eventual capital gain without the volatility of the stock market. It’s the high return potential through a combination of income and appreciation that attracts most investors to real estate crowdfunding.
Disadvantages of Real Estate Crowdfunding
The downside is that due to the “online” and “arm’s length” nature of the platform it is difficult to really know and judge the deal sponsor’s skillset, experience, and integrity. The deal sponsor is the most important part of the deal and therefore this is a big limitation of online platforms where you don’t speak to the deal sponsor before investing.
Conclusion on Crowdfunding in Real Estate
Crowdfunding is one way to get started investing in real estate if you only have a small amount to invest–due to the low minimum investments. In comparing real estate crowdfunding deals and choosing one to invest in, you’ll gain a perspective that will help you if you do graduate to investing directly in real estate syndications.
Kent Ritter is an experienced multifamily investor and entrepreneur empowering you to build real wealth through real estate syndication. Learn More.