For many of us, real estate is both familiar and a little intimidating.
We spend our lives on real estate; we walk through it and drive past it ever day. You’ve seen countless “for lease” signs; perhaps you have bought property yourself. But when it comes to using real estate as a way to grow and protect wealth, there’s a lot to consider.
What are the different ways to invest? What are the possible risks and rewards?
Real estate crowdfunding allows groups of investors to pool their financial and intellectual resources to invest in properties and projects much bigger than they could afford or manage on their own.
I’m Tom, and I’m a Senior Associate on the Investor Services team at RealtyShares. I’ve been in wealth management for the last 8 years, and I’m passionate about helping investors get their bearings in this asset class and build a balanced investing strategy.
In this article, we’ll review the basics so that you can feel confident when deciding whether and how to make your first real estate investment with crowdfunding. You just might discover that it's easier than you thought. (article continues below)
A brief introduction to real estate crowdfunding
In 2012, President Obama signed the JOBS Act. Among other things, it spurred the creation of real estate crowdfunding platforms.
These allow groups of investors to pool their financial and intellectual resources to invest in properties and projects much bigger than they could afford or manage on their own.
This is potentially appealing for several reasons.
Lower minimums: In the first place, investment minimums can be as low as a few thousand dollars, allowing real estate crowdfunding investors to spread their capital across dozens or even hundreds of properties.
Passive investments: In the second place, real estate crowdfunding can represent a much lighter lift in terms of the effort required from the investor. In many cases, the lion’s share of the business planning, quantitative analysis, due diligence, transaction structuring, and asset management are either taken care of or are presented in an easy-to-understand way by the real estate project sponsor or by the offering website.
- Easier to find and compare. Finally, the fact that these investments are generally listed in online marketplaces makes them much easier to find and compare. Prefer equity to debt? Think Dallas is heating up? Great news. With real estate crowdfunding, you choose the individual projects that most appeal to you.
Below I have outlined some of the major differences between crowdfunding and other common ways to invest in real estate. (article continues below)
Disclaimer: There are a number of material differences between the investments listed: 1) Only direct investments in real estate offer investors complete control over the management of a property. Other investment options carry management risk and other risks stemming from a lack of direct control over the investment. 2) Public REITs face greater regulatory scrutiny and reporting requirements than the other investment options presented. 3) The quality of investment offerings on various funding platforms varies widely.
We recommend that you consult with your financial advisor, attorney, accountant, and/or other professionals who can help you understand and evaluate the risks associated with any investment opportunity on the RealtyShares platform.
How does real estate crowdfunding work?
It's pretty simple, actually.
Investors generally visit an online marketplace
and browse opportunities that vary by investment type, geography, and target returns. Once they have chosen an investment that aligns with their goals, their funds are pooled with other investors, and the investment is closed.
From there, if all goes to plan, they collect passive income while monitoring the performance of their investment until it “exits.”
Here’s how to get started:
- Arrive at a good understanding of your investment goals and risk tolerance
- Select an investment that aligns with them
- Perform your own independent due diligence
- Sign the legal documents and fund your chosen investment
- Wait for the investment to close and fund to the Sponsor
- Once the investment has closed, you may begin to receive investment income
It may sound simple, but it’s important to remember that real estate investments carry significant risk and are uninsured. Investors run the risk of losing their invested capital, possibly all of it. So you should be circumspect when considering these investments.
A good rule of thumb is to never invest money you can’t afford to lose.
What differentiates the various crowdfunding platforms?
Visit an online marketplace and you’ll see right away: there are many properties being listed.
A good question to ask is: Where do these investments come from? Is the platform buying them and then selling them to investors? Is the platform allowing any investor to list his property directly on the platform?
There are a lot of listings on these platforms. A good question to ask is: Where do they come from?
All platforms work differently. Generally speaking, the project sponsor is the one who will buy/own the property. Crowdfunding sites are just arranging the financing. When you invest, you are buying a debt or equity stake in the financing.
Sponsor quality. Generally speaking, the real estate project sponsor is the one who will own and manage the property. So their background and track record may be worth considering when deciding whether and how to invest. Different crowdfunding sites tend to work with different sponsors, so it’s important to pay attention.
Investment flow. Many crowdfunding sites offer a constant stream of investments being listed on their platforms. This investment flow has often been cultivated over many years. Greater investment flow can mean more options for investors, which in turn can lead to greater portfolio diversification and personalization.
Investment vetting. Some crowdfunding sites go to considerable lengths to protect investors by evaluating, underwriting, and structuring their investments. Others merely function as a matchmaker. Would you rather conduct your own quantitative analysis on the sponsor’s business plan, or let a corporate underwriting team take a first pass?
Investment minimums. Minimums vary from site to site: some allow you to invest for $500, others require $50K. Investment minimums may affect how real estate investments function in your portfolio as larger minimums can affect your ability to diversify.
- Investing Fees. Real estate sponsors typically pay crowdfunding sites a fee for having raised funds for a project. In addition, investors may pay a fee of 1-2% to cover the cost of investment reporting, tax preparation, and asset management. Fees vary some site to site, so it may be worth investigating before you invest.
What types of investments are being offered?
Real estate investments fall into two main categories: Both are typically offered by real estate crowdfunding sites. Below I have mapped them according to their relative risks, return objectives, and order of repayment.
Such a diagram is often called “the capital stack.”
With debt investments, you’re lending money to the property owner in exchange for regular interest payments and the return of your principal when the loan reaches maturity.
Debt investments are repaid before equity, so they are relatively less risky. As a consequence, their return objectives are relatively lower, and they do not participate in any upside. They also offer relatively consistent cash flow and may be desirable to investors for that reason.
There are several different kinds of debt. First- and second-lien loans
are backed by a lien on the property title. Mezzanine loans
are backed by a lien on the legal entity that owns the property. Because they are relatively higher in the capital stack, mezzanine loans may offer relatively higher returns.
With equity investments, you are purchasing a stake in the real estate project and becoming a percentage owner.
If the investment performs according to plan, you can receive cash distributions as outlined in the subscription (legal) documents.
As you can see from the capital stack, preferred equity investors are paid back only after debt, so they experience relatively higher risk and have the potential to receive higher returns. But in many other ways, preferred equity is like debt. Return rates are capped for these investors, and they do not participate in any upside.
Equity investments experience relatively higher risk and have the potential to receive higher returns.
Common equity shareholders enjoy the highest return objectives among the different funding types. They have the potential to receive periodic cash distributions based on the property’s excess cash flows, as well as participating in any appreciation gains realized when the property is sold.
By the same token, if an investment underperforms, these investors are the last to be repaid, and their capital is at the greatest risk. (article continues below)
What property types are being offered?
Real estate is divided into two types; residential and commercial.
Residential Real Estate
Residential real estate consists of properties developed for people to live on. As defined by law, these properties cannot be used for commercial or industrial purposes, so—from an investing standpoint—they are mainly of interest to those seeking capital appreciation gains.
Such a strategy is often referred to “flipping” or “fix and flip,” whereby a project sponsor purchases a residential property at a discounted rate and embarks on a program of capital improvements. The goal is to sell it at a higher price point within a relatively short time period, using appreciation gains to pay out investors.
Commercial Real Estate
By contrast, commercial real estate is property owned not just for the purpose of capital appreciation, but also with the goal of producing income. Whereas there are relatively few kinds of residential real estate, there are many different kinds of commercial real estate, each with its own unique characteristics.
Apartment buildings with 5 or more units are considered to be commercial real estate. The buildings are not owned by tenants; rather the units are rented out for the purpose of generating income. Regardless of the state of the stock market or the broader economy, people still need a place to call home—so this sector is often considered to have lower volatility
The hotel business—from affordable options to luxury escapes—has seen robust growth
over the past decade. The main reason is the worldwide increase in both leisure and business travel. This category does not, however, include spaces rented through home sharing services like Airbnb.
Office: You probably know an office when you see one: it’s a workplace where you don’t sell anything on the premises. This sector is evolving as companies increasingly adopt open floor plans and embrace telecommuting.
These properties are used to market and sell consumer goods and services. Examples include shopping malls, strip malls, big box retailers, grocery stores, specialty stores, and restaurants. Because of e-commerce, this sector has seen more disruption than any other in recent years. Learn more about the evolving retail landscape
- Industrial: Retail’s loss is industrial’s gain. Goods that might formerly have been purchased in-store are now being bought online and shipped directly to consumers from “fulfillment centers.” These warehouses are located outside urban centers and contain a wide variety of products. Industrial real estate, more generally, is any property that is used to manufacture, warehouse, or distribute products.
What are the risks?
At this point, may be wondering about risk.
As well you should. For a given investment, the sponsor may have misread the market, so the property might not sell at the target price point. Or the building may require more maintenance than was initially anticipated, so income streams might decrease. These are just two examples of things that could cause an investment to underperform.
All investments have risks. The important thing is to learn about them up front and do your best to manage or mitigate them.
The truth is that all investments have risks; the important thing is to learn about them up front and do your best to manage or mitigate them. Below I have bulleted out a few common risks to consider, but you can find a more complete list here
Selling at a loss: There’s no guarantee that the sponsor will be able to sell the property at a profit. In fact, selling at a loss can effectively negate any income you might have received while holding the investment. So before you invest, consider researching what comparable properties have sold for in recent days and using it as a benchmark to determine whether the sponsor’s business plan is realistic.
With many investments on real estate crowdfunding sites, the target hold period is between two to seven years. That means you won’t be able to access your money during that time; trying to do so can result in a loss, if it’s possible at all. On the flip side, a mounting body of research suggests that illiquid investments may actually earn higher returns
than their more easily traded cousins.
- Inflation: According to the Federal Reserve Bank of St. Louis, the annual inflation rate has averaged about 2% over the last ten years. That means your dollars are worth about 2% less today than they were a year ago. Especially with illiquid investments, it’s important to consider: if your return on an investment is 6%, you’re actually making 4% over inflation. And if inflation rates rise, it could erode your actual returns even further.
By the same token, historical property values have tended to rise in tandem with inflation rates, so real estate investments have the potential to act as a hedge against inflation.
How do I pick the right investment property?
When it comes to choosing the right investment, there are many right answers—and just as many wrong ones. Whether you fail or succeed depends in part on your financial goals, your investing timeline, and your appetite for risk.
The most important thing you can do before making your first investment is figure those things out and develop an investing strategy. Otherwise you’re flying blind. The following is a short list of questions to help get you started.
How much investing experience do I have? Both in general and with this particular asset class? Newer investors may be wise to default to a more cautious, less risky approach.
What are my investing goals? Are you trying to pay for your kids’ college? Saving for a long and enjoyable retirement? Or maybe you’re building up a nest egg so you can buy that vacation home in Point Reyes?
When will I need these funds? A shorter time frame suggests that you should be more conservative with your investments. Conversely, a longer time frame allows for more risk-taking.
Do I have a balanced investing strategy? A diversified portfolio can help to mitigate losses in the event of market volatility. It contains investments that vary by asset type, geographic market, risk profile, and return objective—just to name a few.
How much capital should I allocate to real estate crowdfunding? The less capital you have, the more careful you should be in how you invest it.
Have I researched the different crowdfunding sites? Not all are created equal. Some subject their investments to a rigorous vetting process; others do not. Some choose to work with a registered broker-dealer to ensure that they are compliant with the relevant laws; others do not. And of course, fee structures vary widely.
Have I thought about taxes? Like all other income, income from investments is taxed. But there are different kinds of investment income—dividends, capital gains, and interest—and each is taxed differently. Furthermore, certain kinds of investments may allow you to utilize tax deductions.
Thinking about the current market for real estate, where is the demand? Both in terms of property types and regional markets? Where are we in the current real estate cycle? This will affect the kinds of properties, asset types, and hold times you may choose to include in your portfolio—and when you may choose to invest.
- What is my exit strategy? From individual investments and with regard to my portfolio as a whole? Will you wait for your investments to mature? Sell your liquid investments on an exchange? Look to build a cash-flowing portfolio and subsist on that income? Wise investors never go in without a plan to get out.
Your Next Step? Keep Learning.
If you’re ready to make your first real estate investment, the market is waiting for you—but remember to do your research well ahead of time. Due diligence is the lifeblood of any savvy investor’s strategy.
If you take the time to understand this asset class, it has the potential to offer a set of benefits that can help you achieve your financial goals.
In this article and the Real estate crowdfunding is different from stocks, and it can be challenging for a newer investor. But if you take the time to understand this asset class, it has the potential to offer a set of benefits that can help you achieve your financial goals.
Discover why many investors are so fond of it.