Crowdfunding is the latest trend in real estate (RE) finance. In a sector long dominated by major players, investors with smaller asset amounts have looked for new ways to take advantage of the unique benefits of RE investments. While you may have heard of crowdfunding, and even real estate crowdfunding, you likely have some questions about how it works, and the unique benefits this innovative investment channel provides for qualified investors. All of your questions about RE crowdfunding are about to be answered, so grab a cup of coffee and spend a few minutes learning about a revolutionary investment program.
Real Estate Crowdfunding: Defined
Crowdfunding describes the process by which companies raise investment capital from a pool of investors, rather than a single, institutional lender. Another key distinguishing characteristic of crowdfunding is the fact that most crowdfunding campaigns are managed online. The online investment alternatives allow campaign managers to leverage technology to get their campaign in front of a wide range of potential investors.
Many RE investors have gravitated to crowdfunding as a replacement for traditional real estate lenders. Plus, several high-profile developers have launched crowdfunding campaigns to raise capital from accredited investors. More modest players in the industry are also using this avenue to generate funds for smaller projects.
Are you an accredited investor? Rule 501 of regulation D of the Securities Act of 1933 provides the definition of an accredited investor. The Securities & Exchange Commission (SEC) allows companies and private funds to skip the need to register certain investments as long as the firms sell these assets to accredited investors.
Accredited investors have one of two primary characteristics: A minimum net worth of $1 million (excluding personal residence) or annual income exceeding $200,000 for the past two years ($300,000 if you are married).
The government has determined that accredited investors are knowledgeable enough to protect their own financial interests.
Benefits Offered by RE Crowdfunding
Crowdfunding's primary benefit is its ability to connect real estate developers and other professionals to alternative sources of capital. As anyone who has gone through the commercial RE funding process can attest to, getting a loan can be a real pain. Real estate crowdfunding allows business owners to bypass the banks entirely and go straight to individual accredited investors. In some cases, the use of crowdfunding allows investors to keep their individual credit free of any loans or outstanding balances.
Crowdfunding campaigns are a phenomenal marketing tool. The social media-centric nature of crowdfunding campaigns provides a cheap and easy way of communicating with investors. Not only can you connect with investors for the deal in question, crowdfunding campaigns help you expose potential investors to your brand using the power of viral marketing.
Crowdfunding for Investors
Until this point, all of the information we have discussed is relevant for developers and business owners who want to use crowdfunding for future projects. Let's flip the script for a second and look at some of the ways that investors can diversify their portfolios and create value by investing capital in crowdfunding projects. For most investors, real estate crowdfunding has two paths- debt investments or equity investing.
The vast majority of independent crowdfunding investors choose to make equity investments. Equity investments have potentially higher returns, but also a commensurate increase in risk. When you purchase an equity investment you buy an equity stake in a commercial or residential property, and you become a shareholder in that property or basket of properties.
In this scenario, your returns are based on rental income generated from the subject properties, minus whatever fees you pay to the crowdsourcing site. Should you see any appreciation value over the time you hold your shares, you will be cashed out a percentage of that value when the property sells. Most of the time, payouts for equity investments are made annually.
Equity Investment Advantages
Returns can run into the double digits with the potential for higher returns if the property experiences significant appreciation.
Crowdfunding investment fees are competitive with REITs and other types of real estate investments. In addition, you can front load fees and pay them at the beginning of the fiscal year instead of monthly.
As a shareholder in the property, you are eligible to deduct a portion of the property's depreciation/maintenance each year on your income tax return.
Equity Investment Pitfalls
Higher risk profile. As an investor you will not be first in line when payouts are distributed. If the property does not generate a profit, you will not see any ROI.
Holding periods are longer. Equity RE investing is an illiquid form of investing. A standard holding period is anywhere from five to ten years. If you need short term access to your capital, you may want to invest in a debt instrument.
When you engage in debt investing, you are essentially lending capital to the current property owner. Deals are structured in a manner that gives you a fixed return based on the property's current mortgage rate. Your return is also calculated using the amount of capital you have invested, the more capital, the higher your potential profit. Payments are sent quarterly or monthly. In a debt investment, you have priority before any payouts are made to equity investors.
Debt Investment Advantages
Consistent returns. The structure of a debt investment lends itself to stable and predictable income streams.
Lower risk. Debt investments carry less risk since the property owner is putting up collateral to secure the loan. If the owner should fail to pay, you can take ownership of the property with a foreclosure.
Shorter holding periods. Debt investments go hand in hand with short-term development projects. The average holding period is anywhere from six to twenty-four months.
Debt Investment Pitfalls
High fees. When compared to equity investments, the fees charged by crowdfunding platforms tend to be higher, usually because terms for debt investments are shorter.
Returns are capped. Yields for debt investments are limited due to the fact that they are calculated using the mortgage holder's interest rate.
Is Crowdfunding the Future?
Trends come and go, but real estate crowdfunding is likely here to stay. When leveraged effectively, it can create value for both investors and RE developers. If you are a business, it can provide you with desperately needed capital to expand your portfolio of properties.
On the investor side, you can diversify your portfolio by sector and region for a fraction of the cost of acquiring whole properties. Keep in mind that it is still the Wild West out there, and as with any investment due diligence is absolutely essential.