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What is Real Estate Crowdfunding?
Real estate crowdfunding is an alternative investment strategy that allows multiple investors to pool their money together for a real estate investment opportunity that they may otherwise not be able to take on alone. This strategy has become popular since the JOBS Act made it possible for certain small businesses to raise investment funds without registering with the SEC.
Crowdfunded real estate has opened up real estate investing to an entirely new demographic. The most profitable commercial real estate investments were previously reserved for institutional investors and individuals with a high net worth. Today, however, retail investors are able to get involved in the same opportunities as virtually any hedge fund or REIT.
Crowdfunded real estate has even become an investment option for people to add to their retirement portfolios. Many crowdfunding platforms allow investors to contribute funds from their self-directed IRA directly into real estate investment opportunities.
Commercial real estate isn’t the only asset class available through real estate crowdfunding, though. The real estate crowdfunding market has various types of real estate investment options available, including rental properties, farmland, multifamily and commercial properties.
How Does Crowdfunding for Real Estate Work?
A real estate crowdfunding deal starts out with an investor finding a good opportunity and deciding to take on other individual investors to get the deal done. This first investor could be an individual investor, a real estate developer or a real estate investment company, called the sponsor. This process is also often referred to as real estate syndication.
The sponsor will set up a separate legal entity for the real estate crowdfunding investment. This entity is typically either a limited partnership or a limited liability company (LLC).
A limited partnership is made up of two types of partners; the general partner and the limited partners. The deal sponsor is the general partner. They’re in charge of managing the investment and handling the operational tasks.
The limited partners are the passive investors. The limited partners don’t play any role in the operation of the business or management of the asset. They’re simply silent partners hoping to make a good return on their investment.
Limited Liability Company
An LLC is similar to a limited partnership, but the structure and rules differ slightly. Instead of general partners and limited partners, the LLC is made up of members. Separate member classes are created for the deal sponsor and the passive investors. The membership class set up for the investors is similar to limited partners. They don’t play an active role in the operation of the LLC or management of the asset.
The sponsor then creates a private placement memorandum, which spells out the terms of the investment. This will also include a subscription agreement, which is the agreement between each investor and the sponsor. Since the sponsor sets the terms of the investment, it’s extremely important to read this document thoroughly.
Real Estate Crowdfunding Process
Once the sponsor has the entity in place and the terms of the investment outlined, they will choose a real estate crowdfunding platform to submit their deal to. Most real estate crowdfunding platforms will conduct thorough due diligence on all of the crowdfunding investments that are submitted before making them available to investors.
Once a deal is published on the crowdfunding site, investors can review the private placement memorandum and contribute funds to the deal. These funds are usually held in escrow until enough money has been raised to complete the deal.
Types of Real Estate Crowdfunding
There are multiple types of crowdfunding investments available. Investment opportunities fall into two main categories; equity investments and debt.
This type of crowdfunding is the most common. Investors have equity in the assets and receive their share in the profit that the investment property generates. In a typical real estate syndication, the sponsor keeps a percentage of the equity for putting the deal together and the investors share the remaining equity. The sponsor usually keeps anywhere from 20% – 35% of the equity in the deal, so the investors share the remaining 65% – 80%.
Every crowdfunded investment is different, but in most cases, the investor receives a percentage of the cash flow based on the amount of their equity investment. In order to make the investment more attractive, many crowdfunding sponsors offer preferred equity.
Preferred equity crowdfunding investments are attractive to an equity investor because the investors in the deal get paid before the sponsor. For example, in a deal with a 6% preferred return, the sponsor only begins receiving a portion of the cash flow once the profit is high enough for the investors to receive their 6%. Once the return exceeds 6%, the sponsor can begin collecting their share of any amount above the 6% threshold.
There are also different types of equity crowdfunding investments. The most common types are closed-end funds, open-end funds, and private REITs.
A closed-end fund is the most straightforward type of crowdfunding real estate investment opportunity available. This type of investment is typically for a specific property that the sponsor intends to sell within a certain timeframe. With this type of real estate deal, the investors receive cash flow while they own the property. Then, when it’s time to sell, they receive their percentage of the equity back and the deal is over. If there’s a capital gain from the sale, the investors can receive more than they originally invested.
An open-end fund doesn’t have a planned end date and is often not for a specific property. With this type of crowdfunding deal, investors are investing based on the merits of the sponsor and their overall investment plan. The sponsor may buy and sell different properties and use a portion of the profit to grow the total equity. This is similar to how hedge funds, publicly-traded REITs and exchange traded funds operate.
Private or Non Traded REIT
Private and non-traded REITs are becoming an increasingly popular option as a crowdfunded real estate investment. Instead of investing in a specific property, the real estate investor buys shares of a REIT that owns a portfolio of properties. This type of REIT is similar to an open-ended fund but receives additional tax benefits by following specific rules put in place by the Internal Revenue Service. One of the most significant rules REITs have to follow is paying out at least 90% of their taxable income to investors in the form of dividends.
The other type of real estate crowdfunding is debt investments. Debt deals are basically p2p lending. Instead of investing in equity, crowdfunding investors provide a loan to the deal sponsor in exchange for receiving principal and interest payments over a set period of time.
Instead of having a separate loan with each investor, the borrower will have one mortgage loan with the crowdfunding platform. The platform then distributes each investors’ share of the payments.
The most popular debt crowdfunding platform is Groundfloor. They provide short-term loans to real estate investors for residential properties. The minimum investment is only $10, so investors can easily diversify across multiple deals. The loans on the platform typically pay investors between 7% – 12%, and most have terms of only 9-12 months. This means investors can earn an attractive return without leaving their money tied up for a long period of time.
Return on Investment for Real Estate Crowdfunding
There are multiple ways investors earn a return on their money through crowdfunded real estate investing, and the rate of return varies based on the amount of risk involved.
Investors receive cash flow on equity investments from the rental income their properties generate. Once all of the expenses are covered and money is set aside for reserves, the sponsor distributes the cash flow to investors. These distributions are typically either made monthly or quarterly.
The amount of income an investor can expect to receive depends a lot on the type of property and the overall investment strategy. Quality real estate assets with stabilized rent will typically provide a more modest cash-on-cash return due to the lower risk. Value-add opportunities that require renovations and filling vacancies have the potential to provide a greater amount of income, but also come with more risk.
Crowdfunding investors can also earn a profit when the real estate appreciates in value. If the sponsor is able to raise the rents in a property, thus increasing the net operating income (NOI), the value could increase significantly over time. Since the investor owns a percentage of the equity in the deal, they could receive more than they invested when the property sells.
Most crowdfunded real estate deals raise investments for the down payment on the property, and receive bank financing for the rest. As the principal balance is paid down over the term of the investment, the equity increases. As long as the property is maintaining its value, the amount of equity each investor owns increases with each principal payment made.
With debt crowdfunding, the return on investment comes from the interest payments received on the loan. The interest rate on the loan will depend on the amount of risk involved in the deal and the term on the loan.
Most debt deals have a fixed interest rate, so the investors know how much they can expect to receive each month. In some cases, the loan may get paid off early so the total interest earned will be less.
Real Estate Crowdfunding Regulations
Crowdfunding became a popular real estate investment option after the JOBS Act was signed in 2012. This act loosened SEC regulations allowing private entities to raise investments without having to become a publicly-traded company. The IPO process is extremely expensive and involves a tremendous amount of red tape. This made it nearly impossible for most real estate investment companies to receive investments from the public.
Although the new laws give companies an exemption from registering with the SEC, there are still regulations in place to protect investors. Most crowdfunding campaigns will fall under Regulation D, Regulation A+ or Regulation CF.
Regulation D Crowdfunding
Regulation D exemptions are the most common method real estate investment companies use to crowdfund real estate deals because they are typically the least expensive and allow companies to raise an unlimited amount of money. However, the rules are very specific on who the crowdfunding sponsor can accept investments from.
Regulation D offers two avenues for companies to raise funds.
Rule 506(b) – This rule was actually in place before the JOBS Act, but it’s never allowed for true crowdfunding since it doesn’t allow companies to advertise their offering to the general public. Under this rule, the person offering securities can accept investments from up to 35 non-accredited investors and an unlimited number of accredited investors. The catch is that they must have a pre-existing relationship with anyone that invests. This is basically just getting investments from friends and family.
Rule 506(c) – This rule came into effect after the JOBS Act was signed. Rule 506(c) allows companies to advertise their investment offering to the general public and raise an unlimited amount of funds. However, they’re only allowed to accept investments from accredited investors.
Regulation A+ Crowdfunding
Regulation A+ allows a real estate investment company to advertise its offering to the general public and accept investments from non-accredited investors. However, the investment has to be qualified by the SEC and there are reporting and disclosure requirements involved. This can be an expensive process, so it doesn’t make financial sense for most crowdfunding sponsors.
Regulation CF Crowdfunding
Regulation Crowdfunding (CF) has only recently started to be utilized for crowdfunding real estate. This regulation allows companies to advertise their offering to the general public, and accept investments from both accredited and non-accredited investors. It’s also a very affordable process for companies.
Until recently, anyone using Regulation CF was limited to raising only $1,070,000 in a 12-month period. This simply didn’t allow real estate companies to raise enough capital. However, the SEC recently increased that limit to $5,000,000. While this still isn’t enough for most commercial real estate investments, some smaller real estate investors have started utilizing Regulation CF to fund deals.
Accredited Investor vs Non-Accredited Investor
Accredited investors can participate in any type of real estate crowdfunding investment available. Non-accredited investors, however, are limited in the real estate investment platforms they can use and the deals they can participate in.
The SEC defines who is, and who isn’t, an accredited investor. To have accredited investor status, an individual must meet one of the following requirements:
- Had an annual income of at least $200,000 ($300,000 if married) in each of the prior two years, and reasonably expects the same for the current year.
- has a net worth of at least $1 million, excluding the value of the person’s primary residence.
- Holds a Series 7, 65 or 82 license in good standing.
Is Real Estate Crowdfunding a Good Investment?
Crowdfunding can be an excellent alternative investment if it fits your overall long-term investment goals and criteria. It’s important to remember that crowdfunding is a long-term investment that provides little to no liquidity during the investment term.
Crowdfunding used to require large minimum investments, and some crowdfunded deals still do. Luckily, there are enough options available now to try real estate crowdfunding without committing a large sum of money. Real estate has generated more wealth than any other asset class in history, and crowdfunding has made it simple for anyone to participate.
Why Real Estate Crowdfunding?
Real estate crowdfunding offers the usual property investment incentives, such as tax breaks and greater diversification. But crowdfunding specifically has some benefits and risks you should be aware of before investing.
- Once inaccessible real estate investment opportunities available to all
- High return potential
- Easy investment portfolio diversification
- Property management and improvement usually handled by sponsor
- Partial insulation from market uncertainty
- Many projects, properties and platforms are still restricted to accredited investors
- Some investments carry higher risk
- Limited liquidity
- Additional fees from platforms or project sponsors, including high fees for liquidating early
Investing in REITs vs Crowdfunding
Crowdfunding isn’t the only option available to investors who want to passively invest in real estate. Another type of real estate investment is a real estate investment trust, or REIT. While there are a handful of private REITs that utilize crowdfunding, most investors buy shares of publicly-traded REITs that are sold on the stock market along with other publicly traded companies.
Pros for REITs
REITs offer a simple way to invest in real estate with virtually any amount of money, and you don’t have to be accredited. In fact, there are several public REITs with shares priced at less than $10. Many REITs even pay dividends higher than 5%, which makes them popular with investors looking for passive income.
Whether you should invest in REITs or crowdfunding depends on your current financial situation and your overall investment goals.
One of the reasons people choose REITs is because it’s easy. You can open a brokerage account in a matter of minutes, and buying shares in a REIT only takes seconds once you choose which one to buy. Another reason to invest in REITs is that it requires very little capital to get started, and you can easily grow your portfolio over time.
Pros for Real Estate Crowdfunding
One of the downsides to public REITs, however, is that there are significant expenses involved with being a publicly traded company. These added expenses eat into the money available to pay investors. The value of a REIT’s shares is also vulnerable to stock market conditions. With crowdfunding, your equity is directly tied to the value of the property and the income it generates. This often means the value is more stable and predictable.
The truth is, crowdfunding and REITs are both excellent options to invest in the real estate market. In fact, there’s no reason to choose between the two. Both investments have their benefits, so both are worth taking a look at.
Get Involved in Crowdfunded Real Estate
The relatively new world of crowdfunded real estate gives all investors access to opportunities outside of stocks and bonds. Although real estate investment may mean low liquidity, property historically appreciates and provides a likely financial return over time.
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The post Real Estate Crowdfunding Guide by Kevin Vandenboss appeared first on Benzinga. Visit Benzinga to get more great content like this.