Investors often search for strategies to diversify their portfolios while the economy is going through a turbulent time, as it has recently. Real estate crowdfunding and REITs have seen a rise in popularity. Both options provide newbie and seasoned investors alike an opportunity to engage in commercial real estate without actually owning a piece of land.
Even then, there are some significant distinctions that investors should be considered, even though REITs and real estate crowdfunding have many similarities. We examine both investment strategies in this post, alongside their benefits and drawbacks. We conclude with a discussion of how investors might decide which approach is best for them.
What exactly is a REIT?
There are several types of “REITs,” which are businesses that own, operate, or invest in commercial real estate that makes money. The majority will focus on a certain sector (such as retail, hospitality, multifamily lodging, senior living communities, student accommodation, office, self-storage, industrial, and related sectors) or geographic area (e.g., commercial real estate in the Northeast vs. Southwest).
A person purchases a share in a REIT when they want to own a piece of the business that controls and oversees a rental property. They are not making a genuine property investment. Buying a REIT share is comparable to buying an Apple stock in that you are purchasing an ownership position in Apple rather than one of its unique goods. Likewise, REITs fall under this idea.
The Function of a REIT
REITs often have precise investing criteria. After that, they make investments in property that satisfies those requirements. REITs are obligated by law to distribute 90% of their income as dividends to shareholders.
The value of REITs can fluctuate throughout the day, as you would anticipate with normal equities because they are instantly transferable and hence virtually perfectly liquid assets. As a result, REITs are susceptible to wider fluctuations in market activity. Even if the REIT’s investment portfolio has not significantly changed, its value may decline if the stock market declines.
REITs evaluate using a few crucial factors, such as expected growth in profits per share, the expected total return from the company, its dividend yields compared to other investment options, dividend payment ratios, management caliber, and the underlying worth of their assets under management.
Investing in REITs
Many REITs are traded openly on the stock market, in contrast to traditional real estate. Individual investors who desire the flexibility to buy or sell shares at any moment would benefit highly from this. The initial financial commitment is far lower than what one might assume when investing directly in real estate or through other channels like real estate crowdfunding, which suggests reducing the entry threshold for investment because the ordinary investor may only purchase one or two REIT shares.
REITs that are listed on the main stock exchanges can be bought directly, in the same manner, you would buy any other stock or investment. REIT shares can also be purchased through exchange-traded funds and mutual funds that invest in REITs (ETF).
On private markets, some REITs are traded. Since they are not SEC-registered, only a select few investors have access to them. Institutional investors are sometimes the only ones with access to privately listed REITs.
Pros and Cons of REIT
The Benefits
Liquidity
The ease with which shares in REITs may be bought or sold makes investing in them advantageous. It is especially true for publicly listed REITs, which make up the majority of the REITs on the market.
Asset Diversification
There are many properties managed by a REIT, maybe even thousands. It indicates that, unlike when investing directly in a single property, the portfolio profitability is not dependent upon the success of a single asset.
Accessibility for All
Like stocks, most REITs are often easy to buy. Because of this, REIT shares are more widely available and may be purchased by anybody who can buy equities.
Minimal Exposure
A REIT with relatively little exposure is a good option for someone wishing to expand their real estate holdings. A lot more risk might be involved in the alternatives, such as direct ownership, than in a REIT investment. As a result, risk-averse investors would do well to purchase REIT shares.
Management Power
REITs are often managed professionally by individuals with years of expertise in the commercial real estate sector. A board of directors is majorly responsible for holding management accountable. Therefore, given their skilled management and leadership capabilities, REITs frequently recover swiftly from recessions.
The Disadvantages
Transparency Issues
The fact that the average investor knows very little about how their funds will be used is a drawback of investing in REITs. They aren’t always aware of the location or timing of the REIT’s property investments. The investor is instead counting on the REIT to make high investment decisions that adhere to the established investment guidelines. Aside from that, it may be challenging for an investor to determine how specific property is doing concerning the REIT’s overall portfolio or asset allocation.
Limited Control
A person who invests in a REIT has very little (if any) discretion over how the money will be put cash into, in contrast to direct ownership of the commercial real estate. An investor, for instance, won’t have any control over whether a property is updated, refinanced, or sold.
Subject to Changes in the Market
Similar to traditional stocks, the value of REIT shares changes during the day. Compared to individual commercial buildings, REITs are far more susceptible to market changes. Although REITs do so to some extent, individual asset prices do not often have a strong correlation with stock market performance.
Liquidity Premium
The real estate market’s inherent illiquidity. Whether it is for purchasing or selling, real estate transactions often take a long time to complete, typically measured in months. Increased real estate’s temporary illiquidity is caused by the process of getting a building ready for sale, advertising, receiving bids, negotiating contracts, doing due diligence, and closings. Investors should take into account paying a “liquidity premium” while purchasing REITs because they are switchable illiquid assets employing a generating instrument. They incur this extra expense in return for an illiquid asset’s benefit in liquidity over the value of the underlying asset.
What is a REIT, exactly? Related Article
Crowdfunding: What Is It?
Crowdfunding has been acclaimed recently, notably since 2012, when the federal JOBS Act relaxed laws governing how people can raise funds for commercial real estate transactions. Project sponsors needed to have personal contact with individuals who invested in their “deals”, they may participate in what is known as “generic solicitation,” which is what led to the establishment of real estates crowdfunding platforms such as RealCrowd, Crowdstreet, Fundrise, and RealtyMogul, among others, as well as direct crowdfunding of their projects by various sponsors such as Trion Properties, Feldman Equities, Origin Investments, and others.
In a nutshell, real estate crowdfunding refers to the method through which a project sponsor (typically a real estate corporation or LLC) pools the cash from dozens, if not hundreds, of people to invest in their endeavors.
What Is the Real Estate Crowdfunding Process?
Crowdfunding for real estate is subject to several laws and norms. The first step for a project sponsor is to choose the regulations they wish to crowdfund under which of the following allows Broad Solicitation, requires accredited “sophisticated” investors or allows non-accredited investors to engage. It will affect their crowdsourcing campaign is set up and promoted to the general public.
When everything is done, the sponsor may either broadcast their offers directly to investors on their website, on a crowdfunding site like “RealtyMogul” or “Crowdstreet,” or they can mix the two. They will be able to contact investors around the world thanks to it. In any event, the deal specs will include general information regarding the transaction, estimated returns, an investment horizon, and a call to action pushing people to participate immediately. There are frequently minimal investment criteria that must be achieved in order for someone to invest.
It is important to remember that “Crowdfunding” might use to finance both debt and equity for real estate purchases, though the latter is undoubtedly more typical.
Pros and Cons of Crowdfunding
The Benefits
Direct Ownership
Although the latter is clearly more common, it is crucial to remember that “Crowdfunding” may be used to finance debt and equity for real estate acquisitions. Real estate crowdfunding is a great way for anyone to purchase an interest in a piece of commercial property that they would otherwise be unable to do on their own. For example, crowdfunding can enable you to purchase a part in a downtown office building, which would be impossible for most individuals to own outright in the absence of crowdsourcing due to the size, accessibility to such opportunities, or management needs.
Transparency
When investing in real estate crowdfunding, one often understands the same as they are purchasing a stake together with the actual property, its financials, the business strategy for generating projected returns, and more. It is in contrast to acquiring shares of a REIT, which then invests in variable properties.
Minimum Investment
Although some platforms for real estate crowdfunding only accept minimum deposits of $50,000 or more, others let users spend as little as $100. In each case, this is a lot less money than would be required to independently get the sort of property offered through “Crowdfunding”.
Possibility of High Returns
Real estate crowdfunding initiatives often need to offer enticing returns to appeal to everyone. The sponsors use crowdfunding to cover gaps in their capital stack, which leads to higher returns for the investors. Some investors might make sizable returns from crowdsourcing investments since some sponsors use it to cover holes in their capital stack.
Limited Correlation with the Stock Market
Individual commercial property performance often has little association with the stock market, in contrast to REIT shares, which are exposed to daily market changes. During an economic slump, commercial properties frequently do better than the other asset classes and lagged behind other asset classes on average.
The Illiquidity Premium
The illiquidity premium for real estate crowdfunding measures the extra advantages that investor obtains from locking up their cash in an illiquid investment, as opposed to the liquidity premium in REITs that increases the investor’s expenses. Crowdfunded real estate investing offers investors the chance to make significant returns that no REIT can deliver by committing to a longer-term investment than a REIT can be exchanged at the push of a button.
The Drawbacks
Less Liquidity
The downside of the illiquidity premium is that investors must understand that once they participate in a project, Their money will likely be locked for several months or perhaps years before they can get it again. Investors must often commit their money to a crowdfunding venture for at least a year or longer. Some want investors to commit for three, five, or even ten years. Because of this, crowdfunding for real estate is fundamentally less liquid than buying shares of a REIT. Despite this, most crowdfunded transactions have clauses that let investors withdraw their money ahead of schedule, even if doing so entails paying a fine or charge.
Management Experience
The majority of REITs are well-known. Contrarily, any real estate business can start a crowdfunded deal. Consequently, it may not always be clear whether the sponsor has the necessary managerial experience. Before participating in a crowdfunded transaction, every investor should conduct due diligence on the sponsor, particularly the sponsor’s experience. Although this also applies to REITs, real estate sponsors do not have the same level of analyst coverage as REITs, making it more difficult to ease the burden of due diligence through third-party study.
Greater Risk
Diversification may not be a benefit for investors who take part in different projects, but they risk having substantial concentrations in a small number of properties that may be vulnerable to changes in the real estate market. The success of efforts might be adversely affected by a range of risks. These might include construction, building dangers, market risks, management, underwriting, and risky market conditions. However, these risks may be offset by greater profits, similar to the illiquidity premium. Investors in real estate, on the other hand, run the danger of losing everything if a project fails, thus there is a larger responsibility that comes with increased risk. It is never a good idea to spend more than you can stand to lose.
What Is the Difference Between a REIT and Crowdfunding?
Real estate crowdfunding and REITs are comparable in many respects. Both provide the chance for investors to diversify away from conventional equities and bonds while acquiring exposure to the commercial real estate sector, an asset class wh has historically been hard to get without direct ownership (therefore, a significant upfront capital outlay). Both enable investors to gain from the real estate’s cash flow and growth.
Both use the funds gathered from various investors to buy real estate, which is another similarity between them. But there is a crucial difference between investing in real estate through real estate crowdfunding and investing in a REIT, which is what the latter offers you ownership of the underlying collateral.
Here are five further distinctions between REITs and crowdfunding for real estate.
First distinction: Liquidity
Since they may be bought and sold just like other securities, REIT investments are by definition more liquid than real estate crowdfunding. For instance, a shareholder may want to purchase a REIT share during the day and sell it in the afternoons. This will be beneficial to anyone who wants to preserve liquidity for whatever purpose, such as to pay for school, travel, or to purchase a new home, among other things. Investing in real estate is made possible by real estate investment trusts (REITs), which allow investors to do so without worrying about lengthy capital commitments.
For instance, someone can invest in a REIT in the interim and then sell their shares when another chance presents itself if they would prefer direct ownership of commercial real estate but are having trouble finding a suitable transaction.
Less liquidity is available through real estate crowdfunding. Investors are often devoted to a contract for a set amount of time, typically 3-5 years, but frequently longer. Most sponsors will include some departure method, however, doing so might result in fines or costs.
Second distinction: Minimum Investment
One may purchase a REIT with no minimum down payment. Regardless of what the REIT’s worth is currently trading for, investors may buy a single share of a REIT. Numerous REITs lie somewhere in between; some trade for less than $20 a share, while others frequently move for several hundred. It lowers the threshold for anyone wishing to participate in real estate through a REIT but might lack the funds necessary for direct ownership or real estate crowdfunding.
For individuals seeking to contribute at least $5,000, A good compromise often involves real estate crowdfunding. Most agreements demand a higher initial commitment, even though some platforms let users contribute as little as $100. For their crowdfund syndicated deals, some sponsors even demand a minimum commitment of $25,000 or $100,000. It is more than what is required to purchase one REIT share, but still much more than what is needed to buy a commercial property outright.
Third distinction: Individual assets vs a portfolio
Let’s start by stating there are several variations of REITs and real estate crowdfunding. The statement we are about to make is a broad generalization based on most REITs and crowdfunded transactions. Buying a REIT entails purchasing stock in a company that manages a real estate portfolio. As a result, the value of REIT shares is not affected by the performance of a single asset. This aids in distributing risk throughout the REIT’s portfolio.
Most real estates crowdfund transactions (though not all) are structured so that people purchase equity in a particular piece of commercial real estate. To transform an outmoded strip mall into a contemporary living center, the sponsor, for instance, can use crowdsourcing cash. Although the investors are considerably more informed about each project, the success of each initiative will also affect their investment. There is a greater concentration of danger.
However, crowdfunding is occasionally employed to aggregate cash for a property portfolio. To diversify risk, several crowdfunding platforms provide their funds where a portfolio of hand-picked projects. Likewise, many sponsors create funds to invest in a variety of properties.
Fourth distinction: Profit sharing
Law mandates that REITs distribute dividends to shareholders representing at least 90% of their net income. Profit-sharing is less controlled when it comes to real estate crowdfunding. In the latter case, it is up to the specific sponsor to decide on the expected returns, such as the desired returns and waterfall splits, etc. In contrast to REITs, which often provide money to shareholders (investors), payouts to investors in a crowdfunded real estate syndication could not happen for several years following the project’s launch.
Fifth distinction: Management Experience
REITs are often expertly managed by individuals with years of commercial real estate expertise. For risk-averse investors, this adds a degree of safety. They often have more transparent histories and track records, as was already said, they frequently catch the interest of independent, third-party analysts whose work investors may check out as part of the investment evaluation process.
The world of real estate crowdfunding might include a wide range of management experience. While many project sponsors are inexperienced and seeking funding early in their careers, some are as competent. Before participating in real estate crowdfunding, investors must conduct their due diligence on the sponsor (and related—on the site presenting the transaction). The leadership team’s experience has a substantial effect on the outcome of a commercial real estate deal or portfolio of buildings.
Experienced, qualified sponsor teams will make a wealth of information about their investing philosophies, backgrounds, and experiences easily accessible online on their websites so that investors can get to know them and their value offer.
Which Option Suits You Best?
Considering crowdfunding for real estate or a REIT as a potential investment? There is no correct or incorrect answer; as you can see above, each has advantages and disadvantages, and both can be a beneficial addition to an investor’s portfolio.
But those who are risk-averse and want to maintain their liquidity should pick REIT investments. For people who are ready to accept a little bit more risk but desire more financial gain, real estate crowdfunding may be a viable choice. A person’s decision will also be influenced by the amount of money required to participate, since each has various minimum investment requirements depending on the REIT and crowdfunded transaction, accordingly.
Conclusion
Commercial real estate has stopped being seen as an “alternative” investment and has entered the mainstream. Thanks to REITs and crowdfunding, opportunities previously exclusively accessible to high-net-worth individuals and institutional investors are now made open to everyone. As more consumers explore strategies to diversify their financial portfolios, we anticipate this trend to go on.
However, there are various ways to invest in commercial real estate, including the two methods we’ve covered today. Additionally, there are several methods to invest using these vehicles (e.g., through a mutual fund, ETF, or self-directed IRA). Always get advice from your CPA, attorney, and financial adviser before investing in either real estate crowdfunding or REITs.
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