Should you invest in Real Estate Crowdfunding? That may be the question you are having right now to be reading this article. For starters, Real Estate Crowdfunding is essentially a way to fund a project or venture you have by asking and using cash you get from a group of investors. And this article will go through further details on what crowdfunding is, and what are its benefits and drawbacks. By the end of this article, you will be knowledgeable enough to decide whether to go through it and if the risks are worth the benefits.
In the past, the ability to take advantage of commercial real estate prospects, their network, and financial capabilities had a significant impact. Strong networks and long-standing connections with brokers, bankers, real estate owners, and the like would allow access to some of the most lucrative deals for those individuals. The broader the doors that would open to them, the more money they would have to invest.
The bigger, more valuable commercial real estate acquisitions were often closed to regular investors.
All that changed once the JOBS Act was passed in 2012, giving sponsors and investors new avenues to raise money together through internet crowdfunding. There was no longer a requirement for sponsors to be close friends with their investors (also known as country club money). With far fewer limitations, they may sell real estate partnership interests to approved and non-accredited investors.
What exactly is crowdfunding?
The concept of crowdsourcing is well-known to most individuals. Most people are aware of websites like Kickstarter and GoFundMe, which let users ask for funding and donations for side projects or charitable causes. Comparable to this is real estate crowdfunding, except the focus is on raising money (either in the form of a loan or stock) from investors and investing it in real estate projects.
Nonetheless, it would be wrong to lump together the methods used to finance real estate and enterprises not related to real estate under the umbrella of crowdfunding. Developers have historically used a combination of stock from several investors and loans to finance real estate; this practice is crowdfunding. The most significant change made by the 2012 Act was that it removed restrictions on how a developer might locate these various investors. Before the Act, it was against the law for developers to approach investors who they do not know and ask money from them. The Act modified that and permitted general solicitation, which meant developers could promote, set up a website, publish material on social media, and send emails to everyone.
Therefore, the 2012 JOBS Act (JOBS = Jumpstart Our Business Startups) introduced the guidelines for crowdfunding, allegedly for small businesses and ventures, even if real estate was never its intended use. The Act helped real estate, and it has grown to dominate the use of the rules established by the Act crowdfunding is nothing other than the migration from secret backroom deals that the laws previously demanded as part of real estate, and forced it out into the public arena where a developer can openly market their projects and anybody (with certain limitations still) may participate.
It has a significant impact on the transaction. One of the most noticeable of these improvements is a drop in the needed minimum investment. Depending on how the initiative is structured, a person can donate as little as $100 or as much as $1 million. There is no (legal) necessity that an investment must be of a specific size or scale, nor is there any constraint on how a transaction organizes the way cash enters it – a crucial fact for investors to remember when considering any offer.
Consider the following scenario: a sponsor is attempting to raise $10 million in equity for a redevelopment project. Through normal means, they raised $8 million. And to generate the remaining $2 million, they turn to real estate crowdfunding. The sponsor can use various techniques to crowdfund, including conventional and internet media. Content marketing attracts a larger audience since it allows businesses to tap into a potentially endless pool of possible investors.
In the scenario, the sponsor may demand a $50,000 minimum deposit. They will need up to 40 investors to raise $2 million. But in actuality, the $2 million may be generated from fewer people because many may invest substantially more than the minimum.
The Benefits of Real Estate Crowdfunding
Developers and investors are already using the real estate crowdfunding model to finance and invest in real estate, despite the still-early phases of development. Developers, for example, have two primary alternatives for exploiting crowdfunding legislation to fund their agreements. They can agree to publish their projects on real estate crowdfunding marketplaces (platforms) or they can use the regulations to build up their own content marketing platforms to discover prospects and convert them into investors – or they can use a mix of the two. Also, they can use it to pool cash for debt or for equity as needed for a real estate deal.
Similar to this, investors can browse internet markets or make direct investments with developers if they would otherwise have no other way to invest in real estate.
As previously stated, pooling cash from various investors to fund a real estate project is not new. Individuals have been starting real estate joint ventures for many years, and before the 1933 Securities Act, that prohibited solicitation, real estate was crowdfunded with almost no constraints. While developers can publicly seek out potential investors through digital networking and other marketing efforts and tactics, various possibilities (many of which have already been pre-screened) are already available to all investors, who can invest with the click of a button.
Real estate crowdfunding has several advantages in improving the openness, transparency, and accessibility of commercial real estate. Below, we list a few of these advantages.
Invest in Properties You Can’t Buy On Your Own
Lack of funds is one of the biggest obstacles to investing in commercial real estate. The average person lacks the resources and knowledge necessary to buy an apartment building with 100 units or a downtown office skyscraper. Most people would never give it any thought. Individuals may make considerably smaller investments in projects like these through crowdfunding. An investor can acquire equity shares in the agreement for a portion of the project’s overall cost as opposed to individually owning commercial real estate. Think of it as a form of partial ownership.
Without real estate crowdfunding, most investors are forced to purchase more modest apartment complexes or duplexes as rental assets. Scaling a portfolio one deal at a time takes time. It also necessitates a greater level of personal accountability and financial liability on a loan guarantee is frequently provided as a component of the investment. Crowdfunding enables anyone to be a passive investor, putting less of their own money into each project, which reduces concentration risk by enabling diversification.
High Profitability
Commercial real estate projects will promise a high return on investment to attract investors to them when posted on crowdfunding marketplace platforms. Forecasts for 15% or more annual returns in crowdfunded enterprises are not unusual. By contributing to a crowdfunded project, passive investors hope to see a return on their investment of at least double within five years.
Of course, some disclaimers are mentioned here, with the most significant being that real estate investing is rife with predictions for the future. These are the types of claims that SEC-regulated public corporations always disclaim, emphasizing that past performances are no guarantee of future outcomes and that investors may lose money. The same is true in real estate investing; whatever a real estate developer offers an investor about potential returns, whether through preferred returns (dividends) or profit-sharing, are forward-looking statements that cannot be guaranteed.
Investors will want to thoroughly examine each project, paying attention to the sponsor’s underwriting assumptions.
No investor would naively believe a marketing pitch without conducting their research. Nevertheless, one advantage of investing in a crowdfunded real estate deal on an online marketplace is that the portals that offer these chances conduct a pre-screening before approving for posting on their website. It gives at least a bare minimum of assurance (at the very least a bare minimum of compliance), an example, the corporation charged with overseeing the deal established in Delaware. (or wherever).
Similar to this, from the sponsor’s point of view, the markets have mechanisms that support standards that must meet before admitting investors, such as confirming accreditation, knowing your customer (KYC) regulations, and anti-money laundering rules (AML). They make efforts to establish a safe internet environment to prevent hackers from collecting private financial information from investors.
Consistent Income and Equity
Crowdfunding real estate investments can give access to projects that combine stable income and equity growth, along with substantial annualized returns. It is frequently true when investing in value-added real estate transactions with reliable cash flow.
Take a developer who wants to raise capital for a Class B apartment complex. According to local market comparables, the property is already performing well. The business plan is to make aesthetic changes to each unit after selling. To compete more effectively against its Class A rivals, the developer will upgrade the landscape and offer additional on-site facilities. Investors should profit from improved cash flow and property value if that plan is successful. A person investing in a property independently (i.e., outside of crowdsourcing) may have fewer opportunities for income and equity since they lack the time or means to carry out such a value-added project.
One type of passive real estate investment is crowdfunding. There are undoubtedly others. The same principle applies whether you make a passive real estate investment through crowdfunding or other methods: passive real estate investors gain by delegating day-to-day management to others (the sponsor). For everyday operations, maintenance, and upkeep, passive investors can play a supporting role and absolve themselves of financial and other obligations.
The project sponsor will be responsible for these tasks, with any team members they have hired to assist, like the general contractor, leasing agent, property manager, and more. It stands in sharp contrast to owning real estate directly, where you, the owner investor, are responsible for managing any maintenance difficulties, tenant issues, rent collections, and similar matters.
Crowdfunding is a good choice if interested in commercial real estate and do not want to commit to active real estate investment.
Broaden Your Investment Portfolio
Individuals may diversify their investments thanks to crowdsourcing, which is another advantage. Someone who has typically invested in equities and bonds may utilize real estate crowdfunding to supplement their portfolios with high-quality commercial real estate.
Diversification can also take the form of diversifying real estate assets by property type or area.
People may invest in different kinds of real estate through crowdfunding, including residential complexes, office skyscrapers, industrial properties, shopping malls, hotels, and more. For instance, a seasoned investor with a portfolio heavily weighted toward direct ownership of upscale hotels (high risk) could choose to crowdsource to make a few low-risk investments in apartment complexes to help balance their real estate holdings.
The same may apply to geography. The ability to view offers from around the nation is an advantage of crowdfunding markets. As a result, purchasing real estate on the east coast from the west coast is now simpler than ever. Deals that had never crossed their minds are suddenly in the spotlight. An investor may utilize crowdfunding to expand the geographic reach of their real estate holdings (Sun Belt, anyone?).
Due to the availability of online solicitation, hundreds, if not thousands, of transactions are now for the first time visible in one location, i.e. online, which is a fantastic benefit for both investors and developers. Before the 2012 Act, the most each investor could aspire for was access to one or two nearby developers in their immediate social circle. As a result, they could only use the tiny sample set of terms and conditions they were aware of as their complete frame of reference for the types of terms and conditions provided to investors.
Today, anyone interested may browse many real estate crowdfunding markets in less than an hour, access hundreds of opportunities, and evaluate various preferred returns, promotions, transaction structures, and terms and conditions. Pardon me for using a metaphor, it is where real estate crowdfunding truly shines. In addition to democratizing real estate investing, it also levels the playing field for everyone by increasing transparency in the industry.
The Dangers of Real Estate Crowdfunding
The fact that real estate crowdfunding transactions still make up such a small portion of the number of commercial real estate transactions indicates that there are disadvantages to using these platforms for real estate investing.
Given how fresh the notion of real estate crowdfunding is, some real estate investors are, at their core, just wary of it (relatively speaking). Many of the platforms that have arisen are quite new. Several were founded by software gurus who were sponsored by private equity firms, not real estate specialists. This has led to some very valid concerns being raised over the caliber of some of the offers being offered on various crowdfunding platforms.
Some platforms have emerged as more reputable than others throughout time. Initially, investors had difficulty distinguishing between them. Some systems have failed, the most noteworthy being RealtyShares, while others have been bought. There are at least 11 million authorized investors in the United States, so it is clear that for the great majority of investors, crowdfunding is either unfamiliar or still appears a little like the Wild West, even if tens of thousands of investors have found solace in the notion of investing in real estate online.
The hazards that should be taken into account are outlined below and serve as a reminder of the fact that real estate crowdfunding is still in its early stages of development.
A Higher Risk Than Other Equity Investments
Real estate investments made using crowdfunding are thought of as being riskier than typical stock transactions. It is due to a few factors. First, many inactive investors believe that crowdfunding is used as last-resort capital-raising sponsors who post on marketplaces after exhausting all other conventional avenues. One may assume that a deal of otherwise excellent quality wouldn’t have trouble getting the loans and equity required to fund it. Crowdfunding is seen as a sponsor’s last-ditch effort to close the financial gap for their project, which raises serious concerns regarding its soundness compared to other possible equity investments.
For certain sponsors, there could be some truth to this, but investors who let it prevent them from researching passive real estate investment through crowdfunding are missing out on a chance because they don’t understand one of the major hassles in a developer’s daily life: dealing with investors!
Seriously. Sponsors do not want to spend their time teaching investors about real estate, just as investors would not want to sit with a developer for session after session and hear the developer expound on the glories of their history and the characteristics of the project.
The most tiresome component of real estate development is the dog and pony show of raising funds, as it diverts focus from the sponsor’s primary area of competence which is competing with others to locate opportunities, negotiate purchases, put together a team, and execute the business plan. Developers want to go out shaking hands with plumbers, electricians, and carpenters and getting their hands filthy while ensuring that everything is done well, on schedule, and within budget.
Won’t you rather learn about a developer by watching videos while they discuss their business and background than having to sit down and see them merely to go past the first screening process? By automating the process and committing it to digital media, it is possible to remove the overwhelming bulk of that entire procedure. It frees up time for everyone, allowing the developer to focus on what they do best—find opportunities and carry them out—while enabling investors to examine the sponsor on their schedule, at their convenience, and from home.
That is why developers use crowdfunding platforms or create their possibilities: to use technology to disrupt what has historically been a laborious industry of needing to meet with someone to share basic background information to establish a connection. Consider this: you can invest in stocks without ever seeing the company chairman by reading as much as you can online; why not do the same with real estate?
With the ability to automate the whole educational process of exposing investors to real estate, a firm, and a transaction, the only time an investor and developer need to meet is once a choice to invest has been reached, and in-person contact seals the sale by validating the story of the online media the developer has developed and to ask concluding deal-specific questions.
Real estate investments have a higher level of risk than other types of investments since each transaction is a unique business proposal with its location, cost, and set of assumptions that may turn out to be untrue or be proven to be a lie when the project’s business plan is implemented. As a result, sponsors must be honest and transparent with investors about their past to convince them that they have the knowledge and expertise necessary to carry out the business plan effectively.
The worst risk an investor may take is forgetting the three golden rules: you might lose everything, past performance is not guaranteed results, and the bigger the gain, the greater the risk. All that matters are the specifics.
Investments in real estate crowdfunding are illiquid, which is another disadvantage. It is valid for any passive investment made into a real estate fund, regardless of how money was generated. Once an investment is made, there are relatively few ways to get your money back other than selling or refinancing the agreement, which might take years.
Prevalent equity shares, which are the most senior securities in the capital stack and provide passive investors the least influence over an outcome, are their preferred method of holding. The likelihood of receiving payment in a crowdfunded project is decreased since equity investors are often paid last (after principal loan holders, mezzanine debt, and preferred equity).
Some continuous distributions may be provided as preferred returns that are paid as a proportion of the initial investment (dividends in stock market-speak). However, distributions might take years to arrive, particularly in the event of a start-up development arrangement. Those seeking higher liquidity may be better suited to investing in publicly listed REITs, which could be bought and sold daily.
There is no immediate income
As mentioned earlier, the nature of a crowdfunded real estate project (such as a ground-up building) may need years for investors to see a return on their investment.
There are, of course, certain exceptions.
A sponsor taking on a value-add project, for instance, may be able to pay out distributions to investors sooner rather than later if there is a significant cash flow already in place. The same would hold if an individual made an independent investment in a completely stable property that generated a healthy cash flow. The latter scenario would result in the investor receiving a preferred return with immediate access to all net operational profits.
Additionally, borrowing money for a project involving commercial real estate may be done through crowdsourcing. When debt is crowdfunded, investors frequently begin to receive payments on a quarterly, semi-annual, or yearly basis; it may take three or more years for an investor to see any return on their equity investment.
Deal Restrictions
Many platforms continue to need accredited investors, which limits the number of offerings available to regular investors, while there are plenty of options for non-accredited investors.
To be considered an accredited investor, you must have earned $200,000 in each of the previous two years and have a strong likelihood of doing so again in the current year ($300,000 if filing jointly) OR have a net worth of $1 million, excluding your primary residence.
Are you a good candidate for real estate crowdfunding?
Despite such disadvantages, there is no reason to expect that interest in crowdsourcing real estate investments would wane very soon. However, as the industry grows acclimated to real estate crowdfunding, more sponsors are turning to crowdfunding platforms to obtain funds and equity for their enterprises. This pattern is predicted to continue as additional sponsors improve their crowdfunding capabilities. People will have more opportunities to participate, and overall performance will improve.
Does it mean you should consider real estate crowdfunding? There is no correct or incorrect response. It is determined by your overall investment strategy, including your time horizon, preference for active vs. passive investing, and the remainder of your portfolio’s allocation.
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