If this is the case, small, speculative investments are still permissible. However, large, core investments are too risky.
Diversification Is Essential
March 2018 revision Things have improved dramatically for some investors since the 2015 article. Many real estate crowdfunding sites have expanded beyond single property investments to offer multiple properties (pooled) investments. They allow investors to quickly and easily build 120+ property portfolios for adequate diversification. For example, a single investment in the BroadMark hard money loan fund puts an investor in hundreds of properties.
As a result, the information below is no longer applicable in all cases. However, I’m leaving it in place for those who continue to invest solely in single-property investments (since this is still an issue for them).
We looked at how many properties are necessary to protect a direct real estate portfolio against risks. That is related to location, property type, and tenants in Part one of this article, “How many properties do I need to diversify?”
According to institutional investors, the number of properties is in the “hundreds.” That is a considerable number. So we did a quick reality check on the back of a napkin. And we confirmed that it ranges from 120 to “hundreds.”
How does this affect individual investors, then? What about the industry?
How much money will be required?
How much money will be required to diversify? It is dependent on the location. Even with the most generous assumptions (100 properties rather than “120 to hundreds”), the “cheapest” site requires $500K in cash and a minimum total portfolio size of $5 million. The most expensive requires $2.5 million in cash and a comprehensive portfolio of at least $25 million.
After running the calculations, I was taken aback. Here’s how it sounds before we get into what it means.
With his drill, the dentist remarked, “This will only hurt slightly.”
There are two kinds of investments, and most websites cater to one another.
You can invest in individual properties or invest funds in various properties.
What then is the required amount?
1. Investments in individual properties
- One site currently has three individual property investments starting at $5,000.
- *Proper diversification necessitates a $500k investment in real estate.
- To invest that amount safely, an investor should have at least $5 million in assets.
- Another site currently has four individual property investments starting at $25,000.
- *Proper diversification necessitates an investment of $2.5 million in real estate.
- To invest that much money securely, an investor needs to have at least $25 million in assets.
- Investments of Funds
- One site currently offers eight fund investments with a minimum of $25K or $50K. (Let’s go with the $37.5K average.) Each fund appears to have an average of 8 to 15 properties (so let’s use 11.5 as the average).
- *An investor must invest $652K in real estate for proper diversification.
- To invest that amount safely, an investor should have at least $6.52 million in assets.
*Notes:
• Assumes a total of 100 properties to diversify. I understand this is significantly less than “120 to hundreds of properties,” so proper minimums are likely much higher.
• A total “safe” real estate allocation of 10% is calculated from the average at: “How much real estate is ideal for my portfolio?”
What exactly does this mean?
Compared to the average person, I probably know more accredited investors than they do. I’m willing to wager that at least half of the population cannot meet the requirements for the most affordable sites. Most people cannot meet the criteria for the most expensive places.
And to make matters worse, the investor doesn’t require crowdfunding at the top price point of $2.5 million. For just $1 million, investors can access the same billion-dollar private funds institutions have used for decades. It is far less expensive due to economies of scale (fees of around 1%) and 99 percent less time-consuming than manually managing dozens of micro-funds or hundreds of properties. Therefore, this price is just not reasonable.
Real estate crowdfunding is something that makes me interested. Because of this, it pains me to add that I believe the current model is seriously flawed for serious, long-term investors seeking diversification.
It is acceptable when investing “throw away money,” where diversification is not crucial.
But because most accredited investors are long-term investors seeking a diversified and stable investment, it is currently impractical for them until minimums are significantly reduced.
Mutually assured destruction? Perhaps mutually assured success?
I understand the delicate balance websites must maintain between sponsors/borrowers and investors. Many sponsors are funds, looking for the highest minimums possible. They deal with fewer investors, reducing the paperwork and hassles they need to negotiate. Additionally, because fees from those funds frequently compensate websites that deal with funds, they often give them more credibility than investors.
However, the entire system will ultimately fall apart if the rules are written so neither party can succeed over the long term. Both sides must strike a balance if they are to succeed.
What would happen if sites didn’t alter?
There won’t likely be any immediate issues if nothing changes. Presently, times are excellent, and few people default.
However, significant issues will arise in the medium term (1 to 5 years). Investors will realize how under-diversified their portfolios are once the business cycle enters a downturn and defaults start to rise. People will suffer significant financial losses, and the industry will suffer a bad reputation among the public and its clients.
There may be sufficiently new and fresh investors during the subsequent upturn to restart the cycle. However, this won’t last forever; after one or two more business cycles, people will realize this kind of investment is too risky. Additionally, the websites will resemble penny stock industry businesses and never reach their full potential.
What takes place if sites do alter?
I believe there is cause for optimism because any industry or person tends to change once faced with pressure that jeopardizes their long-term survival.
It wouldn’t require much. Minimums must be reduced by a factor of ten from what is currently the low-end. If sites changed to a $500 minimum, it would only require $50,000 in cash and a $500K portfolio size. At these prices, almost any accredited investor would be able to participate.
Furthermore, reducing minimums by ten before real estate crowdfunding promotes the typical investor. With a $50 minimum, all you’d need is $5,000 in cash and a $50,000 portfolio. It is entirely plausible.
The current market value of The Lending Club, which has a $25 minimum, is $6.5 billion. Companies involved in real estate crowdsourcing (in a market 46 times larger than that of consumer loans) could reasonably anticipate growth to $100 billion companies and above.
Not everything will be different.
I voiced my displeasure over the high minimums to one of the sites not mentioned in this article (who I won’t name). In their defense, I was speaking with an account representative who was likely unaware of the underlying issues. At the same time, what he said bothered me. He stated that their website would not change. Because this is a high-end site, the minimums must remain high. He then stated that low minimums were only for cheap “house flipper sites”…and then explicitly mentioned one of the other sites in this article.
Hopefully, that site’s management will eventually comprehend it more effectively than their staff.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.