How Does Real Estate Crowdfunding Work?

It’s hard to believe, but a mere seven years ago real estate online crowdfunding did not exist. Today, there are hundreds of crowdfunding sites raising money for everything from poets to pot plants.

Real estate crowdfunding accounts for over $2.5 billion of the $7 trillion commercial real estate market in the U.S., according to CFX Markets. That’s pretty good for an industry that’s brand new.

Over 100 real estate crowdfunding companies offer investments in all types of real estate including commercial, residential, retail, multi-family and more.

In a nutshell, real estate crowdfunding allows small investors the opportunity to diversify their portfolios with real estate. This is something that was hard to do before because the cost of entry was so high.

It also gives small time real estate developers and entrepreneurs access to capital they could not access otherwise.

Note: This is a multi-part series about Crowdfunding. The next article in the series: Is Real Estate Crowdfunding a Good Investment.

JOBS Act 2012: The Flood Gates Open

Following the 2008 financial crisis, Congress was looking for a way to stimulate the economy. In 2012, they passed the Jump Start Our Business Startups act (a.k.a. JOBS act) by easing many on restrictions on security trading.

Prior to its passage, only high net worth individuals, accredited investors, and professional investment firms had the opportunity to become equity or debt stakeholders in big real estate deals.

So, wealthy people had access to great deals with high returns while the rest of us did not.

If you didn’t have deep pockets – which most people don’t – the most common way of investing in real estate was to buy a house, live in it and carry a 30-year mortgage. You could also buy a duplex, triplex, or fourplex and rent out the other units.

Today, aspiring real estate moguls can put down as little as $500 to become part of a real estate project.

Types of Real Estate Crowdfunding Platforms

There is an incredible number of different types of real estate crowd funding platforms. Some are for accredited investors (high net worth people) only. While others target unaccredited investors. Many welcome both.

Some platforms invest in large projects while others invest in small developments. There are those which invest only in commercial real estate while others in single-family home rehabilitation. Some promote multi-unit apartment complexes, retail malls and even the purchase of raw land.

So, you can invest in just about any kind of real estate! But, there are two major categories of investing to consider.

Equity vs. Debt Crowdfunding

There are basically two investment types one can have through a crowdfunding platform; equity (shares) and debt (loans).

An equity investment is somewhat akin to buying stock. The investor owns a share or piece of the property and the developer trades a percentage of their property for money.

This sort of investment can reap great returns when a property appreciates in value or when it has great cash flow (rents). However, the downside of an equity holding is that the investor can lose everything in the event the investment goes bad.

For example, if a real estate company goes bankrupt, all equity investors have is usually wiped out.

With debt, investors make money by making loans to developers and charging interest. The great part is that investors have a better shot at getting back at least some of their money if the investment turns sour. That’s because loans usually require that the underlying property be put up as collateral. 

The drawback is that the returns are usually not as good as they are with equity. They won’t get rich if the property appreciates in value (because they get a fixed rate of interest) but, they will receive a steady payment.

How Does Real Estate Crowdfunding Work?

Generally, developers don’t have enough money to fund the entire development or project. They will need to acquire a loan and make a down-payment.

The developer will often want to partner with people to fund the down payment in exchange for a percentage of the ownership. They do this for a variety of reasons.

First, they may not have enough capital to make the down payment themselves. The other reason is because they may want to do multiple deals at the same time and spread their money out for diversification.

Regardless of the reason, they need money. Generally, they will approach their friends, family, and other relationships to ask for money in exchange for a portion of the ownership.

But, what if their network doesn’t have enough money?

Real Estate Crowdfunding

That’s where crowdfunding comes in.

Let’s say that they need $5,000,000 to close the deal, but their personal and professional network can only fund $3m. They are $2m short.

So, they turn to a crowdfunding platform and pitch them the deal. If the platform likes the deal, they will commit to raising the capital.

Now, the platform takes the information and puts it on their platform. There is some paperwork and legal work that has to be in the background, but we’ll gloss over that because it’s behind the scenes.

Now, the thousands of investors on their platform can take a look at the deal and potentially invest. Once the goal has been met, the platform goes back to the developer and puts the money toward the down payment and receive a part of the ownership.

Then, the platform turns around and splits that ownership to the hundreds of investors that are involved.

In essence, the platform just connects investors to developers.

Crowdfunding Models

We know that crowdfunding means that real estate deals can be put online and advertised, but there’s more to it than that. There are two primary real estate crowdfunding models and each has its own rules and regulations. The primary two are the Regulation A+ model and the 506(c) model.

Regulation A+

This is essentially a real estate fund which can raise up to $50 million from any type of investor, accredited or unaccredited. The money is pooled together into a Regulation A+ fund and then invests it into deals.

Since the Reg A+ fund accepts investor capital before they find they find a specific property to invest in, the investor doesn’t get to choose the specific deals. So, you can’t examine the full risks and benefits of the transaction, but it’s available to non-accredited investors.

You’re basically trusting the platform to thoroughly vet all property offerings.

This is great because it opens up lucrative real estate deals to unaccredited investors but it’s bad because it only allows them to do it in a pooled fashion.

506(c)

This model is for accredited investors only. In case you’re wondering, an accredited investor is someone with an annual income of at least $200,000 ($300,000 if married), or those with a net worth of over $1 million (excluding your personal residence).

Often, the minimum investment is higher than with Reg A+ funds, but there is more transparency. You get to see all of the underlying information and details of the deal, including the:

• Business plan
• Market analysis
• Operating budget
• Investment memorandums
• and more

Advantages of Real Estate Crowdfunding

Real estate crowdfunding provides an array of advantages for individual investors.

The most obvious one is access to real estate investments that were out of reach because the cost of entry was too high. Generally, investing in these sorts of deal requires a minimum investment of $50,000 to $100,000 or even more. With crowdfunding, many platforms allow you to invest with as little as $500 or $1,000.

That goes to the heart of what crowdfunding was meant to do. It provides smaller investors the door to new investment options previously reserved only for the wealthy.

Another benefit is that real estate is a less volatile investment than stocks which can tank in value over several trading sessions. For example, Apple stock lost 30% of its value in just three months at the end of 2018. That typically does not happen with real estate investments.

While real estate might lose value, it tends to happen over a long period of time.

Many real estate real estate crowdfunding investments also provides cash flow, something other investment types do not. For example, stocks tend to give less than 2% dividends while real estate is often 6-10%.

Another great benefit of owning a share of a real estate crowdfunding deal is that you, as the investor, do not do the hard work of managing a property. Collecting rents, dealing with unruly tenants and fixing busted water heaters are part of the job when one owns most investment properties. Not having a direct ownership can be a blessing.

The tax benefits from owning certain types of real estate bought through a crowdfunding platform are great. The IRS allows depreciation deductions of commercial properties that can soften or eliminate an otherwise high annual tax bill.

The last benefit isn’t to the passive investor, but to the small time real estate developers, entrepreneurs and home “flippers” who can now access capital that had previously denied them, all thanks to crowdfunding.

Disadvantages of Real Estate Crowdfunding

Like any investment, there is a certain amount of risk involved.

First and foremost, real estate, while less volatile than other investments classes, can decline in value. 

Just look at what happened in 2008 during the 2008 financial crisis. Across the board, residential real estate lost over 30% of its value.Thankfully, crisis like these only occur rarely.

The last time this happened was during the Great Depression.

Typically, when real estate values decline, it is a local occurrence. For example, when energy prices declined, real estate markets in energy producing areas saw a decline in property values.

This brings to focus another disadvantage of real estate crowdfunding. Investors must do their homework and know their market. 

Professional investors often have a staff of analysts picking apart the numbers, examining demographics, employment trends and past valuations so they are usually fully up to speed when they make an investment in a particular property. Individual investors, on the other hand, must do this due diligence themselves. Like anything, not knowing what you are buying can turn into a disaster.

Performance: REITs vs. Real Estate Crowdfunding

Real Estate Investment Trusts (REITs) have been around since the early 1960’s and they allow investors to become property owners by buying shares traded on the stock exchange. REITs are often compared to real estate crowdfunding, but there are some significant differences.

The REITs found on many crowdfunding platforms are non-traded REITs which means, unlike traditional REITs, they are not traded the stock exchange. If an investor wants to sell a non-traded REIT they can do so through a licensed broker-dealer which charges substantial fees.

Therefore, many of the REIT products found on crowdfunding platforms are not liquid assets like their stock market traded cousins.

Returns

According to Forbes, a leading business publication REITs realized annual returns of 12% from 1977 – 2010. Unfortunately, because real estate crowdfunding is so new, a long-term comparison cannot be made .

However, REITs beat stocks which only returned 10.0% over the same period. More recently, during the 4^th Q. of 2018 when the stock market got hammered, stocks dropping 13.5% while REITs only declined by 6.1%.

During its short life, real estate crowdfunding has delivered an annual return of around 11% by some estimates.

It should be remembered that this achievement occurred when the real estate market was on a rebound from the 2008 financial crisis, galloping ever upwards at a fast clip.

A Few Real Estate Crowdfunding Companies

Profiled below are a few of the better-known crowdfunding platforms.

Fundrise

Fundrise is one of the early successes in real estate crowdfunding. This platform allows unaccredited investors the opportunity to invest in commercial real estate. The minimum investment amount is $500. 

They market REITs. However, unlike traditional REITs, this investment is not liquid. Investors can expect a quarterly dividend payment and whatever appreciation has accrued when the assets investment term has expired.

In 2017 they returned 11.44% to investors.

You can learn more about Fundrise here.

Realty Mogul

This platform was founded in 2013 and is for both accredited and unaccredited investors.

Realty Mogul tends to invest in apartment buildings, retail centers and class A office buildings. The minimum investment amount is $1,000. They offer both debt and equity investments and have what is called “private REITs” which are similar to REITs sold on the stock exchange.

To date, they have over 130,000 investors, borrowers and sponsors. Realty Mogul has provided financing to over 135 properties and loans amounting to $280 million.

You can learn more about Realty Mogul here.

Equity Multiple

Equity Multiple is focused in bringing institutional grade investments to average investors. So, very large apartment complexes, retail centers, office buildings, etc.

The minimum investment is between $1,000 and $5,000 generally, but it varies by deal.

Learn more about Equity Multiple here.

Real Crowd

This platform offers a wide selection of mostly commercial investments. It has done 128 deals totaling $134 million in equity funding. A minimum investment is $5,000 is required and they offer both equity and debt. A typical investment length is between 24 – 60 months. Investors can put their funds in specific properties. This platform too is only for accredited investors.

Crowd Street

This platform takes both accredited and unaccredited investors. It focuses on institution-quality commercial real estate like large apartment complexes an office towers. 35,000 people have invested in Crowd Street deals. It’s a platform for those who want the security of investing in large commercial properties.

Fund That Flip

While Fund That Flip sounds like a reality TV show, it is, in fact, a crowdfunding platform that provides loans to developers and real estate entrepreneurs. The minimal amount of an investment is $5,000. They promote themselves as “real estate loans simplified”. As their name implies, they provide loans to mostly “re-developers”. They charge investors 1% to 2% and borrowers 2 to 4 points.

Rich Uncle 

Another whacky sounding company is Rich Uncle which is a “blind pool offering” platform. In other words, investors don’t know what the exact, underlaying property is prior to investing. Investors can invest as little as $5. Rich Uncle was started to give everyone an opportunity to take part in REITs. Instead of using expensive broker-dealers, uses crowdfunding to go directly to investors. A downside of the platform is investors are pretty much committed for the term because there is no secondary market to sell this investment.

Patch of Land

This peer-to-peer platform provided over $370 million in real estate loans. Investors can view each project proposal, due diligence documents and other information to determine if the investment is right for them. A minimum investment amount of $1,000 is required. Most deals are 12-month loans. There are no fees for investors or borrowers. Patch of Land takes 1% to 2% of the interest distributions made by borrowers. A minimum loan amount is $100,000. This platform is for accredited investors only.

The Democratization of Real Estate Investing

Like any new business innovation, investors should look at crowdfunding it with a critical eye, ignoring the surrounding “buzz that often accompanies shiny new things.

That said, real estate crowdfunding is a great way of investing in real estate without have the burden of actually managing a property.

Finally, it allows millions of people of modest means to invest in an asset category they otherwise couldn’t access.

Read Part 2: Is Real Estate Crowdfunding a Good Investment

Part 3: Property types and classes in commercial real estate