3 ways to invest in a crowdfunded real-estate project

01-Dec-2017

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By CHARLES CLINTON

When you think of crowdfunding, your first association may be a friend asking for donations on Kickstarter.

While that’s how the industry started, “donation crowdfunding” has been eclipsed by crowdfunded investing, where investors purchase small stakes in projects ranging from tech startups to real-estate developments. In fact, investment crowdfunding (excluding community fundraising tools like Kickstarter) could top $300 billion annually by 2025, according to CFX Markets.

This evolution began after Congress passed the JOBS (Jumpstart our Business Startups) Act in 2012, allowing businesses to broadly market formerly private investments to individuals. The legislation was designed to help fund startups, so many early crowdfunding platforms focused on that. More recently, real estate has emerged as the fastest-growing segment of the industry.

The average investor in a crowdfunded real-estate project is an affluent or high-net-worth professional, from doctors and lawyers to executives and small-business owners. For these individuals, real-estate crowdfunding offers the opportunity to participate in the ownership of projects that were previously available chiefly to institutional investors.

A typical crowdfunded real-estate project raises anywhere from $50,000 to $3 million from individual investors; the total project size can range up to $30 million or higher. For a $10,000 investment, return expectations range from $700 to $1,200 for a one-year debt investment to $5,000 to $15,000 for a longer-term (over three to five years) equity investment.

Unlike REITs, in which investors have no control of which properties are being purchased, these platforms allow individuals to select and invest in particular properties. These can range from multifamily developments and shopping centers to micro-unit residences and self-storage facilities, and can be in urban or suburban areas across the country.

While publicly traded REIT performance correlates closely with public markets, direct real-estate investing is a more natural hedge against dips in stock and bond performance.

On the other side of the coin, real-estate crowdfunding was first adopted by house-flippers who don’t have easy access to bank financing. However, as the industry has progressed, larger, more institutional real-estate firms have started to tap into crowdfunding as a way to raise part of the capital needed for larger projects. It’s now common for a real-estate project to be funded with a combination of a bank loan, funds from the real-estate company itself and investments from both crowdfunded investors and non-crowdfunded investors. Real-estate companies welcome the opportunity to reach new investors looking for passive cash-flow.

Today there are about 150 of these platforms in the U.S. While most platforms help streamline the administrative aspects of the investment process (from online signatures to annual tax documentation), they range widely in terms of how much vetting they do of the investments. Some are led by former real-estate professionals who examine every aspect of a project in a weeks-long process, while on the other extreme, several do no due diligence at all, and are simply providing software for real-estate companies to raise capital.

For investors, the first step is discerning how much diligence the platform itself does, although it’s also ideal to research the track record of the developer independently. Before considering any investment, investors should do their homework and ask questions about anything that is unclear. An unwillingness or inability to field questions from investors should raise a red flag.

While the industry is still young, several distinct business models have already emerged, offering different value propositions to individual investors.

Equity crowdfunding

The closest to the original “real-estate crowdfunding” concept, equity crowdfunding platforms help individuals become partial owners in distinct properties, allowing them to participate alongside real-estate companies who acquire, redevelop, or build. Investors invest passively; they don’t have to manage the property and are entitled to a fixed share of profits. The range of fees charged by a platform for this is typically between 0.5% and 3% annually.

Pros

• Lower barrier to entry: For as little as $5,000, individuals can invest in large, commercial real-estate projects and enjoy the benefits of real estate: strong returns, a low degree of correlation with public markets and historically lower volatility.

• High yield potential: As equity investors, individuals can share in uncapped gains.

Cons

• Risk remains: These investments do carry risk, and some investors may not know how to evaluate risk factors, such as local economy volatility, or potential for higher-than-expected construction costs. While some platforms are anchored by real-estate veterans, not all have robust diligence protocols.

• Lack of liquidity: Many of these investments entail a hold period of up to five years. No prominent secondary markets have emerged yet, so investors must be comfortable with the possibility of their money being tied up for several years beyond that period.

• It’s early: While many platforms tout positive aggregate return figures, it’s inevitable that some projects won’t go well. It will take time for individual investors to truly validate the performance track records of the different platforms.

Syndicated debt crowdfunding

A fast-growing segment, “debt syndication” platforms take some or all of an existing real-estate loan, secured by a deed on the underlying property, and syndicate it out to a network of individual investors at a fixed rate of return.

The originators of the loans are typically private, non-bank lenders, and the short-term loans are issued at relatively high interest rates, offering individual investors a return between 8% and 12%. Private lenders are able to charge vastly higher rates than big traditional lenders (banks) because the loans are issued faster and over shorter terms.

Platforms typically take a 0.5%-1.5% annual fee.

Pros

• Less risky than an equity investment: Debt investors are entitled to repayment before equity investors earn a return, so these investments carry less risk. There is still risk of a borrower defaulting, but since the note is secured by the underlying property, individual investors have added security.

• Extra diligence: The loans upon which these investments are based were originated by professional real-estate lenders, who often have a physical presence and expertise in the markets where they issue loans.

• Short hold period: Relatively short terms (typically under two years) allow investor to reinvest sooner, and reduces liquidity risk.

Cons

• Less upside than an equity stake: Though debt investments are generally more secure, they carry less upside, as the investor’s yield is limited to the interest rate of the loan.

• A middleman: The experienced real estate lender is an additional layer of diligence, but it’s also another party between the investor and the original loan. This typically means a net annual percentage return of 0.5% to 1% lower than platform-issued debt offerings (see below).

Platform-issued (‘pre-filled’) debt crowdfunding

In this model, individuals invest in a real-estate-backed loan, but the platform acts as the lender, doing their own diligence and issuing a loan to the borrower, removing the middleman. Most of these loans are for “fix-and-flips” — single-family homes that the borrower is planning to renovate and resell for a quick profit. Platforms typically charge an annual fee of 0.5 -1.5%.

Pros

• Less risky: Debt investors are the first to be repaid, and the investment is secured by the underlying property.

• Short hold period: The individual typically recoups their money in six months to two years.

• One less middleman: With the platform acting as the lender, one less party takes a fee. So, all else being equal, investors would realize an APR that is 0.5 percentage point to 1.0 percentage point higher than a similar loan via a syndication platform.

Cons

• Less upside than equity, for the same reason that syndicated debt does.

• Less diligence: Unlike syndication, the only loan underwriting is done by the platform (acting as lender). Some platforms practice conservative underwriting, but the companies themselves may have limited operating histories and minimal experience in all the markets where they issue loans.

Charles Clinton is the CEO of EquityMultiple, a real estate crowdfunding platform that offers individuals high-quality equity and syndicated debt opportunities in markets across the country.

https://www.marketwatch.com/story/crowdfunded-real-estate-investments-3-ways-to-do-it-2017-08-17


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