Everything You Need To Know About Real Estate Crowdfunding (Part I)

Investing in real estate is a strategic way to inject some diversity into your portfolio while creating a long-term source of income. Historically, taking part in a private real estate deal meant having the right connections but real estate crowdfunding has opened up a new path for investors. To help investors better understand how it works, RealtyShares has created a comprehensive guide which breaks down the finer points of real estate crowdfunding.  This first part will focus on real estate crowdfunding from the perspective of the investor.  Part II (to be published later) will focus on real estate crowdfunding from the perspective of the real estate company or borrower looking to raise capital.  

WHAT IS REAL ESTATE CROWDFUNDING?

Real estate crowdfunding involves the pooling of funds by multiple investors in a real estate project. This form of crowdfunding is different from rewards-based, venture and loan crowdfunding in terms of how investments are made, the kind of potential returns investors enjoy and the level of risk involved.

There are two basic ways to invest in crowdfunding property deals. First, investors can make equity investments in commercial or residential properties. In exchange for funding the project, the investor receives an equity stake in the property. Returns are realized in the form of a share of the rental income generated by the property and/or profits from the eventual sale of the property. Investors typically receive payouts on a quarterly basis.

Debt investments are an alternative to equity. When you invest in debt, you’re investing in the mortgage loan associated with a particular property. Loans are repaid with interest, a percentage of which is then paid to each investor participating in the deal. These payments may be made monthly or quarterly.

Between the two, equity investments offer the potential for higher returns due to the fact that the profitability of a debt investment is limited by the interest rate associated with the loan. On the other hand, equity investments carry a higher degree of risk and typically require a longer holding period, which makes them more illiquid. Equity investors are also at the top of the capital stack, meaning they’re the last to be paid back.

REAL ESTATE CROWDFUNDING AND THE JOBS ACT

In 2012, President Obama signed the Jumpstart Our Business Startups Act. This Act, which is divided into seven titles, enacted significant changes within securities law and established new guidelines on how startups could raise capital through crowdfunding. Title III of the Act includes specific provisions for crowdfunding.

One of the most important changes associated with the JOBS Act centered on Regulation D, which previously banned general solicitation of investors. In 2013, the Securities and Exchange Commission (SEC) relaxed the rules on general solicitation of accredited investors. That move effectively gave rise to the real estate crowdfunding industry.

Now, instead of having to rely on people in their network to connect them with private real estate deals, investors can search for and invest in opportunities online. Real estate crowdfunding platforms also offer real estate developers an avenue for raising capital to fund projects outside of traditional bank financing.

WHO CAN INVEST?

Up until recently, only accredited investors were allowed to participate in real estate crowdfunding. Being an accredited investor means having a minimum net worth of $1 million or an annual income of at least $200,000. The income threshold increases to $300,000 for married investors. This standard was set because the law assumes these individuals have the requisite experience, knowledge and resources to manage their money.

In October 2015, the SEC finalized its ruling on Title III of the JOBS Act. This opened the door for non-accredited investors to participate in crowdfunding investments. Crowdfunding platforms will be able to allow investments from non-accredited investors once the provisions become final, which occurs 180 days after publication in the Federal Register. Non-accredited investors who earn $100,000 would be able to put 10% of their income into crowdfunded investments each year. The limit is set at 5% for non-accredited investors who earn less than $100,000 annually.

It’s important to note that while real estate crowdfunding platforms will be able to accept investments from non-accredited investors, not all of them may choose to implement this policy. For more on what the Title III ruling means for non-accredited investors, take a look at the links below.

WHAT DO YOU ACTUALLY OWN?

Real estate crowdfunding platforms may differ in terms of how investments are structured. That, in turn, affects what it is investors own when they participate in a deal.

RealtyShares, for example, establishes a separate limited liability company (LLC) for each equity investment opportunity. The LLC holds an interest in the entity that owns the real estate associated with the investment. Investors in an equity deal own shares in the LLC. This structure gives the investor limited liability and it provides them with certain tax benefits associated with pass-through entities.

With debt and certain preferred equity investments, the investment is being made in payment dependent notes of RealtyShares subsidiaries. Each note is tied to the performance of a real estate loan or project investment made by an individual subsidiary. Investors who participate in debt deals have ownership in the note itself.

HOW REAL ESTATE CROWDFUNDING BENEFITS INVESTORS 

Real estate crowdfunding offers numerous benefits for investors who are seeking direct access to private real estate investments. Compared to investing in a real estate investment trust (REIT) or purchasing a rental property, real estate crowdfunding has the edge when it comes to the following:

• Transparency – One of the primary advantages that real estate crowdfunding platforms are able to offer over other types of real estate investments is transparency. With a REIT, for example, investors may only have limited information about the underlying assets. RealtyShares vets each deal and once the deal becomes available on the platform, investors have the opportunity to review the details before making a final investment decision.
• Accessibility – One of the stumbling blocks associated with private real estate deals is the high minimum buy-in that’s often required. It’s not unusual for investors to bring $50,000 or $100,000 to the table to participate. Real estate crowdfunding, on the other hand, sets the bar much lower. RealtyShares, for example, features deals with a $5,000 minimum.
• Diversification – Some of the most successful institutional investors (including the Harvard and Yale Endowments) have sizable allocations in their portfolio in real estate.  Real estate is an important component of any well-diversified portfolio and crowdfunding allows individual investors to fill the gaps. Between debt and equity and investments in both commercial and residential properties, investors have the opportunity to gain exposure to a new asset class with fewer barriers to entry.
• Tax Benefits – Owning an investment property comes with certain perks, including the ability to deduct depreciation and other expenses associated with the property’s maintenance. With a REIT, it would not be possible to take advantage of those tax breaks. The way crowdfunded real estate investments are structured, on the other hand, allows equity investors to reap the rewards of the depreciation deduction without having to actually own the property.

BEST PRACTICES FOR INVESTING IN CROWDFUNDED REAL ESTATE DEALS

As with any other investment, it’s important to practice due diligence when investing in real estate crowdfunding. This ensures that investors are connecting with the right platform and investing in deals that are an appropriate fit for their goals and risk tolerance. Here are some tips investors should keep in mind to ensure that their real estate crowdfunding experience goes smoothly:

• Choose the right real estate crowdfunding platform – There are dozens of real estate crowdfunding platforms to choose from and they vary in their investment approach. The first step for investors is carefully researching prospective tech-enabled crowdfunding platforms to identify the ones that are most likely to fit their needs.
• Carefully consider the fundamentals of each investment yourself Contrary to what some may assume, choosing to invest in real estate using one of these qualified platforms does not mean that they are investment advisors. While many platforms do vet deals beforehand, not all of them do. Accordingly, it is still recommended that investors discuss the details with a financial advisor or fiduciary first.
• Be sure to consider the time to liquidity – Real estate has very different liquidity schedules as well as unique return profiles for each individual investment. With debt investments, for instance, you may be looking at hold times ranging from six months to two years. With equity investments, the hold period can extend up to 10 years. Understanding how long you stand to be locked into a deal from the outset is a must when making investment decisions.
• Don’t forget about risk – Although real estate investing itself can help to diversify and strengthen a portfolio, there are many types of investments within the class to consider in order to diversify the risk. As we mentioned earlier, equity investments tend to be riskier than debt investments but there’s a trade-off when it comes to the kind of returns investors enjoy. Ultimately, investors need to weigh these two factors against one another to determine which option is more suitable.

THE BOTTOM LINE

Real estate crowdfunding has established itself as a major game changer where the larger real estate industry is concerned. By introducing tech-based solutions and removing some of the most challenging barriers to real estate investing, crowdfunding has injected some positive disruption that’s long overdue. For investors and borrowers alike, it continues to be a path that’s worthy of exploration.

This article was originally posted on the RealtyShares.com blog