In this third article in our series on real estate investing, we examine real estate crowdfunding and how it compares to REIT investing. Both are passive investments that allow you to earn rental income and/or capital gains without direct involvement in property management. Although their goals are similar, they have distinctly different characteristics and risk profiles.
Introduction to Real Estate Crowdfunding
Origins
The 2012 JOBS Act introduced America to equity crowdfunding, which is a way for small to medium businesses, partnerships and syndicates to sell private securities directly to the public without first undergoing an initial public offering. The idea grew out of the social crowdfunding phenomenon, in which websites like ArtistShare, Kickstarter and dozens more allowed folks to contribute to artistic projects in return for token thank-you gifts. Equity crowdfunding, by way of contrast, is all business. You purchase assets (stocks, bond, real estate) on a special website called a crowdfunding portal.
Initially, the crowdfunding portals catered only to accredited investors, since that was a requirement for investing in private placements under SEC Regulations A and D. Since then, rules came into effect that allow nonaccredited investors to make limited crowdfunding investments.
Real Estate Crowdfunding Portals
Crowdfunding portals create the marketplace for this type of investing. More than 100 crowdfunding portals have come and gone since their advent, but several have grown to dominate the market. These include CrowdStreet, Rich Uncles, ArborCrowd, RealtyShares and Realty Mogul. The portals offer investments in private real estate equity and debt securities, both commercial and residential, in up to three different ways:
- Syndication: Crowdfunding is a form of property syndication. A sponsor offers shares of a particular property to investors. The shares are issued by an LLC, LP or private corporation that owns the underlying property. Sponsors describe their properties and provide information about costs, risks and rewards (often expressed as internal rate of return, or IRR). When you join a syndicate, you earn a share of the property’s rental income and sale proceeds. Minimum investments vary by property and portal. Most properties have a projected holding period, after which the syndicate will sell the property and distribute the proceeds, including capital gains.
- Funds: These are pools of real estate offerings that operate as an investment fund. Because funds invest in multiple properties, they provide some degree of instant diversification. Investment minimums are usually substantial. For example, CrowdStreet requires an investment of at least $25,000 for its real estate fund.
- Managed investing: You invest through an investment manager via a private managed account to build a personalized portfolio of properties. The manager invests on your behalf to develop your portfolio that’s built to your specifications. A minimum investment of $250,000 isn’t uncommon.
In this article, we focus on syndication, since this is the unique aspect of real estate crowdfunding.
Crowdfunding Models
There are two models (and hence two types of real estate crowdfunding portals) available:
- Rule 506(c): This model is based on Rule 506(c) of SEC Regulation D that acts as a safe harbor for private placements. Investors must be accredited (generally, having annual income of at least $200,000 or net worth of $1 million). Crowdfunding portals of this type are responsible for verifying that you are an accredited investor. Typically, you invest in identified properties with full transparency. This is the model we discuss in this article.
- Regulation crowdfunding: This is the crowdfunding extension of SEC Regulation A that offers everyone limited access to crowdfunding. Sponsors can raise up to $1.07 million per year. Your investment is speculative because the funds are raised before the target property is identified, limiting the investment’s transparency.
Debt vs Equity Crowdfunding
Our focus here is on real estate equity crowdfunding, where your return is based on the property’s performance. In debt crowdfunding, you are essential lending money to the sponsor. You receive fixed interest payments rather than rental income. About 80% of crowdfunding investments are the equity type.
Differences Between Investing in REITs and Real Estate Crowdfunding
As you would expect, both types of investing will thrive when the real estate market is expanding. Both give you access to steady income, or at least the prospect of such. Here’s how they stack up against each other.
Minimum Investment
Publicly traded REITs are available on stock exchanges. As such, your minimum investment is one share, an extremely low threshold. Crowdfunded investments have varying minimum investments, but it’s typically at least $1,000, and often more, for syndicates. Of course, both methods require a much smaller minimum investment than that necessary for direct purchase of a property.
Timing Risk
You can invest in REIT shares at any time. You can employ dollar cost averaging (DCA) to make regular, same-sized purchases that tend to keep your cost per share below the current price per share.
You also decide when to invest in a syndicated property, but the higher minimum investment creates some timing risk. You might be able to make multiple purchases within the same syndicate, but only until the syndicate is fully subscribed. Therefore, DCA investing is usually not available for crowdfunding syndicates.
Diversification
REIT shares are backed by a portfolio of hundreds of properties, providing instant diversification, albeit in usually just one real estate segment (multifamily, office, retail, etc.). Syndicate crowdfunding involves one property at a time. You would need to buy at least 15 properties to start approaching a diversified portfolio.
Involvement
Both investment types are passive. Your job is to collect your dividends. However, with a REIT, you have no control over the assets owned. With crowdfunding, you select your investment properties, but once again have no say in their operations.
Leverage
Both types are leveraged to the extent that the underlying properties are financed through debt, typically at least 60%. You can further leverage REIT shares by purchasing on margin. You also could borrow the money for a crowdfunding investment, and therefore achieve even higher leverage.
Risk
With REIT shares, diversification limits your risk, although you are exposed to the REIT’s management risk. REIT shares trade with the ups and downs of the market. Crowdfunded properties are not diversified unless you own quite a few of them. You also bear the risk that the sponsor has the expertise to successfully manage the property. On the other hand, if you properly vet your investments, you can expect steady rental income regardless of market volatility.
Efficiency
Both types are similar in terms of efficiency. In both cases, expenses reduce the net income you receive. REIT corporations are profit-making concerns, so you are paying for that. In a syndicate, certain fees go to the sponsor and to the crowdfunding platform, and this reduces your net income.
Liquidity
Publicly traded REIT shares are easy to buy and sell. Non-traded REITs are harder to sell, and private REIT shares are illiquid — you must hold them at least one year before you can publicly sell them. The same is true of crowdfunded shares. Furthermore, you might have trouble finding a buyer for the shares after the year expires, since these are unlisted securities.
One other aspect of liquidity affects crowdfunded properties. Normally, the sponsor seeks to sell the property after a specified holding period, and a part of the investment’s return of principal and total return are the proceeds from the sale. However, there is no guarantee a buyer will be found when sought, or that the price will result in a capital gain.
Summary
REIT investing makes sense when you prefer to leave property selection to the REIT company. Real estate crowdfunding is better suited for those who want active selection of passive investments. REIT shares are far more liquid and have a lower minimum investment. Crowdfunding gives you the opportunity to find and invest in properties that will return more than will REIT shares, but you’ll need expertise to find the best crowdfunding deals.