Individuals who want to invest in commercial real estate face two hurdles. First, commercial properties can be very expensive and likely out of reach for all but the most well funded investors. Second, they take a significant amount of time, resources, and expertise to manage once purchased. Again, this is not something that all individual investors have. Fortunately, there are alternatives that allow investors to obtain the benefits of commercial real estate ownership, without the hassle of managing it.
In this article, we discuss one such alternative: crowdsourcing. We will define what it means to invest in a “crowdfunded” real estate investment opportunity, the pros and cons of doing so, and how this strategy compares to working with a private equity firm. By the end, readers will have the information needed to determine if a crowdfunded strategy fits their individual risk tolerance and return objectives.
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Crowdfunded Real Estate Explained
Crowdfunded real estate is a transaction where equity is raised from a “crowd” of investors. To illustrate this point, an example is helpful.
Imagine a commercial multifamily apartment building with a $20,000,000 sale price and an in-place loan commitment for $15,000,000. In this scenario, the eventual buyer needs to provide $5,000,000 in equity to get the deal closed.
There are a number of ways to raise the needed $5,000,000. In a direct investment scenario, a few investors could form a partnership and each contribute a portion of the total equity needed. For example, five investors could come together and each contribute $1,000,000. While this is perfectly acceptable, and common, there aren’t very many individual investors with enough liquidity to contribute $1,000,000 to a real estate deal. Thus, an alternative is to “crowdfund” the needed equity.
In a crowdfunding scenario, one individual or company takes the lead and does all of the legal and regulatory paperwork necessary to create a limited liability company (LLC). Then, they sell shares in that LLC to individual investors in much more manageable increments, say $25,000 or $50,000, until they reach the $5,000,000 goal. So, instead of five investors who each contribute $1,000,000, the crowdfunded scenario could have 100 investors who contribute $50,000 each (NOTE: There is a cap on the number of allowable crowdfunded investors before the deal becomes classified as a real estate investment trust or “REIT”).
How Crowdfunding Works in Real Estate
In theory, it is possible to crowdfund the purchase of anything. But, as it relates specifically to commercial real estate investment opportunities, there are a number of things that need to happen to make a crowdfunded deal work.
Identify Roles and Responsibilities
A crowdfunded real estate transaction typically involves two groups of investors, each with a distinct role to play.
The first is the deal leader, sometimes referred to as the “General Partner” or “GP.” Their responsibility is to find the property, underwrite the cash flows, perform all due diligence, set up the LLC, find investors, and manage the asset once the transaction is closed. This is a significant responsibility and their stewardship of the deal can be a major factor in the returns that it delivers.
The other major role belongs to individual investors, sometimes referred to as “Limited Partners” or “LPs.” In a real estate crowdfunding deal, their role is to provide investment capital. They typically have no say in the day to day management of the property.
Structure the Deal
Every crowdfunded real estate deal structure is unique, but it is up to the General Partner to create it.
Typically, the key point to the deal is how the property’s cash flow is split between the general partner and the limited partners. In most cases, it works on a sliding scale – known as a waterfall – that is meant to incentivize the general partner for performance.
For example, suppose that the general partner put in 10% of the required equity while the limited partners put in 90%. If the property returns between 0% and 8% annually, the split may be “pro rata” meaning that the general partner gets 10% and the limited partners get 90%. But, if the property earns between 8% and 12% annually, the general partner gets a bonus (called a “promote”) so they get 20% of the cash and the limited partners get the remaining 80%. This so-called waterfall structure is very common in crowdfunded real estate deals and all investors should read the offering documentation carefully to ensure they understand it.
Use or Create a Crowdfunding Platform
Once the deal is structured, the next step is to find investors. In crowdfunded real estate projects, there are two options for doing so. The deal leader could use an established real estate crowdfunding platform like Fundrise, Crowdstreet, or Realtymogul, which have a built in audience of real estate investors looking for deals. Or, they could create their own platform by doing the hard work of finding investors on their own. There are pros and cons to both approaches, but the goal is the same, to get the deal in front of investors.
Raise & Invest Capital
With an audience, the final step is to actually raise the needed capital. Typically, this involves the hard work of phone calls, lunches, follow ups, presentations, and lots of paperwork. In a crowdfunded deal, which has many investors, this can be challenging and time consuming from a logistics standpoint, but it can be worth it for a successful equity raise.
Advantages of Crowdfunded Real Estate
From an individual investor’s standpoint, there are a number of advantages to investing in crowdfunded real estate.
Higher Returns
Commercial real estate investments have the potential to provide a higher rate of return than alternatives in the stock market or bond market. But, it should be noted that returns can be highly variable by deal and/or real estate market.
Diversification
Commercial real estate price movements tend to be inversely correlated with those in the stock and bond market. As such, they can provide another layer of diversification to the traditional stock/bond portfolio.
Low Minimum Investment
Purchasing a property with just a handful of partners means that each individual may have to contribute a substantial sum of money. Participating in a crowdfunded investment that includes many partners lowers the minimum investment required for each one. It can vary by deal, but it is often in the $25,000 – $50,000 range.
Greater Stability
Because crowdfunded commercial real estate investments are backed by a real, tangible asset (the property) and contractual lease payments, annual returns tend to be more stable than those found in other asset classes.
Regular Cash Flow
By definition, commercial real estate properties contain space that are leased to tenants, each of whom pay some monthly rental amount. Rental income is used to pay for the property’s operating expenses and anything left over is distributed to investors. These distributions create regular cash flow for investors, which can also be categorized as passive income because the deal leader does all of the hard work to manage the property.
Disadvantages of Crowdfunded CRE Investments
Crowdfunded commercial real estate investments are not without potential downsides. The most notable are described below.
New / Untested
The business of crowdfunding is not new. However, some of the real estate investing platforms/crowdfunding sites that offer them are. Although they vet the deal leaders for experience, track record, and quality product offerings, they don’t necessarily vet deal structure or suitability for individual investors. In addition, they are relatively young and there are many unknowns about what would happen to investor funds should they go out of business.
Illiquidity
As with most private real estate investments, the deal structure requires investors to commit capital for a certain amount of time, usually five to ten years. During this time, investors are not able to access or sell their shares except under extenuating circumstances. Even then, it is usually at a significant discount to value.
No Guaranteed Distributions
Although regular cash distributions are the goal, they aren’t guaranteed. They are highly dependent on property performance and if there is not any cash flow to distribute, it is possible that investors may not receive anything until there is.
Difficult Due Diligence
Again, real estate crowdfunding sites do a minimum amount of due diligence on deal leaders and the individual deals themselves. But, often the deal leaders are unknown to individual investors and their offerings may be in unknown locations where it can be difficult to independently verify their due diligence.
Tax Implications
For individual investors, there are tax implications on two fronts, income and capital gains.
Regular distributions received from the deal are reported on a document known as a “K-1” and they are taxed as ordinary income. Depending on each individual’s tax bracket, and other sources of income, the implications can be different. As such, the key point to remember is that distributions are subject to income tax.
If the property is sold for more than its cost basis, the profit is subject to capital gains taxes, which vary based on how long the property was held.
Every tax situation is unique so it is always best to consult a CPA or tax attorney prior to committing capital to a crowdfunded deal.
Investment Risks
Crowdfunded real estate deals are subject to the same risks as a typical CRE deal. The biggest risks fall into three categories: market risks that rental rates can change, vacancy risk that the property will lose tenants, and interest rate risk that changes in the cost of debt will impact the profitability of the investment.
Risk can never be eliminated completely, but active steps can be taken to minimize it.
Hold Time
Commercial real estate profits are made over the long term. This is because it takes time to implement an investment strategy. In addition, tenant leases usually include “escalation clauses” that call for rents to rise slowly over time. After years of increase, the property increases in value. Holding periods can vary by deal and market conditions, but five to ten years is common.
Investment Fee
If a crowdfunded real estate deal is sourced from a third-party platform, the deal fees (origination fee, advisory fee, etc.) may be higher than a non-crowdfunded deal because there are more people that need to be paid. The higher the fees, the less profitable the deal becomes. Individual investors should always look at the fee schedule for a deal to ensure they are reasonable and consistent with other market participants.
Crowdfunded vs Private Equity Real Estate
Private equity firms are a type of investment company that invests in the equity of other companies, including those that own real estate. In a private equity commercial real estate transaction like the one described above, the private equity firm acts as the deal leader (the general partner) and crowdfunds investment capital from accredited investors who meet certain income and/or net worth requirements. In this way, investing in a private equity deal is similar to investing in a crowdfunded deal.
But, a private equity deal is not the same as a crowdfunded deal that is sourced from one of the major website platforms like Fundrise or RealtyMogul. Those platforms source many different deals for potential investors to evaluate and act as an intermediary between the deal leader and the end investors.
Summary & Conclusion
The term “crowdfunded real estate” refers to a type of transaction where equity capital is sourced from a “crowd” of individual investors.
For an investment firm looking to crowdfund one of their own commercial real estate projects, they can do so by identifying roles and responsibilities, structuring the deal, using or creating a platform, and raising capital.
For individual investors, there are a number of benefits to a crowdfunded investment including: higher returns, low minimum investment, portfolio diversification, and regular cash flow.
But, there are also a number of risks including illiquidity, long holding periods, and high fees.
The investments offered by a private equity firm are similar to those offered by a crowdfunding site in the sense that they source equity investment capital for individual properties from a number of individual investors. But they are different in the sense that they may or may not be advertised on a web platform.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or info@fnrealtypartners.com for more information.
