What is real estate crowdfunding?
Crowdfunding is defined as “the use of small amounts of capital from a large number of individuals to finance a new business venture”. In the same vein, real estate crowdfunding involves combining multiple small investments from many different people to purchase real estate and other investment properties.
How does real estate crowdfunding work?
In a simple real estate crowdfunding deal, many people’s small investments will be aggregated in order to purchase a real estate property (equity investment), with the intent of holding for income or improving the property and selling at a future point in time, distributing the gain upon sale amongst the investors. In other cases, the deal will involve debt financing. Some deals are a combination of both debt and equity.
3 roles in crowdfunding process
The sponsor is the person or group of people with the relevant knowledge and real estate experience to be able to choose properties that have good potential for investment, and then execute the necessary plans to increase the value of the property to either reap higher distribution of profits or sell the property for a higher price than originally acquired. The sponsor is responsible for due diligence, financial analysis, and the full management of the property.
The platform is the medium for sponsors to offer investment opportunities to potential investors. The platform allows regular investors like you to invest modest amounts into quality projects and properties in ways that were not possible in the past. Some examples of platforms include Fundrise, RealtyMogul, and CrowdStreet.
The investor – you! By investing into crowdfunded real estate properties, you become a part owner of the property. The great thing about crowdfunding is that it allows the investor to find investments that interest them specifically – with the ability to invest locally or anywhere in the world.
Pros and cons of real estate crowdfunding investing
Pros of real estate crowdfunding investing
- Small capital investment required
- Targeted investment – choose which properties you’d like to invest in
- Gain access to real estate investing opportunities you wouldn’t normally have access to – for example, commercial plazas, hotels, office buildings, etc.
- Allows diversification of your portfolio – real estate is not heavily correlated with the stock market
- Allows for passive investing – you don’t need to manage any properties, worry about tenants, contractors, or any of the other issues that comes with actual real estate ownership
- Higher annualized returns than other traditional investments, such as stocks and bonds
Cons of real estate crowdfunding investing
- Riskier than other types of investments – the crowdfunded deal is backed by one single asset (the property), which can be subject to a number of business and external risks
- Non-liquid investment – the investment cannot be sold quickly in the way that stocks can be, which has the effect of locking up your money for a longer period of time – 5 to 7 year holding periods are common in crowdfunded real estate
- Better deals are only offered to accredited investors (investors with $1 million in assets or $200,000 in annual income)
Types of real estate crowdfunding investments
There are a number of ways that a real estate crowdfunding deal can be structured, specifically with respect to its mix of debt and equity, which has an impact on the safety of the investment, its income potential, and potential return on investment.
Debt investing means that the investors in the deal act as lenders to the property owner or sponsor, with the loan being secured by the property itself. As an investor, you will receive a regular fixed interest payment, based on the interest rate determined for the crowdfunding opportunity. When the debt arrangement ends, you will receive back your principal (the amount you originally invested). Debt investors have priority over other investors when it is time to payout or liquidate the investment. In terms of risk, debt investments are often less risky and offer less reward.
Equity investments are the most common opportunity in real estate crowdfunding, it is also the riskiest, but offers the highest overall return. Equity investors own a piece of the property and are entitled to their portion of the income from the property. Upon the sale of the property, equity investors receive their share of the appreciation in value. Equity investors have unlimited upside, but also stand to lose their entire investment if the investment fails to perform.
Types of investors
In the space of investing, investors are broken out into two categories:
- Accredited investors: Some platforms only grant access to accredited investors, or limit specific investment opportunities to accredited investors. In the United States, an accredited investor is someone who has a net worth of $1 million or more (excluding their primary residence), or who has an income over $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year.
- Non-accredited investors: A non-accredited investor is any investor who does not meet the above requirements. Many crowdfunding platforms now allow non-accredited investors to participate in offerings. However, in the United States, SEC rules limit the amounts that non-accredited investors can invest.
Earning passive income from real estate crowdfunding
Investing in properties through real estate crowdfunding can be an attractive option for investors looking to diversify their portfolios, gain access to real estate without active investment, and earn passive income either through fixed interest payments, distributions of dividends, and/or sharing in the appreciation of the property once sold.
Frequently Asked Questions (FAQs)
How does real estate crowdfunding compare to investing in REITs?
Real estate investment trusts (REITs) allow investors to make investments in real estate without having to actually buy any property, and are normally traded on public exchanges. REITs distribute rental income from their properties as dividends to shareholders. REITs are managed by a real estate management company that purchases and manages properties. As a REIT investor, you do not have any say or control over what properties are purchased, sold, or operated. As a real estate crowdfunding investor, you get more control and discretion over your individual investments – choosing which properties to invest in.
Is real estate crowdfunding legal in the U.S.?
Yes. The JOBS Act passed in 2012 cleared the way for real estate investors to invest through crowdfunding. However, SEC rules may dictate how much you can invest.
Is income earned from real estate crowdfunding taxable?
Yes. Capital gains and dividends earned from your investment are taxable. Please consult a tax professional to determine your tax filing obligations.