How to assess crowdfunding investment in real estate

Crowdfunded_Real_Estate_Deals

Commercial crowdfunded real estate (CRE) has recently gained popularity. Yet many developers do not grasp crowdfunded real estate dynamics. If you’re used to more traditional ways of investing in real estate assets, your expectations may need to shift.

With that in mind, here is a summary of what you need to know in order to evaluate CRE deals.

Pros and disadvantages of crowdfunded real estate deal

If you’re new to this type of investment, it ‘s important to understand the pros and cons of crowdfunding for real estate before assessing any deals.

The big advantages of real estate crowdfunding have made it ever more popular as a way to invest in real estate. Here are some of the advantages:

  • Crowdfunding allows you access to assets you would otherwise not be able to take part in. Most people lack the time, knowledge, or financial flexibility to purchase, renovate, and sell a hotel at a higher price. Crowdfunding lets you take part in such opportunities.
  • Other passive investments in real estate, like REITs, don’t let you invest in individual properties. Crowdfunding transactions do.
  • There is much money to be spent on good crowdfunding deals. CrowdStreet lists its completed investments at the time of this writing and the lowest internal return rate of over a dozen realized investment results is 13 percent. Returns nearer to an annualized 20 per cent are not uncommon. In contrast, the stock market produces annualized returns within the range of 9–10 per cent.
  • Crowdfunded immovable property will help diversify your portfolio. Real estate β€” especially the types of projects that are often funded through CRE platforms β€” is not closely associated with the stock market. So while maintaining a portfolio with high potential returns, it is a great way to diversify.

On the other hand, there are certain inconveniences to be aware of:

  • Crowdfunded real-estate deals can be far more risky than investing in REITs, stocks or other investment types. Most crowdfunded real estate deals are sponsored by one asset, and most strategies involve execution risk. For example, if a CRE deal is to renovate an office building and rent it up to 90% occupancy, a lot of things need to happen.
  • CRE deals are not cash investments. You can’t sell your stake easily to someone else in a CRE deal, and most deals have time frames ranging from 3 to 7 years. Some may even be longer. Do not consider a CRE deal unless you are prepared for years to tie that money up.
  • There is no guarantee that they will complete a CRE project on time. If a deal is planning to renovate and sell a hotel in three years, and the economy is in recession, waiting longer to sell may make sense.

How risky is project and type of property?

As with most investment classes, the amount of risk involved in crowdfunded real estate deals varies. Before you dive into the numbers, it is important to get a feel for the risk.

Here are a few questions:

  • How much execution risk does the project involve? Ground-up development is more risky than completing a moderate-scale renovation of a new property. The project’s complexity is an important factor and it’s important to be sure the potential for reward justifies the risk.
  • What type of property is economically sensitive? Many forms of commercial real estate are cyclical while others are immune to recession. Occupancy and revenue of a hotel, for example, will likely drop significantly during tough economic times. The office building has long leases and therefore won’t get hit as hard.
  • Is it already occupied, or is the target return of the project assuming it will be leased up? A commercial property mostly full of tenants is less risky than one with high vacancies.

What kind of investment does the deal represent?

There are three main types of crowdfunding investments you can make from the perspective of a capital structure. In the next section we will be getting more into capital structures. Let’s go over the three main ways that you can invest in commercial real estate deals right now.

Shared Equity

Common equity is probably what you think of when you hear the phrase “investing in real estate.” Common equity holders own an interest in the profits of the property. For instance, if you contribute 1 per cent of the common equity to a CRE deal and it generates a net profit of $1 million, you are entitled to a profit share of $10,000.

Although common equity has the highest potential for return, it is also the most risky of all three types of investments. There is no guaranteed return and the return on investment depends on how well the property is performing.

Investing in Debt

Many crowdfunding deals provide the capability to make an investment in debt. You are essentially acting as the mortgage lender for the deal in this investment. You provide some of the project financing and get regular, predetermined interest payments. This is the least risky way to engage in crowdfunded real estate deals but it also has the least potential for reward.

Debt can also be distinguished according to seniority. For instance, a deal could list both “senior debt” and “subordinate debt.” In the event of bankruptcy, the senior debt will be paid first and has priority when it comes to claims on the business’ assets.

How to assess crowdfunding investment in real estate
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But there’s something like excessive debt, so be sure to see how debt-reliant a given deal is.

You will see the information as part of the “capital stack” in most CRE articles. For example, you can see a capital stack the looks like this:

CAPITAL TYPEAmountPercent of Total
SPONSOR CO-INVESTMENT$1,000,00010%
INVESTOR EQUITY$3,000,00030%
SENIOR DEBT$6,000,00060%
TOTAL$10,000,000100%

Besides the ones in the table, there may be other forms of money. For example , in addition to investor equity and senior debt, many deals use preferred equities or other forms of non-senior debt.

There’s no specific cutoff on how much debt is excessive. Generally speaking, I like to see debt representing no more than 70 per cent of the total capital stack. Be sure to consider if the potential return justifies the level of debt that the project takes on.

Take the crowdfunding platform

A crowdfunding deal involves three parties: you (the investor), the sponsor and the crowdfunding platform for immovable property.

The platform is a middleman among investors and sponsors of the deal. Dealing with a crowdfunding platform:

  • Vetting every deal it sends out,
  • Investor Commercial Transactions,
  • Collecting investment capital, and
  • Regulatory matters relating to deals.

Any crowdfunded real estate opportunity has a lot to do with the investment merits (or lack thereof) of the platform it is advertised on.

Is the deal offered by a reputable platform with a successful trading history? The crowdfunding of real estate is still in its early days, so even the largest CRE platforms do not have a ton of data on previous deals. It usually takes 5–7 years before the return of a given deal can be quantified.

That said, there are several well-established and reputable crowdfunding platforms for real estate that get an idea of how their deals have been performed. As of 2014, CrowdStreet, one of the largest CRE platforms, has offered 309 deals. As of June 2019, only 14 were exited, and returns were reported.

Lack of performance data represents an obstacle to a thorough analysis. You can however look at how closely a specific platform scrutinizes the deals it advertises. Does the platform accept a large percentage or a tiny fraction of the deals it reviews?

How much sponsor experience does he have?

The sponsor is the firm planning to execute the actual investment strategy. The experience of the sponsor is important when assessing a possibility of crowdfunded real estate. The sponsor negotiates the price of the purchase, hires contractors and oversees daily operations.

Crowdfunded real estate transactions can be major businesses. So it is important to see how much the sponsor has experience with similar deals. What is their track record for finished projects?

Most sponsors with much experience will be keen to show it. Failure to locate a sponsor’s biography or a link to their website is a red flag.

Has that sponsor skin in the game?

In CRE deals, the sponsor is always contributing some of the equity required to fund the deal. But there is a huge difference between a sponsor contributing 5% of the capital to an agreement and a sponsor contributing 30%. The most popular range seems to be 10–25 per cent.

This is referred to as the co-investment sponsor and, given that all other factors are equal, the better. I’m not saying a sponsor should have to invest a lot of money to make me want a offer. But keep in mind that the more money a sponsor wants to put in, the more motivated they will be to ensure that the project proceeds as intended.

How big are the fees?

Sponsors are paid for on two main ways.

Second, usually there is a fee for the purchase until the transaction is signed. If a CRE deal plans to buy a hotel for $10 million and there is an acquisition fee of 1.5 percent, the sponsor will receive $150,000 once the purchase is finalized. Acquisition fees are common in the range of 1–2 per cent. Anything higher could be a bit excessive though it should take into account the complexity of the deal.

Also, a sponsor can make money by taking a cut of the profits from the deal. This typically only occurs after investors first get a certain amount of profit. Unless a deal yields a return over a base amount (known as the preferred return), the sponsor is not paid.

As is known, sponsor return generally kicks in after investors have received an annualized return of 6–10 per cent. A common split percentage for sponsors is receiving 25–30 per cent of profits after the preferred return has been met.

Many deals have sponsor returns escalating as profits climb. I prefer this structure, because it encourages the sponsor to generate superior returns. So might a profit-split structure look like this:

  • 7% preferred return, and the first 7% of the annualized return on investment is paid to investors who have contributed equity financing.
  • 80 per cent of profits go to investors from 7–15 per cent of annualized returns and 20 per cent goes to the sponsor.
  • 70 percent goes to investors from 15–20 percent, and 30 percent goes to the sponsor.
  • If any aspect of the annualized return reaches 20 per cent, the sponsor will earn 40 per cent of that portion.

It can be a lot of money to sponsor returns of 20 per cent or more. But this type of structure really encourages sponsors to deliver on behalf of their investors. You don’t want to see a structure that splits excessive profit, but don’t run away from a deal just because sponsors get a big cut in profits.

What is and is it acceptable, the expected internal rate of return ( IRR)?

Typically crowdfunded real estate deals publish a targeted internal rate of return. Complicated are the equations involved in measuring IRR. The best way to think about IRR is through an investment’s total return, measured on an annualized basis.

CRE deals have different structures for the returns. Some have substantial annual bonuses, for example, while others pay a big lump-sum fee when the property is sold. In an apples-to-apples way, the IRR can help to compare one deal to another.

Second , make sure that the IRR for the project is attainable. Anything targeted IRR between 12 percent and 18 percent is common for CRE deals. If a project advertises a far higher IRR, this may be a red flag.

In addition, compare IRR and overall project risk with others of a similar nature. Don’t compare the targeted IRR of a hotel renovation project with the development of office buildings. Comparing the returns of two hotel renovation projects and other factors can help you select the better opportunity.

How is the deal going to make you money, and is it meeting your needs?

There are two main ways that crowdfunded real estate deals can make money: rental income and the eventual property sales.

Most CRE deals regularly allocate the revenue to investors. In other words, the net rental income collected is typically distributed proportionally to investors if the sponsor acquires an apartment complex.

But not all deals forthwith distribute income. If the investment includes constructing a new shopping center, it will take some time to complete the construction and occupy enough space to make a profit.

The other way a CRE deal can make money for investors is by selling the real estate asset to a profit. When a CRE deal acquires a property for a total of $12 million, including maintenance costs, and sells it three years later for $15 million, investors get a share in profit.

Both ways can be great sources of profit, but the deal needs to be meaningful to you. If you rely on your income investment portfolio, CRE deals which will not generate cash distributions until the third year are probably not the best choice for you. An arrangement that targets 8 per cent annual cash dividends and a fairly small profit on the property’s sale can make an income-seeker more sense.

Thought of the big picture

For crowdfunded real estate deals there are not many set-in-stone analytical rules. There’s no set IRR to look for, no specific level of debt that’s too much, and no specific amount of co-investment sponsor that you need to search for.

Take all of these considerations together to form an overall image of the investment value of a contract. Using this broad picture along with your investment goals and risk appetite to determine if a offer is a good investment for you. It takes time to assess deals correctly. The best advice I can provide is to read as many real-world CRE offers as possible on the main websites, before agreeing to contribute the money to an agreement.

Crowdfunded returns on real estate can be a great way to boost your portfolio revenues and returns. Just make sure that you do your research first.

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