The 2012 Jumpstart Our Business Startups (JOBS) Act kicked off the current boom in real estate crowdfunding platforms. There are currently more than 100 of these services. Each has its own investing approach, fees, deals and reputation. And here at Investor Junkie, we review the cream of the crop.
However, in every single crowdfunding platform review we write, we give the same piece of crucial advice: Do your own due diligence before investing.
This advice applies to investing in anything. And it’s perhaps even more important when applied to real estate crowdfunding. That’s because the whole industry is new and untested.
So how exactly do you do this due diligence? What are the most important factors to evaluate?
Before You Begin
First things first. Before you start evaluating specific investment deals, you need to do some due diligence on the crowdfunding company itself.
Most sites will prominently display some data that indicates the company size, scope and success statistics. For example, Realty Mogul posts the following stats:
Realty Mogul is an easy-to-use real estate investment platform that, thanks to its private REITs, allows both accredited and non-accredited investors to take part in potentially lucrative opportunities.
- "Pre-vetted" Investments
- Simple Investment Process
- No Capital Calls
- Greater Control Than REITs
- Private REITs
- Accredited Investor
- Illiquid Investments
You can easily compare companies by this displayed data. But proper due diligence requires even more.
- What is the company’s investing niche and strategy? Do you feel comfortable with its chosen markets and approach?
- How long has it been in business?
- Does the platform post actual documents, such as title insurance and inspection reports, for you to download and study?
- How transparent is the company? Does it provide an accounting of past deals so you can see if it performed proper due diligence?
- How many defaults has it had, and is it transparent about why?
- What fees does it charge investors?
- How many of the deals that come to the company get funded? What due diligence does it do on each deal before posting it on the crowdfunding platform? What is the pre-vetting process? How does it qualify the sponsors it allows to post deals on the platform?
- Are the deals prefunded by the crowdfunding company? Does it have its own money in the deals? Does its client base include institutional investors?
- Do the founders and staff members have adequate real estate industry experience?
- With so many real estate crowdfunding startups since 2012, there will be some companies that don’t make it. What will happen to deals you’re involved with if the company goes into bankruptcy? Are your investments protected?
The answers to these questions will help you identify a handful of crowdfunding platforms on which you’d consider deals and eliminate the overwhelming task of combing through the offerings on 100-plus existing real estate crowdfunding sites.
Once you’ve selected the platforms on your “short list,” you’re ready to review the opportunities available. Each opportunity should provide all the information you need to do proper due diligence.
The 5 Things You Need to Know
Of course when comparing deals, you’ll want to make sure you’re comparing apples to apples. Equity deals are completely different from debt deals. Multi-family deals are different from single-family deals. Commercial deals are different from residential. Mezzanine-level debt is different from senior level. And so on.
To help you make sense of what you need to look for, we’ve compiled this list of five metrics to look at when screening a real estate crowdfunding deal. Keep in mind that this is not necessarily the be-all-and-end-all list of everything that you’ll want to take into consideration when comparing opportunities. But it should get you started on the right path.
#1: Local Market Demographics and Trends
In real estate investing, location is key. Each opportunity should include a market report that provides an unbiased look into the property’s location. Carefully examine this data down to neighborhood specifics.
I certainly have learned the importance of doing this firsthand. In Baltimore, where I invest, property data varies by block. A row of dilapidated, boarded-up townhouses selling for only $8,000 each will be just one block away from homes valued at $250,000 each. The importance of understanding the local market cannot be understated.
The market report provided on the crowdfunding platform should provide details on:
- The local rental market and rent comparables
- The demographics and size of the population, including whether it’s growing or shrinking
- The outlook for job growth and diversity of jobs in the area
- Local property tax rates
- Utility costs
- Property values
- School district rankings
- Crime statistics
- The projected number of units that are being built into the local pipeline
- And more.
Of course, you can — and should — verify that the market report is accurate with a quick Google search.
By its very nature, real estate is a long-term investment with high transaction costs. You can’t move a property to a better location. That’s why these factors need to be thoroughly investigated and evaluated before investing.
#2: Investment Term or Holding Period
Holding periods should be specifically projected for each deal. A holding period is the time that elapses between when you invest and when you’re repaid your investment plus stated earnings.
The average holding period for most crowdfunding platform deals is three to seven years. That means your investment funds will be tied up for that amount of time. You’ll receive your initial investment plus interest and/or equity sharing after the real estate sponsor sells or otherwise ends the deal.
You will find language like this in most deal documents: “The estimated investment holding period described herein is only a projection, and there can be no assurance when or if an investment may be liquidated.”
The point is to make sure you understand that you’re investing in an illiquid asset and that you should invest only money that you don’t need in the short term. Unlike stock investments, there is no secondary market to buy/sell/trade your interests in a real estate crowdfunding deal.
#3: Projected Pro Forma and Net Cash Flow
As an equity investor in a crowdfunding deal, you can expect distributions. The documents should tell you how much and when to expect payouts.
Typically, your payouts will come from positive cash flow. The cash flow will be the result of rental income, refinancing proceeds or income from the sale of the property. Real estate crowdfunding business plans show the expected schedule of income and expenses on a projected pro forma.
The bottom line is net cash flow. This is the difference between income and expense over a given period. You’ll be able to compare deals by reviewing the projected pro forma.
These are projections, so you need to consider the fact that expectations may not be met and make sure that income beyond projections is awarded to investors just as unforeseen expenses will be deducted.
#4: Internal Rate of Return and Cash-on-Cash Return Targets
The internal rate of return (IRR) is one of the most common metrics used in real estate crowdfunding and therefore one of the easiest to compare deal to deal. IRR is the annual rate of earnings on an investment and is typically expressed in a percent range (e.g., 13%–15%).
Here’s how it’s calculated. Let’s say you invest in a deal with $50,000 with a projected IRR of 15% per year and your holding period is three years:
|Year 1||$50,000 x 115% = $57,500|
|Year 2||$57,500 x 115% = $66,125|
|Year 3||$66,125 x 115% = $76,044|
The IRR is a gross number. What’s more important is the projected return typically shown as a “cash on cash” annualized percentage. This is the target investor return, net of fees and expenses. From what I’ve seen posted across many real estate crowdfunding sites, this number is typically around 8%. The higher the projected IRR or cash on cash, the riskier the deal.
One caveat you’ll find on most sites is something like this: “An investment involves a high degree of risk including fluctuating values of real property, lack of liquidity, environmental concerns, legal and regulatory risks, and other risks.”
#5: Equity Multiple
Another metric to use when you compare one deal to another is equity multiple (EM). The equity multiple is a ratio of your returns to paid-in capital.
The calculation is:
Cumulative Distributed Returns / Paid-In Capital = Equity Multiple
So if you invest $50,000 into a deal and earn a net profit of $20,000, your equity multiple is 1.4x, calculated as:
$50,000 + $20,000/$50,000 = 1.4x
Like IRR, the higher the equity multiple, the greater the projected return on your initial investment and the greater the potential risk.
Other Things to Consider
There are also other criteria to consider and compare across deals, including:
- Whether or not capital calls might be required. These are when investors are asked to contribute more during the holding period for an unforeseen expense or need.
- What the expected exit cap rate is.
- How much the management and administrative fees are.
- The terms of debt financing.
Real estate crowdfunding requires more due diligence than investing on a consumer loan (where every investment comes with a risk rating). There are no standardized risk ratings. You will likely need an hour or more to review the documents of just one deal.
To compare deals and uncover the best opportunity for you personally, you need to roll up your sleeves.
One real estate crowdfunding expert, Ian Ippolito, suggests that you need at least 100-plus properties to diversify your portfolio against geographic, regional, tenant and property risk.
That means you need a lot of capital if you want to invest responsibly. Many sites require a $5,000 minimum investment in each deal. This means you need $500,000 of cash to diversify into 100 properties.
You shouldn’t put all your investment funds into one sector, though — not even real estate. (Experts I’ve read suggest that real estate investments should make up no more than 10%–25% of your total investment portfolio.) So you’d really need much more than $500,000 of investable assets to properly mitigate your risk.
Recently, a few sites — including Fundrise — have lowered their minimums to $500. Groundfloor offers access to some deals with just $100. Ippolito believes this trend toward lower minimum investments will continue. And for crowdfunding to gain the momentum required to sustain the industry, it needs to.
Risk and the need for substantial capital to properly diversify are two of the reasons that only accredited investors (individuals with at least $1 million in assets or income over $200,000 a year in the last two years) are allowed to invest on most of the crowdfunding sites.
Fundrise lets non-accredited investors take advantage of real estate investments with a low required minimum and attractively low fees. However, publicly traded REITs might be a safer option for your investment bucks.
- Low Minimum
- Low Fees
- No Accreditation
- 90-Day Guarantee
- Commercial Real Estate Access
- Passive Investment
- Quarterly Redemptions and Distributions
- Investment Liquidity
- Tax Consequences
If you don’t already have a real estate background, investing via crowdfunding requires a lot of time and effort to educate yourself. There are many different types of investments, each with unique advantages and pitfalls. If you don’t fully understand each investment, you could easily lose a lot of money.
For these reasons, conservative experts consider real estate crowdfunding investing to be speculative. This means you should invest only what you’re willing to lose and no more.