What is Real Estate Crowdfunding?
Learn how to build wealth and earn passive income in real estate while someone else does all the work.
Whenever the economy is experiencing a tumultuous period, as it has been recently, investors typically look for ways to diversify their portfolios. This has led to a renewed interest in REITs and real estate crowdfunding. Both are ways to invest in commercial real estate without owning a property outright, which appeals to novice and experienced investors alike.
Yet while there are certainly similarities between REITs and real estate crowdfunding, there are some key differences for investors to consider. In this article, we take a look at both ways of investing, including the pros and cons of each. We wrap up with an analysis of how investors can determine which strategy is best for them.
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What is a REIT?
A REIT, which stands for “real estate investment trust,” is a corporation that owns and/or manages income-producing commercial real estate. There are many types of REITs. Most will focus on a specific product type (e.g., retail, hospitality, multifamily housing, senior living facilities, student housing, office, self-storage, industrial and the like) or geography (e.g., commercial real estate in the Northeast vs. Southwest).
When an individual buys a REIT share, they are purchasing a share of the company that owns and manages the rental property. They are not investing in an actual property. Consider a REIT share like purchasing an Apple stock: when you buy a share of Apple stock, you are buying an ownership stake in Apple – not one of Apple’s specific products. The same concept applies to REITs.
How Does a REIT Work?
REITs typically have well-defined investment parameters. They then invest in real estate that meets those parameters. By law, REITs are required to return 90% of profits to investors in the form of dividends.
Because they are immediately tradable and hence almost perfectly liquid assets, the value of REITs can go up and down throughout the day, just as you’d expect with traditional stocks. REITs are therefore subject to broader swings in market activity. If the stock market plummets, the value of a REIT might follow suit – even if there has been no substantial change to the REIT’s investment portfolio.
REITs are generally valued based on a few key criteria, including: anticipated growth in earnings per share, anticipated total return from the stock, its dividend yields relative to other investment alternatives, dividend payout ratios, management quality, and the underlying value of their assets under management.
Investing in REITs
Unlike traditional real estate, many REITs are publicly traded on the stock exchange. This provides tremendous liquidity for individual investors who may want to maintain flexibility to purchase or sell shares at any time. This is also means that the bar is low for investment; the average investor can purchase as few as one or two REIT shares – making the initial capital contribution much lower than one would expect when investing in real estate directly, or through other vehicles like real estate crowdfunding.
REITs that are listed on the major stock exchanges can be purchased directly, just as you would purchase any other stock or security. REIT shares can also be purchased through a REIT mutual fund or exchange-traded fund (ETF).
Some REITs are privately traded. They are not registered with the SEC and are only available to select investors. Typically, only institutional investors have access to privately traded REITs.
REIT Pros and Cons
One benefit to investing in REITs is that shares can be purchased or sold with the click of a button. This is particularly true with publicly-traded REITs, which account for the majority of REITs available on the marketplace.
- Diversity of Assets
A REIT has dozens, if not hundreds and thousands, of properties under management. This means the viability of the portfolio is not contingent upon the success of one individual asset, which is the case when investing directly in a single property.
- Accessibility to Everyone
Most REITs can be purchased as easily as a stock. This lowers the barriers to ownership and makes REIT shares accessible to everyone; if you can buy stocks, you can buy into a REIT.
- Limited Exposure
Someone who is looking to add real estate to their portfolio can do so by investing in a REIT with very limited exposure. The alternatives, which include direct ownership, can carry much more risk than investing in a REIT. As such, buying REIT shares is a particularly good choice for risk-adverse investors.
- Strength of Management
REITs are typically professionally managed by people who have decades of experience in the commercial real estate industry. Management is generally held accountable by a board of directors. As such, REITs will often bounce back quickly after recessions given their adept leadership and management experience.
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- Lack of Transparency
One downfall of investing in REITs is that the individual investor generally has very little knowledge about how their money will be spent. They don’t necessarily know where or when the REIT will be investing in a property. Instead, the investor is banking on the REIT making wise investment choices that align with the predefined investment parameters. Moreover, it can be difficult for an investor to discern how an individual property is performing as part of the REIT’s larger portfolio or asset allocation.
- Limited Control
Unlike direct ownership of commercial real estate, someone who invests in a REIT has very limited control (if any) in how funds will be invested. For example, an investor will have no say in whether a property is renovated, refinanced or ultimately sold.
- Subject to Market Fluctuations
Just as the prices of traditional stocks rise and fall throughout the day, so do REIT shares. REITs are subject to market fluctuations, much more so than the value of an individual commercial property. The value of individual assets typically does not have a strong correlation with stock market performance, whereas REITs do – at least to some degree.
- Liquidity Premium
Real estate is inherently illiquid. If you want to buy and sell real estate, there is typically a lengthy period of time, often measured in months, during which a transaction will occur. Preparing a building for sale, advertising, finding bidders, negotiating contracts, due diligence and closings all add to the time illiquidity of real estate. By creating an instrument by which such an illiquid asset can be traded with such ease, investors are said to pay a ‘liquidity premium’ when they invest in REITs. This is a cost they incur above the value of the underlying asset that provides them with the benefit of liquidity for an illiquid asset.
What is Crowdfunding?
Crowdfunding has made a splash over the last several years, particularly since 2012 when the federal JOBS Act loosened the regulations for how people can raise capital for commercial real estate deals. Whereas project sponsors once needed to have a personal relationship with those who invested in their deals, now, sponsors could engage in what is called “general solicitation.” This is what led to the emergence of real estate crowdfunding platforms like RealCrowd, Crowdstreet, Fundrise and RealtyMogul among others, and to the direct crowdfunding of their deals by many sponsors, like Trion Properties, Feldman Equities, Origin Investments and others.
In short, real estate crowdfunding is when a project sponsor (usually a real estate corporation or LLC) pools capital from many dozens, if not hundreds of investors to invest in their deals.
How Does Real Estate Crowdfunding Work?
There are many rules and regulations that govern real estate crowdfunding. A project sponsor will first have to determine which rules they want to crowdfund under—i.e. which of those that allow for general solicitation and require investors to be accredited and/or “sophisticated,” or those that permit non-accredited investors to participate also. This will influence how their crowdfunding campaign is structured and marketed to the public.
Once this has been established, a sponsor will may post their deal on a crowdfunding platform like Crowdstreet or RealtyMogul or the like, as a means of gaining exposure to investors from all over the world, or they may post directly to investors from their own website – or they may adopt a combination of the two. In any event, the deal specifics will include general information about the deal, projected returns, investment horizon, and a call to action that encourages people to invest today. There are usual minimum investment thresholds that must be met for an individual to invest.
It’s worth noting that crowdfunding can be used to raise both debt and equity for real estate deals, though the latter is certainly the most common.
Crowdfunding Pros and Cons
- Direct Ownership
Investing via real estate crowdfunding is a great way for someone to hold an ownership stake in a piece of commercial property that they would be unable to own on their own. For example, crowdfunding can open the doors to owning a piece of a downtown office building – an asset that few individuals would be able to own outright on their own due to either scale, accessibility to such opportunities, or ability to manage, absent of crowdfunding.
Unlike buying shares of a REIT which then invests in an array of properties, when investing with real estate crowdfunding, a person usually knows exactly what they are buying a share in – the actual property, its financials, the business plan for producing anticipated returns, and more.
- Minimum Investment
Although real estate crowdfunding can have minimum investments of at least $50,000 or more, there are some platforms that allow people to invest with less (as little as $100, even). In all cases, this is substantially less than what would be needed for capital when buying the kind of property offered via crowdfunding independently.
- Potential for High Returns
In order to appeal to everyone, real estate crowdfunding usually requires projects to have attractive returns. Some sponsors utilize crowdfunding to fill gaps in their capital stack, which in turn can result in generous profits for those who invest via crowdfunding.
- Low Correlation to Stock Market
Unlike REIT shares, which are subject to daily market fluctuations, the performance of individual commercial properties tends to have little correlation with the stock market. Commercial properties tend to lag any downturn in the economy, and often outperform other asset classes during a recession.
- The Illiquidity Premium
Unlike the liquidity premium in REITs that costs the investor more, the illiquidity premium for real estate crowdfunding is a measure of the additional benefits an investor receives from tying up their capital in an illiquid investment. By committing to a longer term investment than via a REIT that can be traded at the click of a button, investing in crowdfunded real estate provides investors the potential for substantial returns that no REIT can offer.
- Less Liquidity
The flip side to the illiquidity premium is, of course, that investors must accept that once they invest in a project, their money will likely be tied up for months or years before they can access it again. Most crowdfunding deals require investors to make a capital commitment of at least a year or more. Some require investors to commit to a three, five or even ten-year time horizon. This makes real estate crowdfunding inherently less liquid than investing in a REIT. That said, there are usually provisions to allow investors to exit crowdfunded deals early, even if doing so results in a penalty or fee.
- Management Expertise
Most REITs are well-established. Crowdfunded deals, on the other hand, can be launched by just about any real estate company. As such, the management expertise of the sponsor can sometimes be questionable. It is important for any investor to do their due diligence on the sponsor—particularly the sponsor’s expertise—prior to investing in a crowdfunded deal. Though this is true of REITs also, many REITs enjoy analyst coverage whereas there is no equivalent for real estate sponsor so the burden of due diligence is not facilitated by third party analysis as it can be by REITS.
- Greater Risk
By participating in individual projects, investors do not benefit from diversity but can end up with high concentrations in single assets that may be vulnerable to real estate market cycles. Any number of risks can negatively influence the success of individual projects. These can include market and construction risks, as well as underwriting and management risks. Like the illiquidity premium, however, these risks are, theoretically, offset by higher returns. However, in real estate a near miss on a project can as easily become a total loss for investors so with greater risk comes greater responsibility to conduct thorough due diligence on the project and the sponsor before investing, and not to invest anything more than you can comfortably afford to lose in its entirety.
REIT vs. Crowdfunding: What is the Difference?
REITs and real estate crowdfunding are similar in many ways. Both give investors the opportunity to diversify away from traditional stocks and bonds, while gaining exposure to the commercial real estate market – an asset class that has traditionally been hard to access without direct ownership (and therefore, a significant upfront capital outlay). Both also allow investors to benefit from the real estate’s cash flow and appreciation.
They are also similar in that they utilize the pooling of capital from a diverse range of investors in order to purchase property. However, investing in a REIT means you are investing in the corporation that invests in real estate whereas investing through real estate crowdfunding gives an ownership stake in the underlying collateral – an important distinction to be made.
Here are five other differences between REITs and real estate crowdfunding.
Difference #1: Liquidity
Because REITs can easily be purchase and sold, just like other stocks, they are inherently more liquid than investing through real estate crowdfunding. For example, an investor can purchase a REIT share in the morning and sell it that same afternoon, if they so choose. This is a benefit for those who need to preserve liquidity for any reason – e.g. to pay for college, to take a vacation, to purchase a new home, etc. REITs allow people to invest in real estate without worrying that their capital will be tied up for the long-term. For example, if someone would prefer direct ownership of commercial property but is struggling to find an appropriate deal, they can invest in a REIT in the meantime and then cash in those shares when another opportunity arises.
Real estate crowdfunding offers less liquidity. Investors are usually locked into a deal for a predefined period, usually 3-5 years but often longer. Most sponsors will have some mechanism for an early exit but doing so could carry penalties or fees.
Difference #2: Minimum Investment
There is no minimum investment when purchasing a REIT. Investors can buy a single REIT share for whatever the value of the REIT is trading for at that time. Some REITs trade for less than $20 per share, whereas others routinely trade for several hundreds of dollars – and there are many that fall somewhere in between. This creates a low bar for someone looking to invest in real estate via a REIT, who may not have the capital needed to invest in real estate crowdfunding or direct ownership.
Real estate crowdfunding is often a happy medium for those who are looking to invest at least $5,000. Although some platforms allow people to invest with as little as $100, most deals require a more substantial initial investment. Some sponsors even require a $25,000 or $100,000 minimum investment in their crowdfund syndicated deals. This is still significantly less than what someone would need to buy a commercial property outright, but more than would be needed to invest in a single REIT share.
Difference #3: Portfolio vs. Individual Asset
Let us start by saying REITs and real estate crowdfunding can each take many forms. What we are about to say is a generalization based on the majority of REITs and crowdfunded deals. When someone buys a REIT, they are buying shares in a corporation that owns a portfolio of properties. Therefore, the value of the REIT shares is not subject to the performance of an individual asset. This helps spread risk across the REIT’s portfolio.
Most (but not all) real estate crowdfunded deals are structured so that people are making an equity investment in a specific commercial property. For example, the sponsor might be crowdfunding capital for the repositioning of an outdated strip mall into a modern lifestyle center. The investors have much more knowledge about the individual project, but their investment is also subject to how that individual project performs. There is more concentrated risk.
That said, sometimes crowdfunding is used to pool capital for a portfolio of properties. Many of the crowdfunding marketplaces offer their own funds in which are held a portfolio of curated deals, and many sponsors also set up funds with which to invest in a multitude of properties in order to spread risk for investors.
Difference #4: Profit Sharing
REITs are required, by law, to return at least 90% of profits to their investors in the form of dividends. With real estate crowdfunding, profit sharing is less regulated. With the latter, it is up to the individual sponsor to identify projected returns – the preferred returns and waterfall splits etc. REITs may make regular distributions but in a crowdfunded real estate syndication, distributions to shareholders (investors) may not occur for years after inception.
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Difference #5: Management Experience
REITs tend to be professionally managed by people who have decades of experience in the commercial real estate industry. This provides an extra layer of protection for risk-adverse investors. They tend to have more transparent backgrounds and track records and, in many cases as mentioned above, attract the attention of third party, independent analysts whose research investors can examine as part of the investment evaluation process.
Management experience can vary widely in the real estate crowdfunding realm. While some project sponsors are equally as well qualified, there are many more who are inexperienced and trying to raise capital early in their careers. With real estate crowdfunding, it is critically important that investors do their own due diligence on the sponsor (and related—on the platform offering the deal) before investing. The success of a commercial real estate deal, or portfolio of properties, is heavily dependent upon the experience of those at the helm.
Seasoned, professional sponsor teams will have extensive educational materials about their investment philosophy, background and experience readily available online on their websites so investors can get to know them and their value proposition.
Which One Is Right For You?
Trying to decide whether to invest in a REIT or real estate crowdfunding? There is no right or wrong answer; as you’ve seen above, there are pros and cons to each and both can be a valuable addition to an investor’s portfolio.
That said, those who are risk-adverse and looking to preserve liquidity will want to opt for investing in a REIT. Those who are willing to take on slightly more risk, but perhaps earn higher returns as a result, might want to consider investing in real estate crowdfunding. How much a person has to invest will also influence their decision, as each has their own requirements for minimum investment depending on the REIT and crowdfunded deal, respectfully.
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Commercial real estate, once considered an “alternative” investment, has become mainstream. Opportunities that were once only available to institutional investors and other high-net-worth individuals are now making their way to everyone courtesy of REITs and crowdfunding. We expect this trend to continue as more people look for ways to diversify their investment portfolios.
There are many ways to invest in commercial real estate, though, including the two vehicles discussed here today. Moreover, there are even multiple ways to invest using these vehicles (e.g., through a mutual fund, ETF or self-directed IRA). Always consult your CPA, lawyer and/or financial advisor before investing in either REITs or real estate crowdfunding.
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