Following the Great Recession of 2008 and subsequent finance industry regulations, emerging companies were left with little or no access to the capital markets. The Jumpstart Our Business Startups Act (JOBS Act for short) was conceived by Congress to help fix this problem by broadening who can invest in startups. Owing perhaps to its appealing acronym, the legislation passed with bipartisan support. Individual investors can now access private investment opportunities more easily than at any time since the Securities Act of 1933. Before long, innovative companies began using the changes brought on by the JOBS Act to open other investments to individual investors. Real estate has proven to be a natural fit for the new rules. While large commercial real estate projects were previously funded almost exclusively by professional investors and the very well-connected, real estate companies can offer access to their projects to a much broader set of investors, in much smaller increments. With potential returns that exceed average historical stock market and REIT performance, this shift offer tremendous opportunity for forward-looking investors. As with any new investment vehicle, investors are best served by moving cautiously. More on that shortly.
How Real Estate Crowdfunding Impacts CRE Finance
The new paradigm affords real estate firms a new channel for raising capital, allowing them to broaden their network of investors and, in many cases, raise capital more efficiently and at lower cost. For real estate firms looking to quickly fill a relatively small portion of equity capital, real estate crowdfunding platforms can provide a flexible means of rounding out financing. In other cases, a real estate crowdfunding platform may be able to ‘pare back’ the real estate firm’s equity position in a deal, or pare back a private lender’s loan issued to a real estate Sponsor, effectively “syndicating” the investment to the crowdfunding platform’s investor network. In either case, the real estate firm is able to recoup some capital.
Not every commercial real estate transaction is a good fit for crowdfunding, however. Crowdfunding platforms acting judiciously on behalf of their investor network will never raise capital for real estate firms with no track record (in other words, for real estate firms that can’t raise capital elsewhere). Some real estate firms may be operating with too much confidentiality sensitivity to have their transaction marketed via a crowdfunding platform.
For those real estate firms that are able to make effective use of real estate crowdfunding, the new paradigm will allow them to do more business and realize greater overall returns over time. For the commercial real estate industry more broadly, real estate crowdfunding should allow for a greater volume of aggregate transactions to occur in the long run.
What Real Estate Crowdfunding Means for Individual Investors
For investors, there is reason for both optimism and caution. On the one hand, the advent of real estate “crowdfunding” brings unprecedented access, diversification options and far greater ability to self-direct real estate investment decisions. On the other hand, the attractive yields in real estate carry attendant risk, and not all of these platforms have the experience behind them necessary to evaluate these risks (or even claim to). As of Q2, 2017, economic indicators remain strong, with nationwide unemployment falling to its lowest rate since before the Great Recession. However, political volatility and uncertainty have begun to temper investor optimism, as many – including Fed Chairperson Janet Yellen² – have expressed concern over frothiness in commercial real estate markets. How well real estate investing platforms weather a market correction, and to what extent they can continue finding attractive risk-adjusted returns for investors across market cycles, will be huge storylines as the industry matures over the coming months and years.
While the method of investment is new, the foundation of sound investing remains the same – experience, analysis and clear and open communication remain essential. Here are some key factors we believe everyone should consider when getting started in crowdfunded real estate investing and evaluating platforms:
This is the best place to start but, in some ways, the hardest thing to evaluate. What is the experience level of the team? While these new companies will tend toward younger leadership across the board, all successful platforms will have a requisite level of real estate expertise, legal acumen and technological experience, as well as a strong network within the broader real estate industry. The team behind your platform of choice does not need to be old, and it does not need to be large, but it should reflect real experience and a broad set of skills.
Over the past couple years, the track record of companies since inception has grown in importance (as opposed to the career track records of founding members). Some companies have flagged or closed their doors entirely, while others continue to build on early successes and present quality deal flow to investors, improving their product along the way. You can find details on our track record in this recorded Quarterly Update Webinar with CEO Charles Clinton
Deal Diligence & Transparency
As always in real estate, due diligence and transparency are paramount. Is the platform pre-vetting each deal or posting everything that comes their way? Is there enough information being provided for you to properly evaluate each investment? If there are gaps, are there knowledgeable people available to answer questions? Is the platform soliciting your feedback and evolving to meet your needs? Your relationship with your real estate investment platform should be a two-way street. Again, communication is key – a platform should be willing and able to lay bare all key attributes of the deals they present.
Platform Backing & Pricing
These are long term investments, will the platform be around years down the road? Keep in mind that, should a platform go under, your investments could be in peril. Many nascent platforms are not positioned for long-term survival – lacking robust funding, the backing of an established real estate company with a longer operational track record, or both. Also consider how the platform makes money. There is no standardized pricing model in the industry, with some platforms imposing a burdensome fee load and others claiming no fees at all. When it comes to the world of investing, the best pricing model is the one that aligns incentives correctly – ideally, the platform will only make money when investors make money.
Sponsors and Lenders
What is the experience of the real estate company behind the deal? If the company is relatively new, do the principles have the necessary experience? Take a look at past transactions carried out by the sponsor or inquire with the platform. With respect to the platform, make sure they have strong sponsor relationships and established standards for vetting sponsor partners. Also ensure that the platform provides a channel for communicating with the sponsor.
Ultimately, you as an investor need to know who you’re investing with. Any opacity around the background of a sponsor or lender, and the details of their business plan, should be regarded as a red flag.
Risk vs Reward of Deal
This balance depends on a variety of factors that vary by deal – location, type of project, hold period, deal structure, leverage, assumptions made in underwriting, and a variety of other factors that deserve their own article. Platforms that aggressively trumpet sky-high returns on their deals should be viewed cautiously – you want to invest with platforms that operate realistically when it comes to presenting the risk and potential reward of offerings. Remember that the fundamentals of good investing don’t change just because it’s taking place on the internet.
With real estate markets in gateway cities potentially overheating, and the potential for prolonged inflation, it’s more critical than ever that platforms have a robust nationwide network to source deals in markets that project attractive risk-adjusted returns amid volatility at the national level.
Diversification & Investment Minimums
The best platforms will enable investors to easily create a diversified portfolio of real estate investment, much like E*Trade did in the 1990s. This means that investment minimums should be low and there should be a range of projects across asset classes to invest in. As of this writing, more than five years since the JOBS Act was signed, distinct models have emerged among platforms with respect to the kinds of investments offered to individuals (our CEO spoke with Marketwatch on this topic), and investment minimums run the gamut from as little as $1,000 to $50,000 or more. Among those platforms offering relatively small investment minimums, there’s more opportunity for diversification by the day. However, investment platforms vary in quality, per the criteria above.
Real estate crowdfunding has earned more and more attention from mainstream press and the investing community, and has grown steadily year-over-year since inception. Still, the industry remains tiny as a share of the overall U.S. commercial real estate market, representing less than 5% of annual transactions. As such, real estate crowdfunding represents more than a passing fad; there is plenty of room to grow for those platforms who do proper diligence on real estate companies looking to raise capital, and who provide proper risk disclosures and transparency to prospective investors.
In the long run, surviving platforms will harness the wisdom of crowds to create a broad private market for real estate investing and finance that’s more efficient, whereby capital is better and more quickly allocated to markets and developers that need it with less red tape.
The JOBS Act has ushered in a new era of greater access for individual investors. The fundamentals of real estate investing have not changed, though: it is an inherently risky practice that demands careful diligence on the part of not just real estate crowdfunding platforms, but also their constituent investors.