Think investing in real estate is only for the ultra-rich? Think again. The rise of crowdsourced real estate financing allows more accredited investors to become real estate investors than ever before.
What is real estate crowdfunding?
Real estate crowdfunding is an investment by a large group of people who provide monetary contributions toward a specific piece of property or real estate fund. It is an industry that is growing rapidly due to advances in financial technology and federal legislation.
Crowdfunded real estate, simply put, is an extension of crowdfunding, which has been on the rise for the last decade. Many people are likely to be familiar with donation-based crowdfunding, made popular by websites such as GoFundMe or Kickstarter.
How does real estate crowdfunding differ from donation-based crowdfunding?
Financing a real estate project through crowdfunding is slightly different than donation-based crowdfunding. With donation-based crowdfunding, individuals are contributing to a cause they believe in without seeking anything in return.
When an investor puts funds into real estate crowdfunding, on the other hand, they expect a monetary return on their investment (even though there is no guarantee that they will receive a profit). Depending on the structure of the real-estate investment offering, real estate crowdfunding can either be grouped under the category of equity crowdfunding or debt crowdfunding. The primary difference between equity crowdfunding and debt crowdfunding is the type of financial security that you are investing in.
Equity crowdfunding is somewhat similar to purchasing stock in a company because the investor puts money into the fund to gain ownership in the real estate investment. If the real estate investment does well enough, investors may receive a portion of the investment’s profits. CrowdStreet and RealtyMogul are examples of equity crowdfunding platforms.
Debt crowdfunding, also known as peer-to-peer lending or loan-based lending, is when the investor essentially acts as a traditional lender and provides the owner of the property with the necessary funds at an agreed-upon interest rate. Patch of Land and PeerStreet are both examples of debt crowdfunding platforms. The interest rate is typically less than what a bank would charge, and investors benefit from the capital and interest repayments on their portion of the loan contribution.
There are some platforms, such as Fundrise, that offer both debt and equity crowdfunding options.
How did real estate crowdfunding begin?
Ten years ago, the ability to crowdsource real estate funding was rare. The Securities and Exchange Commission (SEC) had regulations in place that set a high bar designating who could be equity investors. However, all of that changed in 2012, when Congress passed bipartisan legislation called the Jumpstart Our Business Startups (JOBS) Act.
The last section to be implemented by the SEC was Title II of the JOBS Act, which allowed crowdfunding platforms to publicly solicit investments, and came into play in May of 2016. In the years that followed, real estate crowdfunding became far better-known and more popular among investors.
The JOBS Act changed the crowdfunding game. Specifically, it made it legal to raise capital for new businesses online. The details on how equity and debt crowdfunding are used is detailed on the SEC's website. In summary, there are limits to how much an individual can invest (depending on their income), who can qualify as an investor, the types of businesses that can use crowdfunding, and how much capital can be raised through crowdfunding. Image source: Getty Images.
How crowdfunding works for real estate
Let's say there is a vacant piece of land in an urban neighborhood with strong development potential. A real estate development company decides to use the property for a new mixed-use development. The development company has several options to raise the money needed to turn this vacant land into a place where people want to live, such as real estate crowdfunding.
Through real estate crowdfunding, the developer can utilize an online platform that enables a large group of people to invest small dollar amounts in the project. If the development company chooses to follow the crowdfunding option, here's how that could work:
- First, the developer identifies an online platform that is suited to the company or mixed-use development. Each platform is different and most real estate crowdfunding sites receive significantly more project applications than they select.
- If the investment passes all the legal, physical, and financial due diligence requirements the platform requires, that platform will then allow the developer to solicit funds using their site.
- An investor can then use that platform to contribute financially to the development.
- The funds are then tied up until the investor delivers on the project.
The amount an investor can contribute to a crowdfunded project will vary depending on their annual income and the real estate crowdfunding platform’s minimum investment amount.
What if someone wants to get involved but there isn't a specific real estate project they want to invest in? Real estate crowdfunding platforms have established their own real estate investment trusts (REITs) known as eREITs. An eREIT allows individuals to invest in a fund with a designee who makes the decisions on which properties to invest. One thing to note, though, is that eREITs are not the same as publicly traded REITs and may have investment minimums and required holding periods.
Crowdfunded real estate has changed the game by creating more opportunities, both for real estate investors and for those looking to secure funding.
The real estate crowdfunding market is still new and not without its limitations. While the SEC's tight regulations are designed to protect individuals, these can still be relatively risky investments that are highly illiquid. The JOBS Act and resulting regulations also restrict the amount of money that can be raised through real estate crowdfunding. Often, this is not enough capital to finance the entire real estate development.
With that being said, the advent of crowdfunding is democratizing real estate investments, and supportive federal legislation has enabled the industry's fast growth.