The Jumpstart Our Business Startups Act, or JOBS Act, which was passed by Congress in 2012, eased several of the country's security regulations affecting investors.
Intended to encourage small-business funding, the law provided opportunities for the general public to participate in the early capital-raising activities of start-up and early-stage companies.
The Act, adopted by the Securities and Exchange Commission (SEC), paved the way for the launch of a completely new industry: real estate crowdfunding. Crowdfunding generally refers to a financing method in which money is raised through soliciting relatively small individual contributions from a large number of people.
Applied to real estate, crowdfunding was a game changer.
More opportunities for developers seeking funding
Prior to the passage of the Act, government regulations restricted private investments from being marketed publicly. Start-up companies had to privately solicit funds through networking and relationship building with interested investors. As a result, real estate developers typically raised funds for their projects by seeking large investments from a small number of private sources.
When the Act passed, every real estate company was allowed to market properties and their own projects to new investors. Crowdfunding platforms, created by technology specialists and real estate entrepreneurs, became the ideal mechanism for developers to get their deals exposed and funded by a huge population of online real estate investors. Essentially, the real estate crowdfunding platforms provided a new source of funding by making it easy for these companies to publicly solicit smaller investments from many individual investors.
Online technology platforms created their own marketplace where real estate developers and project sponsors can post their deals and individual investors can easily invest a smaller amount as part of the crowd. Over a hundred crowdfunding companies have since sprung up.
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.
More opportunities and advantages for individual investors
As you might imagine, prior to the passage of the Act that removed the marketing and advertising restrictions, many of the best investments were only available to the wealthiest and most well-connected investors. You had to know someone to be introduced to an insider opportunity. And, you had to personally investigate the opportunity thoroughly, without the benefit of readily available documents for your due diligence, before investing.
Readily accessible information
Real estate crowdfunding companies provide platforms where everyday investors can access these types of deals in a real-time marketplace. While you still need to do your own due diligence, the platforms provide ready access to detailed deal information, educational materials about real estate investing in general, and forum conversations. Many of the crowdfunding companies even pre-vet both the deals and the deal sponsors, providing extensive due diligence documents online for investors to review at their leisure.
In fact, comments by -- and conversations with -- members of the crowd are considered to be an integral part of crowdfunding. Broker-dealers and funding portals are required to have communication channels, such as an online forum, available for each particular investment opportunity. The crowd of investors can weigh in on the pros and cons of the deal and ask questions of each other, company management, and the deal sponsors themselves. A person who represents the company or the sponsor and comments must identify themselves, allowing complete transparency to the public.
Prior to the passage of the Act, it was very difficult to diversify one's real estate portfolio of deals. Private deals required a sizable investment from each participant. With crowdfunding, real estate investors have the ability to diversify with a plethora of investments to choose from and the crowdfunding component provides the opportunity to invest small minimums.
An argument can be made that crowdfunding helps investors reduce overall risk by allowing them to spread the risk over many investments and share that risk with other investors. For example, Lending Club allows hundreds of investors to share in the financing of one loan. An investor can invest just $25 in one loan, and the risk of default is spread over thousands of consumers, rather than just one. Investing $25 in 200 loans means the risk of losing money becomes infinitesimally smaller. In fact, Lending Club reports that no person with 200 notes has ever lost money in the history of the site.
Should you invest with crowdfunding?
Now anyone can technically invest in a crowdfunding offering, although the SEC places limitations on how much you can invest. The limitation depends on your net worth and annual income -- many of the real estate crowdfunding sites require that you verify you're an accredited investor before you can invest.
Of course, just because you can doesn't mean you should. These former regulations were put in place to protect less sophisticated investors from risks involved in more speculative investments, such as start-up businesses and more complicated investments like certain real estate development projects.
On most crowdfunding platforms, you're investing directly in a deal via a broker-dealer or funding portal that acts as an intermediary, not an advisor. While the broker-dealer is required to offer educational materials to help investors understand what they're investing in, the onus to understand what due diligence you need to do and to do it properly is on the investor.
Some real estate crowdfunding platforms have established their own real estate investment trusts (REITs), known as eREITs.
The real estate crowdfunding market is still relatively new, and not all the companies who jumped in and created platforms will be successful. It's important to evaluate crowdfunding investments before you jump in.