There are no set guidelines for how much debt is appropriate, but I typically look for total debt that makes up less than 70% of the capital stack. And if a project's debt is relatively high, I expect that additional risk factor to be reflected in the expected return.
How much experience does the sponsor have, and how much money are they putting in?
Notice the line in the capital stack above that says "sponsor co-investment." In most deals, the sponsor will contribute some of a project's required funding, giving them skin in the game along with investors. There's no specific cutoff to look for, but all things being equal, the more money a sponsor is willing to put in, the more confident it makes me as an investor.
It's also a good idea to do your homework on the deal's sponsor. Do they have a lot of experience? Is the sponsor experienced with this particular type of deal, or at least with deals that are similar in nature?
Are the fees reasonable?
In most passive investment opportunities, the people who play an active role in making investors money get paid, and this is certainly true in crowdfunded real estate investing. So, a big part of your analysis should be to determine whether the fees are reasonable and whether the sponsor's interests are aligned with your own.
There are two main ways a deal sponsor gets paid. There is generally some sort of acquisition fee when the funds have been raised and the property is acquired. The acquisition fee is usually a percentage of the purchase price of the property, and 1% to 2% is standard.
The second way a deal sponsor can get paid is known as sponsor return, which is where the real money can be made. In most crowdfunding deals, a certain return is paid to investors before the sponsor gets a dime (known as the preferred return). Beyond the preferred return, the sponsor gets a certain percentage of the returns the investment generates. For example, a deal may pay the first 6% of annualized returns to investors, and the sponsor gets 20% above that amount.
In many cases, the sponsor return is a multi-tiered structure, designed to motivate the sponsor to produce even higher levels of return for investors than the project was targeting. My preference is to see deals with relatively low acquisition fees and generous but reasonable sponsor returns. In a nutshell, I want the sponsor to be really motivated to make me money.
What is the target return?
Crowdfunded deals will generally state a targeted internal rate of return, or IRR, for their investors. And although the mathematics of IRR are a bit complex, the thing to know is that this is a return metric that combines any expected income from the deal, as well as the expected profits from the eventual sale of the property.
One thing to keep in mind is that the target IRR should be taken into account in combination with the rest of the deal's features, and that higher IRR projections aren't inherently better than lower ones. For example, a lower-risk deal with a 14% IRR from an experienced deal sponsor can be a far better investment opportunity than a high-risk investment targeting a 20% IRR from a sponsor with less experience.
It's also worth noting that many deals have two target IRR levels listed -- the project-level IRR and the investor IRR. You want to pay attention to the investor IRR, as this is the return the deal sponsor anticipates that you will actually receive after they've collected any performance-based fees.
What is the target holding period?
With most crowdfunded real estate investment opportunities, there is some sort of target holding period, or a timeframe for the entire investment. This is because crowdfunded investments generally have some type of exit strategy -- typically a profitable sale of the property after a certain number of years.
For example, a sponsor may plan to acquire an old apartment building, renovate all of the units over a period of two years, lease up the building at higher rents, and then sell the property after holding it for four years.
It's important to point out that these are just estimates. There's nothing that obligates the sponsor to complete the investment strategy by a certain time, nor is there anything that prevents them from selling a property sooner than expected. For instance, if the sponsor plans to sell the property after four years and there happens to be a recession going on at that time, they may decide it's in investors' best interests to wait.
The target holding period is important to include in your analysis because during this time, a crowdfunded real estate investment is extremely illiquid, even as far as real estate investments go. In other words, if you're going to need the money to fund your child's college education in seven years, you should only consider investment opportunities with target holding periods that are significantly shorter.
Does the investment have an income component?
This one is pretty self-explanatory, but it's worth pointing out. Many investors automatically assume real estate investments will pay income, but that isn't always the case with crowdfunding investments.
If you rely on your investments to generate a steady income stream, you need to carefully evaluate a deal's distribution plan. Some crowdfunding deals, for example, don't anticipate paying any distributions to shareholders for the first few years. And unlike some income-based real estate investments, like REITs, a deal's income projections are just that -- a projection. Keep this in mind when doing your investment research.
What are the requirements for investing in a crowdfunded real estate deal?
There are a few crowdfunded real estate investments that are open to all investors, but these are generally purely income-focused deals or funds that spread your money among a bunch of different investments like a mutual fund would. The majority of single-asset crowdfunding real estate deals are only open to accredited investors. This means that you have either:
- At least $1 million in net assets, excluding the value of your primary home.
- At least $200,000 in annual income ($300,000 when combined with a spouse’s) for each of the previous two years and an expectation of the same this year.
If you don't meet these requirements, you'll need to focus on deals that are open to all investors, not just accredited investors.
For single-asset crowdfunding deals, minimum investments are at least $25,000. Most platforms, though, require a minimum investment of $50,000.
Tax implications of real estate crowdfunding
Now for everyone's favorite part -- taxes.
If you invest in a crowdfunded real estate deal and you make a ton of money, the increased tax bill isn't necessarily a bad problem to have. However, it's better to know what to expect before you're in that situation.
With that in mind, there are four types of taxes you could potentially face as a real estate crowdfunding investor:
- Income tax: Rental income generated by the properties you invest in can result in taxable income, which will be reported to you (and the IRS) on a K-1 tax form each year. The good news is that thanks to the magic of real estate depreciation, the taxable amounts you see are likely to be lower than the amount you actually received.
- Capital gains tax: When a property sells for more than its purchase price, capital gains tax is owed on your share of the profits. If the investment was held for more than a year, this will be subject to long-term capital gains tax. If not, it will be considered ordinary income.
- Depreciation recapture: For real estate investors, depreciation can lower taxable rental income each year. However, upon the sale of the property, the IRS takes that benefit back. Any cumulative depreciation benefits you receive will be taxable as ordinary income upon the property's sale. This tax is known as depreciation recapture.
- State taxes (and not necessarily in your own): As a part owner in a property in a different state, that investment falls under its respective state jurisdiction and all property taxes apply.
As an investor in a crowdfunded real estate deal, you're considered to be a part of a partnership. Shortly after the end of each tax year, you'll receive a K-1 tax form that will report your share of income (or loss) from the partnership. If there is a loss, you can use it to reduce other forms of passive income -- say, capital gains or stock dividends -- but you generally can't use it to reduce the rest of your taxable income. Also, in most cases, you'll be required to file a state tax return for any partnership income in the state in which the partnership conducts its business.
These are general rules, of course, so be sure to consult a tax professional to help.
Is real estate crowdfunding investing right for you?
There's no perfect answer to this question, but one key takeaway is that there's a tremendous amount of variety within the crowdfunded real estate industry in terms of risk tolerance, time commitment, and other factors, so it's likely that there's some form of real estate crowdfunding that's right for you as long as you're a long-term-focused investor.
If you're ready to jump in and start exploring crowdfunding, make sure you read our reviews of todays best crowdfunding platforms first.