Equity crowdfunding has become a popular way for investors to raise funds for their real estate deals, as well as a way to earn passive income from real estate. There are several ways to get involved with crowdfunding in either capacity, but like all things real estate, several factors must be considered. Take a look at exactly what real estate crowdfunding is and how each type of equity crowdfunding works.
What is equity crowdfunding?
Equity crowdfunding is a method private companies use to raise capital from the public. A private company puts out an offering through a crowdfunding platform to sell securities to private investors in order to fund their project. Equity crowdfunding is popular in real estate investing and development, as well as several other types of private companies.
Equity crowdfunding allows anyone to be an investor in a commercial real estate project or company. It also allows entrepreneurs to raise capital without having to spend years jumping through hoops to meet the Securities and Exchange Commission's (SEC) requirements.
For example, say an experienced real estate investor secures a safe, profitable deal, but they don't have the necessary capital to purchase the property. The investor can take the deal to an equity crowdfunding platform to offer other investors the opportunity to get involved.
However, crowdfunding platforms don't accept all deals submitted. Crowdfunding sites vet all investment opportunities very carefully. They want to minimize the amount of risk the equity crowdfunding investors on their platform take.
How does equity crowdfunding work?
Historically, real estate developers and start-up founders were very limited as to how they could raise equity capital. As crowdfunding has evolved, it's allowed more people to fund deals and start-ups with investments from the public.
When a real estate investor gets an investment property under contract and has met any legal requirements, they can submit their deal to an equity crowdfunding platform to review. If the deal makes it through the platform's due diligence process, they will start an equity crowdfunding campaign.
Once the investor has a crowdfunding campaign going for their deal, the investment opportunity is listed on the crowdfunding platform's site for investors to review and invest in. Different campaigns on different platforms will have different minimum investments.
The campaign will have a target amount. If enough investors like the deal and fund the campaign, the deal gets funded, and the real estate is purchased. The investors now have their equity in the property and will begin receiving distributions based on the deal structure.
Some details of an equity crowdfunding campaign will depend on the platform being used. Different platforms have their own requirements on the deals they will post and how the investments are handled. Some crowdfunding platforms simply act as a matchmaker, while others will provide a funding portal along with an escrow account.
How is an equity crowdfunding deal structured?
When someone invests in an equity crowdfunding offering, they're buying equity in the real estate investment. They actually become part owners. However, they don't play any sort of active role in the investment.
The person who puts the deal together is the issuer, sometimes referred to as the sponsor. They find the deal, negotiate the price and terms, and manage the asset once it's purchased. The issuer is also the one who guarantees any loans.
The sponsor typically either forms a limited liability company (LLC) or a limited partnership with most crowdfunding strategies. This LLC or limited partnership will purchase the asset.
In an LLC, the angel investors are buying Class A membership interest. The Class A members are the ones who provide the capital contributions and make up a certain percentage of ownership. The sponsor has Class B membership interest. Class B members own the remaining membership interest in the LLC and act as management for the entity.
If the deal is a limited partnership, the investors are limited partners, and the issuer is the general partner. Limited partners provide equity capital but don't participate in the management of the partnership. The general partner doesn't contribute capital but manages the partnership.
In some instances, the sponsor can also have Class A membership and can also be included as a limited partner, if they also provide capital contributions. In this case, they would normally have a separate entity that has Class B membership interest or is a general partner.
The amount an investor pays for their piece of the deal doesn't normally correlate to the purchase price. The issuer gets a percentage of the equity for putting the deal together. That percentage can vary but is normally somewhere between 20% and 35%.
Many of these deals are structured so investors get their target rate of return before the sponsor gets any distributions. This is referred to as preferred equity.
For example, say the issuer offers the deal with a preferred return of 6%. That means if the investment doesn't reach a 6% return, the sponsor doesn't get a share of the profits. Once returns are above 6%, the sponsor begins to earn their profit.
There are different ways the amount of money the sponsor gets from the profit is calculated. Usually, the sponsor will begin receiving their equity share worth of the profits on anything above the preferred rate of return.
For example, suppose the equity is split 75/25 between the sponsor and investors. The preferred return is 6%, and the actual return for the year was 8%. The investors would get the full 6% and then share 25% of any net income above that.
In some cases, the split changes once the return hits a certain threshold. The split may increase to 50/50 once the returns hit 10%. In this case, the sponsor gets 25% of any returns between 6% and 10% as well as 50% of anything above that.
Costs and fees
The sponsor can get paid in a few ways. Besides getting paid distributions on anything above the preferred rate, the sponsor also usually charges an asset management fee. The asset management fee is normally between 1% and 2%, depending on the size of the deal. They may also charge an acquisition fee once the entity purchases the property. There could also be a disposition fee once they sell the property.
Finally, the sponsor profits at the end when they sell the property. This is when they get paid on their equity share. For example, suppose the partnership nets $1 million when they sell the property. If the sponsor has 25% equity, they'll get $250,000, and the rest will get distributed to the investors accordingly.
Most of the time, there's a target exit date. This is when the sponsor plans on either selling or refinancing the property so the investors get their capital back. This time frame is normally between 5 and 10 years.
This is just one simple example of how an equity crowdfunding deal may be structured. Deals can be structured any number of different ways, and they often are.
It's also becoming more popular for private real estate companies to choose to be structured as a real estate investment trust (REIT) for the tax benefits. This is a different structure than the typical preferred return and equity split other real estate crowdfunding offerings provide.
Instead, a REIT is required to pay out a minimum of 90% of its taxable income to investors in the form of dividends. Keep in mind, however, that taxable income is calculated after noncash expenses like depreciation and amortization. You can learn more about private REITs here.
How is equity crowdfunding different from stocks?
While there are several rules and regulations that make equity crowdfunding different from stocks, the main differences are liquidity and investment limits.
Stocks are publicly traded, so investors can buy a stock in the morning and sell it in the afternoon. You can also sell any portion of your stocks that you wish at any time.
With equity crowdfunding, you're buying your equity directly from the sponsor and committing to the full term of the investment. While some forms of equity crowdfunding allow you to sell your shares, the options are limited compared to publicly traded stocks.
The level of risk is usually higher with equity crowdfunding. For the most part, publicly traded companies are well-established and stable. With crowdfunding, you're investing in a brand-new deal, and you're trusting the sponsor to make it successful and earn a profit for you.
Crowdfunding also has limits in place as to how much capital a company can raise, as well as who they can raise investment capital from.