There may be other types of capital besides those in the chart. For example, many deals use preferred equity or other forms of non-senior debt in addition to investor equity and senior debt.
There’s no specific cutoff in regards to how much debt is too much. I generally like to see debt making up no more than 70% of the total capital stack. Be sure to consider whether the potential return justifies the level of debt the project is taking on.
Consider the crowdfunding platform
There are three parties involved in a crowdfunding deal: you (the investor), the sponsor, and the real estate crowdfunding platform.
The platform is the middleman between investors and the deal’s sponsors. A crowdfunding platform handles:
- vetting each deal it posts,
- advertising deals to investors,
- collecting capital from investors, and
- regulatory issues involved with the deals.
The investment merits (or lack thereof) of any crowdfunded real estate opportunity have a lot to do with the platform it's advertised on.
Is the deal offered by a reputable platform with a history of successful deals? Real estate crowdfunding is still in its early days, so even the largest CRE platforms don’t have a ton of data on previous deals. It generally takes 5–7 years before a particular deal’s return is quantifiable.
That said, several well-established and reputable real estate crowdfunding platforms, are getting an idea of how their deals have performed. One of the largest CRE platforms, CrowdStreet, has offered 309 deals since 2014. As of June 2019, just 14 have been exited and report realized returns.
Lack of performance data is an obstacle to conducting a thorough analysis. However, you can look at how closely a particular platform scrutinizes the deals it advertises. Does the platform accept a large percentage of the deals it reviews or a tiny fraction?
The sponsor is the company that plans to execute the actual investment strategy. The sponsor's experience is important when evaluating a crowdfunded real estate opportunity. The sponsor negotiates the purchase price, hires contractors, and oversees day-to-day operations.
Crowdfunded real estate deals can be massive undertakings. So it’s important to see how much experience the sponsor has in similar deals. What's their track record for completed projects?
Most sponsors who have a lot of experience will be eager to show it. Not being able to find a biography of the sponsor or a link to their website is a red flag.
In CRE deals, the sponsor always contributes some part of the equity needed to fund the deal. But there’s a huge difference between a sponsor who contributes 5% of the capital for a deal and one who contributes 30%. 10–25% seems to be the most common range.
This is referred to as the sponsor co-investment and, all other factors being equal, higher is better. I’m not saying that a sponsor needs to contribute a ton of capital for me to like a deal. But keep in mind that the more money a sponsor is willing to put in, the more motivated they'll be to make sure the project proceeds as intended.
How hefty are the fees?
There are two main ways that sponsors get paid.
First, there’s typically an acquisition fee once the deal closes. If a CRE deal plans to buy a hotel for $10 million and there’s a 1.5% acquisition fee, the sponsor will get $150,000 once the purchase is finalized. Acquisition fees in the 1–2% range are common. Anything higher could be a bit excessive, although the complexity of the deal should be taken into account.
A sponsor can also make money by taking a cut of the deal's profits. This typically only happens after investors get a certain amount of profit first. Unless a deal produces a return above a baseline amount (known as the preferred return), the sponsor doesn’t get paid.
Sponsor return, as it’s known, generally kicks in after investors have received a 6–10% annualized return. Receiving 25–30% of profits after the preferred return has been met is a common split percentage for sponsors.
Many deals have escalating sponsor returns as profits climb. I prefer this structure, as it incentivizes the sponsor to produce superior returns. A profit-split structure might look like this:
- 7% preferred return, so the first 7% in annualized investment returns are paid to investors who contributed equity financing.
- From 7–15% annualized returns, 80% of profits go to investors and 20% goes to the sponsor.
- From 15–20%, 70% goes to investors and 30% goes to the sponsor.
- If any part of the return exceeds 20% annualized, the sponsor gets 40% of that portion.
Sponsor returns of 20% or more can be a lot of money. But this type of structure really incentivizes sponsors to deliver for their investors. You don’t want to see an excessive profit splitting structure, but don’t run away from a deal just because sponsors get a big cut of the profits.
What is the projected internal rate of return (IRR) and is it realistic?
Crowdfunded real estate deals typically publish a targeted internal rate of return. The math involved in calculating IRR is complicated. The best way to think of IRR is the total return of an investment, expressed on an annualized basis.
CRE deals have different return structures. For example, some have large annual distributions, while others pay out a large lump-sum profit when the property is sold. The IRR can help compare one deal to another in an apples-to-apples way.
First, make sure the project’s IRR is achievable. Anything between 12% and 18% targeted IRR is common for CRE deals. If a project advertises a significantly higher IRR, it could be a red flag.
Also, compare IRR and the overall risk of the project with others of a similar nature. Don't compare the targeted IRR of a hotel renovation project with office building development. Comparing the returns and other factors of two hotel renovation projects can help you pick out the better opportunity.
How will the deal make money for you, and does it meet your needs?
Crowdfunded real estate deals can make money in two main ways: rental income and the eventual sale of the property.
Most CRE deals distribute income to investors on a regular basis. In other words, if the sponsor acquires an apartment complex, the net rental income collected is typically distributed proportionally to investors.
But not all deals distribute income right away. If the investment involves building a new shopping center, it can be some time before construction is complete and enough of the space is occupied to produce a profit.
The other way a CRE deal can make money for investors is through a profitable sale of the real estate asset. If a CRE deal acquires a property for a total of $12 million, including renovation costs, and sells it for $15 million three years later, investors get a cut of the profit.
Both ways can be great profit sources, but the deal needs to make sense for you. If you rely on your investment portfolio for income, CRE deals that don't generate cash distributions until the third year probably aren’t the best choice for you. A deal that targets 8% annual cash distributions and a relatively small profit upon the sale of the property may make more sense for an income-seeker.
Consider the big picture
There aren’t many set-in-stone analytical rules for crowdfunded real estate deals. There’s no set IRR to look for, no specific debt level that’s too much, and no specific amount of sponsor co-investment you need to look for.
Consider all of these factors together to form an overall picture of a deal’s investment merits. Use this big picture in conjunction with your investment goals and risk tolerance to decide if a deal is a good investment for you. It takes practice to properly evaluate deals. The best advice I can give is to read the details of as many real-world CRE deals on the major platforms as possible before offering to contribute your money to a deal.
Crowdfunded real estate returns can be a great way to boost income and returns in your portfolio. Just be sure to do your research first.