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How to Evaluate Crowdfunding Real Estate Investments

Crowdfunded real estate can give you strong income and returns in your portfolio, but there’s a lot to know before you get started.

[Updated: Apr 15, 2021 ] Aug 22, 2019 by Matt Frankel, CFP
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Crowdfunded commercial real estate (CRE) has recently surged in popularity. But many investors don't understand the mechanics of crowdfunded real estate. If you're used to more traditional ways of investing in real estate assets, you might need to shift your expectations.

With that in mind, here’s an overview of what you need to know to evaluate CRE deals.

Pros and cons of crowdfunded real estate deals

If you’re new to this type of investment, it’s important to understand the pros and cons of real estate crowdfunding before you evaluate any deals.

Real estate crowdfunding's big advantages have made it increasingly popular as a way to invest in real estate. Here are a few of the benefits:

  • Crowdfunding gives you access to investments you otherwise wouldn’t be able to participate in. Most people don’t have the time, knowledge, or financial flexibility to buy a hotel, renovate it, and sell it at a higher price. Crowdfunding allows you to participate in these kinds of opportunities.
  • Other passive real estate investments, such as REITs, don't let you invest in individual properties. Crowdfunding deals do.
  • There's a lot of money to be made on successful crowdfunding deals. At the time of this writing, CrowdStreet lists its completed investments and the lowest actual internal rate of return out of more than a dozen realized investment results is 13%. Returns closer to 20% annualized aren't uncommon. For comparison, the stock market generates annualized returns in the 9–10% range.
  • Crowdfunded real estate can help you diversify your portfolio. Real estate -- especially the types of projects often funded through CRE platforms -- isn't closely correlated with the stock market. So it's a great way to diversify while maintaining a portfolio with high potential returns.

On the other hand, there are some drawbacks to be aware of:

  • Crowdfunded real estate deals can be far riskier than investing in REITs, stocks, or other types of investments. Most crowdfunded real estate deals are backed by a single asset, and execution risk is involved in most strategies. For example, a lot of things need to happen if a CRE deal is to renovate an office building and lease it up to 90% occupancy.
  • CRE deals aren't liquid investments. You can't readily sell your stake in a CRE deal to someone else, and most deals have time frames ranging from 3–7 years. Some can be even longer. Don't consider a CRE deal unless you’re willing to tie that money up for years.
  • There’s no guarantee that a CRE project will be completed on time. If a deal plans to renovate and sell a hotel in three years and the economy is in a recession, it might make sense to wait longer to sell.

How risky are the project and property type?

Like most investment classes, crowdfunded real estate deals vary in the amount of risk involved. It’s important to get a feel for the risk before you dive into the numbers.

Here are some questions to ask:

  • How much execution risk is involved in the project? Ground-up development of a new property is riskier than completing a moderate-scale renovation. The complexity of the project is an important factor, and it’s important to be sure the reward potential justifies the risk.
  • How economically sensitive is the property type? Some types of commercial real estate are cyclical, while others are recession-resistant. For example, a hotel's occupancy and revenue will probably fall significantly during tough economic times. An office building has long leases and isn’t likely to get hit as hard.
  • Is it already occupied, or does the project’s target return assume it will be leased up? A commercial property that is mostly full of tenants is less risky than one that has high vacancy.

What type of investment is the deal?

There are three main types of crowdfunding investments you can make from a capital structure perspective. We’ll get more into capital structures in the next section. Right now, let's go over the three main ways you can invest in commercial real estate deals.

Common equity

Common equity is what you probably think of when you hear the phrase "real estate investing." Common equity holders own an interest in the property’s profits. For example, if you contribute 1% of the common equity to a CRE deal and it earns a $1 million net profit, you’re entitled to a $10,000 share of the profits.

Although common equity has the highest return potential, it is also the riskiest of the three types of investments. There’s no guaranteed return and investment performance depends on how well the property performs.

Debt investment

Many crowdfunding deals offer the ability to make a debt investment. In this investment, you’re essentially acting as the deal’s mortgage lender. You provide some of the financing for the project and receive regular, predetermined interest payments. This is the least risky way to get involved with crowdfunded real estate deals, but it also has the least reward potential.

Debt may also be differentiated in order of seniority. For example, a deal might list both "senior debt" and "subordinate debt." The senior debt will be paid first and has priority when it comes to claims on the business’ assets in the event of bankruptcy.

man in a suite running from debt wrecking ball

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But there is such a thing as excessive debt, so be sure to see how debt-reliant a particular deal is.

You can find this information in most CRE postings as part of the "capital stack." For example, you may see a capital stack that looks like this:

Capital Type Amount Percent of Total
Sponsor Co-Investment $1,000,000 10%
Investor Equity $3,000,000 30%
Senior Debt $6,000,000 60%
Total $10,000,000 100%

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?

How much experience does the sponsor have?

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.

Does the sponsor have skin in the game?

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.

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