This article will profile a successful real estate crowdfunding investment. Real estate crowdfunding started in 2012 and is therefore a relatively new investment alternative. However, real estate has been one of the longest investment classes in history.
In October 2016, I decided to invest $10,000 in my first real estate crowdfunding investment. It was a “Class A,” 30,265 sqft, two-story office building in Conshohocken, Pennsylvania. Conshy, as the city is commonly known, is located 25 miles northwest of downtown Philadelphia. I even wrote a detailed post about the project to get the community's advice before investing.
The building was purchased at 70% occupancy. There was a value add plan to lease it up and bring the rents to market rates. The sponsor, Haverford Properties, planned to hold onto the property for five years. The goal was to hopefully sell it for 40% more.
Instead, the sponsor decided to sell the equity portion of the deal for a 22.7% premium in 4Q2019 after three years and call it a day. Below shows a deposit I received of $12,271.84 from IRM, the new servicing manager that took over from RealtyShares in 2019.
Lessons Learned From A Successful Real Estate Crowdfunding Investment
My first reaction to getting my capital back plus a net 22.7% gain was that of happiness and relief. RealtyShares decided to close its doors to new investors in November 2018 and sell its book of business to a new operator, IRM.
The transition period was filled with uncertainty, but I had faith either a competitor would buy RealtyShares or an experienced operator would purchase the existing assets, earn its fee, and wind them down. After all, an individual LLC was created for each investment and would continue going no matter the fate of the real estate platform.
My next reaction after getting my capital back was inspired out of greed. 22.7% over three years is only about a 7% compound annual growth rate. A 7% return in 2018 was fantastic given the S&P 500 closed down 6.24%. But a 7% return in 2019 when the S&P 500 closed up 31% is dismal.
Then I remembered the sponsor had promised to pay out annual distributions from its Net Operating Income of 8.4% a year. If this was true, then my total return over three years would be closer to 48%, for an attractive and steady 14% Internal Rate Of Return (IRR).
Here are some important lessons I've learned from this real estate crowdfunding exit that should help us better evaluate future investments.
1. Never Get Mesmerized By Blue Sky Real Estate Scenarios
The sponsor that gets me worried is one that tries to sell their deal too hard. One way to attract capital to their deal is to provide a Blue Sky Scenario that makes their potential returns sound amazing. Just know that a Blue Sky Scenario is highly unlikely to happen. I'd assign it a 10% chance of coming true.
As an investor, your goal is to look at multiple scenarios, including a Downside Scenario, a Realistic Base Case Scenario, and a Blue Sky Scenario. If a sponsor does not give at least two different return scenarios in its marketing and research material, I would move on or at least question them further.
A good rule is to take whatever the sponsor's forecast is and cut it by 30% to calculate your expected return. Of course, a sponsor who has a history of overpromising and underdelivering will hurt their future capital raising needs. Therefore, it's up to the investor to stick with only repeat sponsors with a long track record of delivering or surpassing on their promises.
One more thing, the sponsor described the Conshy office building as Class A. But if you look at it below, it looks more like Class B to me. In my mind, Class A office buildings are those ultra-modern skyscraper or iconic type office buildings in major cities such as the TransAmerica building in San Francisco or the Chrysler Building in NYC.
Also, you never know when there might be a recession around the corner. So it's good to have those bear case scenarios before investing in real estate.
2. Skin In The Game Matters In Real Estate
Below are the sources of financing for the Conshy, PA real estate deal. Out of a total of $5,927,433 in financing, only $267,433 or 4.5% came from the sponsor. That is not a lot of skin in the game.
Instead, I think we investors should expect the sponsor to have at least 10% of their capital in the deal. After all, banks usually require homeowners to put down at least 10% for a primary residence and 30% for a rental property investment.
Notice how the sponsor writes “(16.4%) (1)” next to Sponsor Equity to make the amount seem bigger than it really is. Sure, the sponsor's equity is indeed 16.4% of total equity raised. However, their skin in the game is really only 4.5% of total capital.
If you plan to take more risk as an equity investor, you want the sponsor to feel as much pain as possible if things go wrong. I have seen several deals go south for equity investors because the sponsor had very little equity invested.
3. Understand The Capital Structure
The Conshy, PA deal was composed of 73% debt ($4,300,000) and 27% equity ($1,627,433). If the sponsor was a complete failure at adding value to the property and ended up selling the office building for only $4,300,000, equity investors would lose 100% of their capital even though the property value declined by only 27%.
The reason why equity investors lose 100% is because equity is LAST to get repaid in the capital structure. See below the priority in repayment in the capital structure, also known as the capital stack.
I don't know what the terms were for debt investors in the Conshy, PA deal, but I can imagine it would be something like 7-8% a year for five years. The target equity return in the deal was more than double.
Let's say the sponsor did a fantastic job and Conshy, PA became the new Amazon headquarters on the east coast. The commercial office building rises in value to $10 million in five years. In this scenario, debt investors would still only get 7-8% a year in interest payments and 100% return of capital in five years.
But equity investors would get roughly: $10 million sale – $4.5 million debt = $5.5 million equity. I've excluded selling costs in the equation for simplicity. The equity return would therefore be 238% or a 27% IRR over five years.
The more bullish you are on the property, the more equity risk you should be willing to take. However, to make an appropriate investment, you must analyze the capital structure.
4. Real Estate Marketplace Platform Risk
Because RealtyShares closed its doors to new investors at the end of 2018, there was a lot of uncertainty regarding what would happen to the existing deals. Would some shady sponsors try and take advantage of the closure and not follow their operating agreement? Would investor's money disappear into a black hole?
For about five months, there was not a lot of clarity as to what was going on as RealtyShares sought a buyer. In the end, a company by the name of IRM was created to manage the existing book of business through to completion.
IRM would earn the remaining fees and investors would feel more confident that someone was at the helm to make sure sponsors kept doing what they were supposed to be doing.
Once IRM took over, it would take them another three months or so to get familiar with all the deals, the interface, and the sponsors. Only then did updates start coming out again. Further, there were many examples where payments took longer than usual to pay out.
I was never really worried my money would disappear. The operation of RealtyShares and the individual real estate investments I made were in separate LLCs. Besides, sponsors wouldn't want to risk committing fraud in such a public setting.
As a real estate crowdfunding investor, you've got to spend time researching each platform. You must understand each business model and making sure it has enough capital.
It was my understanding that RealtyShares had a closing dinner to celebrate a new round of funding. However, the investors got cold feet and pulled their investment last minute.
If you are very worried about platform risk, CrowdStreet has a unique business model. CrowdStreet connects the investor directly with the sponsor. In other words, if you invest in one of their deals, you will be investing on the sponsor's platform. This could be lower risk or higher risk, depending on the sponsor.
5. The Investment Truly Is Passive
During the three years of investing in this Conshy office building, I received quarterly updates on the progress of the building. After all, the sponsor's goal was to increase the occupancy and rent per square foot in order to one day sell the building at a higher price.
Below is a sample of a quarterly update. Passivity is one of the best reasons for owning a triple-net property.
After reading the first couple of updates, I stopped reading them because I started feeling the stress of being a landlord again. Instead of following along, I just let the sponsor do their job and earn their fee. I couldn't get out of the deal anyway, even if I wanted to.
I reminded myself that the reason why I sold one of my key rental properties in 2017 was so that I could focus my attention on my family and not have to think about the work that is involved in real estate.
In the end, the deal provided a ~40% total return net of fees after three years. The return would have been closer to 48%, but the sponsor didn’t pay out distributions from NOI for a couple quarters. During this time period all I had to do was file a K-1 each year.
Diversifying My Real Estate Holdings Further
By 2023, I should be getting back at least all my remaining ~$410,000 in capital. I've received about $400,000 back so far. It is currently invested in 14 remaining commercial and multifamily real estate assets across the country (equity fund).
One deal in Austin that has already closed was a home run. A student housing deal in Arizona that closed was a turd. The sponsor sold the property below its purchase price.
Out of the remaining 14 deals, supposedly 9 of them are on track to hit their average IRR of 16.7%. Meanwhile the rest are below plan thanks to COVID. But the two that are below plan have aggressive IRR targets of 19.8% and 20%, respectively. So hopefully, even if they return half those figures I'll be happy.
Although investing $800,000 may sound like a lot, it's actually much less than the $2,745,000 in exposure I had in just one San Francisco rental property with an $815,000 mortgage.
The way I see it, I significantly diversified my real estate holdings. I've also so far boosted overall returns, paid down debt, and created 100% passive income.
When I sold my SF rental property in 2017, I was at my wit's end dealing with rowdy tenants and figuring things out as a first-time dad. Being able to reduce stress and buy back my time has been huge.
Real Estate Crowdfunding Returns
According to my dashboard when this deal was paid out, I've received $281,340.39 in capital back so far. $165,445 of the capital came on February 5, 2020 from the equity fund I'm invested in. And $12,271.84 from the Conshy deal on February 11, 2020.
Although the chart above says “earnings exclude principal,” I don't think it's right given a couple deals have closed. But I won't really know the 4Q201 details until an overall fund report comes out in 2Q2020. When I get the details, I may write about the other investments as well.
My plan going forward is to reinvest at least $500,000 in capital across at least two real estate crowdfunding platforms. I will continue to focus on the heartland where valuations are lower and cap rates are higher. The potential growth is also higher due to migration trends.
I also plan to go from 100% equity investments to 70% equity investments. The remaining exposure will be 30% debt investments to lower my risk profile.
Latest Private Real Estate Returns
Below is my latest private real estate investing dashboard. It shows $810,000 of capital invested and $624,270 paid out.
Because I will have at least $500,000 to invest, the ideal real estate investment for me would be another “best of the best” fund that shoots out just one K-1 each year.
I like the idea of having a management committee pick what it thinks are the best investment on their platform. I don't mind paying an extra fee. In the past, there have been times when I've seen an attractive deal and couldn't get in in time because I was too slow and demand was too great.
Best Real Estate Crowdfunding Platforms
If you're trying to decide between Fundrise or CrowdStreet, have a read of my post that compares the two. For most people, investing in a diversified fund through Fundrise is likely the best way to go. It's more simple and less risky. But the returns will likely be lower.
To round out my 100% passive real estate holdings, I am also an investor of the following publicly-traded REITs: O and OHI.
2020 is the year where I'm going to be predominantly focused on real estate investing. Stocks had their time in 2019. With interest rates plummeting, coronavirus fears rising, and an increased interest in tangible assets that provide steady income, I believe real estate will outperform again as it did in 2018.
I ended up buying a new forever home in mid-2020 for my family. This was one of the best lifestyle investments ever as we got locked down for 1.5 years.
Just make sure to do your due diligence and invest in a risk-appropriate manner. Just like the stock market, there are certainly investment losers. If you can't take the risk, online savings accounts are paying a boring 1% risk-free. But my bet is in real estate.
Readers, any other lessons you've learned from a successful real estate crowdfunding investment? What do you think about real estate investing this year compared to stocks and other asset classes?