Real estate crowdfunding is increasingly becoming a popular alternative to REITs for individual investors seeking real estate exposure. As we saw in the March 2020 stock market downturn, publicly-traded REITs declined even more than stocks. But there are real estate crowdfunding risks to be aware of.
The arguments in favor of real estate crowdfunding, also known as private real estate investing, are typically the following:
- Their deals provide higher risk adjusted returns
- Crowdfunding assets are uncorrelated with the stock markets and are hence more stable than REITs.
- Investors can invest more precisely in certain states and real estate types e.g. multi-family, commercial office space, debt, equity
- Fees are generally lower than private real estate funds
- Commercial real estate and multifamily properties have performed better than residential
It's because I believe there is tremendous value in the heartland of America (non-coastal cities where prices are softening). Valuations are much cheaper and net rental yields are much higher.
But despite my bullishness, let's talk about the risks we should all be aware of. There are no guaranteed investment returns except for returns in CDs, money markets, Treasuries, and paying down debt.
Real Estate Crowdfunding Risks
Here are the main real estate crowdfunding risks to be aware of. Before you make any private real estate investment, it is imperative to understand your downside and upside. There are never any guarantees when investing in risk assets like real estate, stocks, crypto, fine art, and so forth.
Real Estate Crowdfunding Risk #1: Due diligence limitations
Most crowdfunding websites directly target individual investors who are not experts in commercial real estate investing or finance in general. The issue is that without these specialized skills, how are you then supposed to properly assess a given deal on a real estate crowdfunding website? It is simply impossible. You therefore must put your faith in the real estate crowdfunding platform to properly vet each deal.
And even if you are an expert and understand real estate investing, you will mostly lack local market knowledge to make property level decisions. Real estate investors need to specialize for a given region or city to really manage to identify the better deals. You will certainly not be able to perform good quality due diligence on an office building located in Denver if you reside in Dallas and have limited knowledge of the Denver market.
On the other hand, when investing in REITs, you do not need to do any investment decisions on the property level. You directly invest in a well-diversified portfolio and the professional managers then take care of the underlying real estate investment decisions.
A Carefully Vetted Funnel For Deals To Get Approved
Below is an example of a Fundrise funnel where only 5% of the deals are approved and invested. The most obvious risk is simply fraud, that the sponsor is not who they say they are and they're going to steal your money. This is why I've proactively met with people from various real estate crowdfunding platforms to look them in the eye, hear their “why,” and make a proper assessment.
Real Estate Crowdfunding Risk #2: Unsecured Investment
Real estate crowdfunded investments are generally unsecured investments. In other words, if the platform were to go under, investors could lose their capital. While most investors are aware of the risk, the nature of the security of investments may be changing.
The solution to a real estate crowdfunding platform like Fundrise going under is the hiring of a third party bank who acts as the custodian of all assets. For example, Pershing has over a trillion in assets managed. It is not going anywhere even if a real estate crowdfunding platform fails.
At least with real estate crowdfunding, if there are troubled times, there is the underlying real estate asset that can be worked out, unlike lending money to people via P2P.
Real Estate Crowdfunding Risk #3: Lack of Understanding
Investors need to understand the different types of risks associated with equity versus debt investment. Investors must also understand the different types of investment options under each of those umbrellas. Equity is riskier in the sense that you could lose all your money more easily than you could with debt.
Understanding the structure of the deal, when they get paid back, how they get paid back, how much they are going to get paid back are all key elements. It's important for everyone to spend time reading all the documents on the real estate crowdfunding platform.
Part of that process of getting up to speed on deal terms is gaining a fundamental understanding of whether equity or debt investment is right for the individual investor, lawyers say.
Read all the research provided on the platform. Then do further diligence over the internet. Ask people who live in the area for their opinions regarding job growth, economic growth, etc.
I suggest everyone read my real estate crowdfunding investment guidelines to become a better investor.
Real Estate Crowdfunding Risk #4: High Loan-to-Value Ratio
It’s crucial for investors to consider the loan-to-value ratio for debt deals and to avoid high ratios. The higher the loan-to-value ratio, the more risk the investor might lose a significant amount of their principal investment in a downturn. For example, a 95% LTV means that if prices decline by 5%, the investor loses 100% of their principal.
The key is to diversify your real estate crowdfunding investments. Given the minimums are often as low as $5,000, it's much easier to build a diversified real estate portfolio.
If you want to buy the median home price in NYC of $1.2M, you'd have to come up with a $240,000 downpayment and then take on almost a $1M mortgage! That's massive concentration risk. With $240,000, you could easily build a 20 property real estate crowdfunding portfolio to reduce risk.
You must also understand what the capital stack looks like for each deal a sponsor is raising money for. Are you an equity or a debt investor? Equity has more risk, but more upside. Debt is senior to equity on the capital stack and is less risky, but has has lower returns.
You need to determine whether you want to invest in debt or equity real estate as well.
Real Estate Crowdfunding Risk #5: Government Regulation
Given the industry took off with the passage of the JOBS Act in 2012, real estate crowdfunding is still relatively new. The government is generally in the best interest of protecting the consumer from risk and fraud. Therefore, more government regulation is generally good.
However, too much government regulation slows down innovation and may raise fees for the end investor. My bet is that the government loosens its definition of accredited investor. This way more people can partake in real estate crowdfunding deals. But, the government could raise the requirements of who is defined as an accredited investor as well.
Real Estate Crowdfunding Risk #6: Platform Risk
There is a risk that the real estate crowdfunding platform could shut down since most are not cash flow positive. If the platform shuts down, your investments should be protected. Investors of the platform don't have a lien on your investments in your respective real estate deals. You are an investor in real estate deals, not the real estate crowdfunding company itself.
However, there will likely be some disruption as individual investments get transferred to a fund administrator. Coverage teams responsible for following up with sponsors may whittled down as well.
If you are to invest on the platform, please make sure they explain to you what happens to your investments in case their firm goes under. Further, please do research on their latest round of company funding to see how long of a runway they have to survive.
Platforms such as RealtyShares and PeerStreet filed for bankruptcy in the past. With high mortgage rates and a slowdown in transaction volume, expect more bankruptcies to occur for the least well capitalized companies or most aggressive companies.
Real Estate Crowdfunding Risk #7: Sponsor Risk
The final real estate crowdfunding risk to be aware of is Sponsor risk. Sponsors bring deals to the platforms like CrowdStreet. CrowdStreet screens each sponsor and deal carefully before allowing its members to invest. However, sometimes, sponsors might be risky due to a poor track record or scheming general partner.
Hence, as an investor, you need to research each sponsor carefully as well. Make sure to diversify your individual real estate investments if that is the route you plan to go.
Risks Are A Part Of Real Estate Investing
Real estate crowdfunding has so far returned between 7% – 15% since 2012. But their timing couldn't be better as real estate prices bottomed around 2011-2012 since the 2008-2009 financial crisis.
Now coastal city real estate is expensive and cooling off. The real estate crowdfunding risks are growing there. However, heartland real estate continues to do quite well. People are moving to lower cost areas of the country and working remotely. The rise of work from home due to the pandemic should increase the demographic shift towards lower-cost areas of the country.
I'm betting that real estate crowdfunding enables a tremendous amount of new capital into lower cost regions of the country. I put my money where my mouth was and sold a SF rental property in 2017 for 30X annual gross rent. With the proceeds, I reinvested $550,000 into real estate crowdfunding. My goal is to take advantage of lower valuations and higher net rental yields in non-coastal cities.
Below is my real estate crowdfunding dashboard that shows $291,054.81 in returns so far from $810,000 in invested capital.
For those who can pick the right investments now, they should see a handsome reward in the future. Alternatively, you can simply invest in a focused eREIT to gain exposure.
Invest Only On The Best Platforms
With real estate crowdfunding, you don’t need to risk $100,000 or more to invest in commercial real estate. Instead, you can invest for much lower amounts such as $5,000. Real estate crowdfunding risks can be minimized by investing with the right platforms. They are:
1) Fundrise, founded in 2012 and available for accredited investors and non-accredited investors. I’ve worked with Fundrise since the early years, and they’ve consistently impressed me with their innovation. They are pioneers of the eREIT product. Most recently, they were the first ones to launch an Opportunity Fund in the real estate crowdfunding. Opportunity Funds exist to take advantage of new tax laws.
2) CrowdStreet: Portland-based CrowdStreet was founded in 2014 and focus their deals in 18-hour cities. 18-hour cities tend to be cheaper and have higher growth potential. The platform is mainly for accredited investors looking for ways to tap the mid-market. Crowdstreet focuses on 18-hour cities for their investment opportunities.
Both of these platforms are among the oldest and largest real estate crowdfunding platforms today. They have the best marketplaces and the strongest underwriting of deals. Investing on the best platforms helps minimize the risks of real estate crowdfunding.
Investors should carefully consider their own investment objectives when assessing the gamut of real estate opportunities that are available. Pay attention to real estate crowdfunding risks. Always review the full offering materials.
About the Author
Sam started Financial Samurai in 2009 as a way to make sense of the financial crisis. He proceeded to spend the next 13 years working at Goldman Sachs and Credit Suisse. Sam went to The College of William & Mary for undergrad and UC Berkeley for b-school. He owns properties in San Francisco, Lake Tahoe, and Honolulu and has $810,000 invested in real estate crowdfunding. In 2012, Sam was able to retire at the age of 34 largely due to his investments.