What to consider when investing in commercial real estate via crowdfunding platforms.
In this episode you’ll learn:
- What are accredited investors and how many are there in the U.S.
- What are crowdfunding real estate platforms.
- What are the new rules for non-accredited to invest in crowdfunding investments.
- How fast is crowdfunding real estate growing.
- What are the risks of commercial real estate investing.
- What is the criteria for selecting a crowdfunding real estate platform.
Investing in Real Estate on Crowdfunding Platforms
This month new U.S. securities regulations take effect which allow many more individuals to invest in commercial and residential real estate deals via the Internet using crowdfunding platforms.
Crowdfunding real estate represents online investments by institutions and individuals in private, non-publicly traded debt and equity securities tied to real estate.
Prior to May 2016, only institutions and individuals who qualified as accredited investors were permitted to utilize online crowdfunding platforms to provide equity capital and debt financing for commercial office buildings, retail centers, hotels, apartment complexes, single family homes and other projects.
The U.S. Securities and Exchange Commission defines an accredited investor as an individual who individually or jointly with one’s spouse has a net worth of at least one million dollars excluding the value of one’s primary residence or who individually earned at least $200,000 per year for the last two years (or joint income of $300,000) and reasonably expects to do so in the future.
The SEC estimates 10% of U.S. households qualify as accredited investors.
Under the new rules, non-accredited investors with an annual income or net worth less than $100,000 can invest the greater of $2,000 or 5% of the lesser of their annual income or net worth in crowdfunding investment offerings.
If both their annual income or net worth is greater than $100,000, then non-accredited investors can invest 10% of the lesser of their annual income or net worth up to a maximum investment of $100,000 per year.
Crowdfunding real estate has grown substantially in the past few years. According to recent research published by the University of Cambridge Judge Business School, in 2015 the volume of crowdfunding real estate transactions including both debt and equity was $1.27 billion, a 360% increase over 2014.
Examples of crowdfunding real estate sites include Realty Mogul, Patch of Land, and Acquire Real Estate.
Despite its growth, crowdfunding real estate transactions comprise only 0.2% of commercial real estate transaction volume which was approximately $500 billion in 2015 according to JLL Research and Real Capital Analytics.
While new SEC regulations and the proliferation of crowdfunding real estate platforms makes it easier than ever for individuals to invest in commercial real estate, deciding where to invest is not an easy task and can involve significant risk.
Not only do investors need to choose from over 125 different real estate crowdfunding platforms, which vary by fees, size, and experience, but they then need to choose specific real estate deals which can vary dramatically in terms of risk.
Platform Due Diligence
Which platform should you use? I simply don’t know. To date, I have only invested on one platform and I am still conducting due diligence on others.
The criteria I am using to evaluate the various platforms includes the fees they charge, the experience of the platforms’ operators who conduct due diligence on real estate deals, the experience of the deal sponsors who will be managing the properties, whether the platform operators have their own capital at risk by co-investing or prefunding deals, and back-up plans in case a platform closes.
In terms of individual real estate deals, real estate risk is a function of the security type, the property sector and the level of redevelopment for the specific property.
Real Estate Security Types
Real estate security types include debt, mezzanine debt, preferred equity and common equity.
Debt typically comprises 50% to 80% of most commercial real estate transactions. Loans are the least risky way to invest in private real estate because the loan is secured by the property. The senior debt holder has first claim on the property in case the developer/borrower defaults. Of course, the degree of riskiness for a mortgage loan depends on how much leverage is involved.
Preferred equity and mezzanine debt form the middle layer of the capital stack used to fund a real estate transaction. Preferred equity and mezzanine debt holders receive a healthy yield in terms of interest and dividends, and in the case of default they have first access to any proceeds after the obligations to the senior debt holder have been satisfied.
The common equity holders take on the most risk in exchange for hopefully the highest return. Their returns can be magnified based on the amount of leverage used in the transaction. Usually the real estate developer / deal sponsor own a meaningful share of the common equity along with outside shareholders, including investors from crowdfunding sites.
Real estate risk can also vary by property type and the level of development anticipated.
Real Estate Investment Types
Core real estate consists of quality properties with existing long-term leases and no need for substantial redevelopment of the property. The main source of return is a stable stream of income.
Value-added and opportunistic real estate consists of properties that require varying degrees of redevelopment, repositioning and lease-up. Lease-up is the process of rewriting leases and attracting new tenants following the development or redevelopment of a property.
While core, value-added and opportunistic real estate represent the different degrees of redevelopment and lease-up risk, real estate investing risk can also vary by property sector.
Real Estate Sectors
Investors demand higher returns for riskier property sectors. For example, investors consider hotel investments the most risky and office buildings in central business districts and apartment buildings least risky, with retail centers, industrial complexes and suburban office buildings falling in-between in terms of risk and required return.
Different properties and real estate sectors can be compared by looking at capitalization rates (i.e. cap rates), which represent a property or sector’s net operating income divided by the property asset value.
According to Real Capital Analytics, the cap rate for the hotel sector has fallen to approximately 8.5% at the end of 2015 compared to close to 10% in 2009.
Meanwhile, the cap rate for the central business district office building sector is below 6% after being close to 8.5% in 2009. The apartment sector cap rate is also below 6% while cap rates for retail, industrial and suburban office building sectors are between 6.5% and 7.5%.
In today’s low interest rate environment, investors have been willing to accept lower and lower expected returns for individual deals as more capital has flowed into the real estate sector.
Individuals who invest in real estate via crowdfunding platforms need to decide whether these lower expected returns are sufficient to justify investing in an area with significant risks.