Crowdfunding is a way of raising money by reaching out to a pool of investors who contribute a small amount of money towards a common goal. In real estate, crowdfunding is a method to finance a specific real estate deal. The process is usually conducted through an online platform to reach an audience of potential investors.
For developers, crowdfunding offers them access to capital for a real estate development project. This approach has become a feasible alternative to traditional ways of raising capital.
As for the investors, it offers them the ability to buy into a property and become a shareholder in an asset they may never be able to acquire as individuals.
How does crowdfunding work?
The idea behind crowdfunding is that when a developer or real estate professional finds an opportunity, they don’t always have the ability to pursue the project independently. So they allow individuals to contribute some of the capital in order to execute the project.
First, the sponsor identifies an opportunity, plans the acquisition of property, and even takes the responsibility of its management and eventual sale of the asset. The crowdfunding platform is where the sponsor finds the investors who are looking to create passive income from real estate.
A Special Purpose Vehicle is created to acquire the asset in which the investors are shareholders.
Types of Crowdfunding in Real Estate
Common equity is a riskier way to invest in a deal as you become a shareholder in the property. When you invest this way, you receive returns based on the property’s rental income and are entitled to earn a share of the property’s appraised value in case it is sold. For example, if you own 10% in a deal and earn Rs.1,00,000 net profit, you are entitled to Rs.10,000. Equity investment provides high returns but also carries a higher risk.
Debt-based funding has been more popular as investors receive a fixed interest rate appropriate to the amount that you have invested.
- Crowdfunding allows investors access to assets that may otherwise be out of bounds for them.
- Investor access to high-income projects with low minimum investment amounts.
- Allows investors to invest in a specific property of your choice, without the hassles of maintenance and management.
- Crowdfunding investments are transparent as opposed to REITs
- For sponsors, crowdfunding allows easy access to funds compared to other instruments.
- Crowdfunded real estate investments are highly illiquid. Unlike when you own a property, you can’t sell your investment whenever you want. You are committed for the entire holding period of the project.
Evaluating a crowdfunded real estate investment
Investing in a real estate deal can be highly rewarding but at the same time, highly risky. When evaluating an investment opportunity, it’s important to understand all factors.
Here are some of the factor to look at before investing:
- The Project
Before investing in an asset, it’s crucial to assess the risks involved in a project. Ground-up development of a new project is riskier than a renovation project but most crowdfunding deals are new developments. A commercial property that is already generating revenue is less risky.
Some projects are cyclical while others are recession-resistant. For example, a hotel project would be affected during an economic downturn but an office building with a long lease wouldn’t be affected as much.
- The Investment Type
When you invest in an equity-based model, you receive returns based on property rental income or earn a share of the property’s appraised value in case it is sold. Equity provides better returns compared to debt investing.
Under debt funding, you will receive a fixed interest appropriate to your investment. This model provides a consistent return.
- The sponsor
The sponsor is the individual or the company that identifies the investment opportunity, manages the property, and responsible for the returns. Deal sponsors usually have contributed to the project fund themselves and bring their expertise in managing an asset of this class. Although most crowdfunding platforms vet the sponsor and conduct a background check, we recommend that you one yourself.
- The Target Return
Crowdfunding deals generally state an internal rate of return (IRR) for their investors. The return metric combines expected rental income from the asset and the expected profits for the eventual sale of the property. Most deals distribute a residual income to investors.
- The Holding Period
With crowdfunding deals, there is a holding period for the investment. Typically real estate investments have an exit strategy – a profitable sale of the asset after a certain period of time. The holding period is important to include in your analysis as real estate investments are highly illiquid and you should assume for a sale after the holding period.
- The Fee Structure
There are mainly two ways a sponsor gets paid.
Firstly, there is an acquisition fee once an asset is purchased. Acquisition fees range from 1-2% is standard. The sponsor also gets a certain percentage of the deal’s profit. This typically only happens after investors get a certain amount of profit first.
- The Legal Stuff
Before investing in a crowdfunded deal, understand how the deal is structured. In most cases. your investment goes into a separate legal entity that acquires the property. All the terms should be spelled out on paper before the investment is made.