What I Learned From Investing in Real Estate Crowdfunding Platforms
Most personal finance sites these days focus on investing mainly in stocks, bonds and index funds. Warren Buffett is a big advocate of index fund investing. If one of the world’s wealthiest individuals says to do it, I’m in.
I’ve been investing in Vanguard index funds ever since starting a scratch dental specialist practice. A few years ago I decided to diversify my portfolio and noted that many personal finance blogs recommended something called “real estate crowdfunding platforms“.
Several friends own and manage real estate so I decided to begin the process of trying to decide on either:
- purchasing local homes or apartments to rent
- investing in real estate via these so called crowdfunding sites
I’m a detailed person and as Dave Ramsey recommends, “NEVER invest in something you don’t understand“. With no idea regarding either of the options I planned on pursuing, it was time to begin my due diligence process.
You also should do this for any investment you don’t understand. Next, I took a few of my real estate buddies to lunch to pick their brains. Most of them dealt in real estate on a full time basis. Bottom line: They knew their stuff.
One of my neighbors (occupational therapist) began buying single family homes in our area roughly the same time I began the due diligence process. After interviewing him, it allowed me to see things from two view points:
- People that dealt with real estate as their PRIMARY job
- Those that had a full-time job but invested on the side
This was important because there is always going to be two sides to a story.
Real estate pros and cons
I’m not going to bore you with all of the minute details I learned from interviewing my friends. Here’s a brief summary:
Easy to understand
Because most are familiar with real estate to some degree (we’ve purchased a home or two), investing in it can be much easier to understand. You’re buying physical property.
Real estate can be improved
When you own physical property, it’s essentially under your direct control. My friends made a point on stressing the need to:
- providing great service to tenants
- keeping up the grounds and building to a high standard
By doing so, you can tangibly improve the value of your investment and build wealth.
Real estate must be managed
On the flip side, either you must manage property (takes time away from your day job) or hire someone (can be costly). Also, if your property is NOT occupied, costs can add up quickly such as:
- finance payments
- management fees
- maintenance costs
Physical property has higher transaction costs
As an index fund investor, most of the transactions costs are minimal. But when purchasing real estate, the transaction costs are considerably higher. Sometimes these costs can significantly affect the value of the investment and make it more difficult to turn a profit.
Physical real estate creates liabilities
As a doctor, I’m used to the possibility of legal liability so this was a biggie for me. Real estate investing involves taking on a great deal of financial and legal liability. Even though most people hold their investment properties in a corporation, there are often personal guarantees associated with the business, and the risk of losing the income and profits generated by the company.
Real estate can be leveraged
If you use debt to buy real estate & if your rent pays all of your expenses, your tenant is essentially buying your house for you. Not a bad deal. In essence, you are using other people’s money (OPM) to build wealth.
Once you become debt-free, are fully funding retirement accounts and looking for ways to diversify investments, focusing on passive income is the next step.
My goal for you with this blog is to replace your current income, thus allowing you to spend more free time doing things you love…for me tennis, family trips, coaching my kids and traveling with my beautiful wife ( I hope she reads that last part!).
Before I started the due diligence process, the only real estate I had purchased was our home and office building.
Here’s a snapshot of our pre-real estate investment portfolio:
- 95+% Vanguard Index Funds (mainly Vanguard Total Stock Market Index Admiral Fund VTSAX)
- <1% Bonds
- 5% Cash (Emergency Fund)
- Remainder personal and business checking accounts
After studying the pros and cons, I decided to begin investing in real estate with two of the popular online real estate crowdfunding platforms:
- Patch of Land
There are over 200+ real estate crowdfunding platforms today due to the passage of the 2012 Jumpstart Our Business Starts Up Act (JOBS Act).
Retail investors can now invest in larger commercial & residential real estate details that were once reserved for only institutions and the wealthiest of individuals.
Real estate crowdfunding is an exciting space and sounded like a good place to start real estate investing and creating streams of passive income.
My goal is to create enough passive income through investments to replace my current income as a dental specialist.
One of the downsides to investing with these companies is that many require investors to be an accredited investor.
According to Wikipedia, an accredited investor is one who is:
- a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, or has assets under management of $1 million or above, excluding the value of their primary residence
- a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year or a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.
If you are NOT an accredited investor at this time, fear not. More and more crowdfunding sites are beginning to allow non-accredited investors access to their deals.
Pros of Investing in Real Estate Crowdfunding
- Little to no management required. As soon as I make an investment, the deal is done (similar to when I invest in index funds.)
- Low minimum investments. Some <$2,000.00.
- High projected returns. from 8-20+% yields depending on a debt or equity deal ( Much better than current CD rates <2%)
- Mailbox money!!
- Ability to choose your own investments.
- Minus the hassles of owning physical property No midnight calls to fix a stopped up toilet.
Cons of Investing in Real Estate Crowdfunding
- Occasionally pay extra fees vs to going directly to syndicators
- Less diversification vs investing in a REIT such as Vanguard Real Estate Index Fund
- Many require being an accredited investor
- Hassle of having to track different investments and payments
- Can be difficult making 1031 exchanges
Two Main Types of Investments
Most investments on crowdfunding sites are offered as either a debt or equity investment. Let’s take a look at both.
I turn to Investopedia for a little help:
When investing in real estate debt instruments, the investor (typically you) is acting as a lender to the property owner or the deal sponsor. The loan is secured by the property itself and investors receive a fixed rate of return that’s determined by the interest rate on the loan and how much they have invested.
In a debt deal, the investor is at the bottom of the capital stack which means they have priority when it comes to claiming a payout from the property.
- Shorter hold time– Debt investments are most often associated with development projects. As a result, they typically have a shorter holding period compared to equity investments. Depending on the nature of the deal, the hold time may last between six and 24 months. That’s a plus for investors who aren’t comfortable tying up assets for the long-term.
- Lower risk– Because of the way deals are structured; investors take on less risk with debt investments. The loan is secured by the property, which acts as an insurance policy against repayment of the loan. If in the end the property owner or sponsor defaults, investors have the ability to recoup the loss of their investment through a foreclosure action.
- Steady income– Debt investments are more predictable in terms of the amount and frequency of return payouts. While every deal is different, it’s not unusual for investors to earn yields ranging from 8% to 12% annually. These returns are typically paid on a monthly or quarterly basis.
- Capped returns – Debt investments entail less risk, but one major downside is the fact that returns are limited by the interest rate on the loan. Investors have to be clear about whether they’re willing to sacrifice the potential to earn higher yields in exchange for a safer bet.
- Higher fees – While most real estate crowdfunding platforms don’t charge investors anything to create an account and research debt investments there’s usually some type of fee involved to participate in a deal. The crowdfunding platform usually takes a percentage off the top before any interest is paid out, which can eat into your returns.
Most real estate crowdfunding deals involve equity investments. In this scenario, the investor is a shareholder in a specific property, and their stake is proportionate to the amount they have invested.
Returns are realized in the form of a share of the rental income the property generates, less any service fees paid to the crowdfunding platform. Investors may also be paid out a share of any appreciation value if the property is sold.
- No cap on returns – Equity investments offer a broader horizon, in terms of earning potential. It’s possible to see annualized returns ranging from 18% to 25% (Nice!). Since there’s no cap, however, the sky is really the limit from an investor’s perspective.
- Tax benefits – One perk of owning an investment property is being able to deduct certain expenses associated with its ownership, such as depreciation and the cost of repairs. With equity crowdfunding, deals are normally structured through an LLC, which is treated as a flow-through entity for tax purposes. That means that investors can reap the benefits of the depreciation deduction without having to own property directly.
- Lower fees – Equity investments have the potential to be cheaper where fees are concerned. Rather than paying upfront fees and monthly service fees, investors may pay a single annual fee to maintain their position in the property. The fee is calculated as a percentage of the total amount invested and often runs between 1% and 2%.
- More risk – Equity crowdfunding may put more money in investors’ pockets, but it means taking a bigger gamble. Investors are second in line when it comes to receiving a payback on their investment, and if the property fails to live up to its performance expectations, that can easily translate to a loss.
- Longer hold period – Equity investors are looking at a much longer time frame compared to debt investors. Hold times can stretch out over five or even ten years, which is an important consideration if you’re interested in maintaining a high degree of liquidity in your portfolio
My first investments
After doing my homework, I decided to invest in two debt deals, one with RealtyShares & one with Patch of Land. Neither one of them have closed as of this writing.
RealtyShares offered what they called the “Nationwide SFR Package” a $2.625 million dollar loan to Ingersoll Financial secured by 125 properties in multiple states. Ingersoll Financial purchased the properties for $3.75 million (average of $30,000 per property), and RealtyShares advanced $2.625 million ($21,000 per property) to be used to complete the purchase.
Ingersoll Financial plans to do minor repairs and clean up and to remarket the properties to local investors interested in purchasing individual or smaller groups of these homes.
- Loan: $2.625 million
- 12-month loan (with possible 6 month extension)
- 1st Lien Position
- 10% APR on loan, net of all fees
- Minimum Investment: $10,000
- Loan to Cost: 70%
Other information provided:
- Major documents including the appraisal, budget, plans
- Financials of the project
- Info on the developers
- It’s a 12-month loan, seemed like a decent length to see a good return, and interest would be paid out every month. This might be a nice source of passive income..
- 10% APR was much better than I was getting from money market funds (<1%).
- Developer has a good track record, with personal guarantees on the loan.
- The project is spread out over multiple states with multiple listings.
Pulling the trigger
In August 2016, I pulled the trigger and invested the $10,000 minimum.
The first 9 months were great until the deal began to fall apart…
I initially began receiving monthly interest payments (~$83.33 per month).
The calculation is: 10% APR with an initial investment of $10000 = $1000 for the year.
Divided by a year (12 months), this comes out to $83.33 a month.
2) Patch of Land
In April 2017, I decided to invest in another debt investment, this time with Patch of Land (I was still being compensated by debt deal #1 at the time).
I won’t go into as much detail as the first.
- 12 month hold term at 11.25%
- Underlying loan secured by first position lien on title and personal guaranty of the individual borrower
The below financial estimates are based on Patch of Land’s investment of $3,470,000 to the borrowing entity that will hold title to 1355 Marlin Drive, Naples, Florida.
|Estimated Renovation Costs||$400,000|
|Origination and Processing Fees||$48,580|
|Estimated Closing Costs||$35,000|
Standard Interest-only distributions will be paid monthly as loan payments from the borrower are processed and distributed based on your corresponding fractional investment amount.
Total repayment of capital is expected on or before the end of November 2017. Distributions will be made directly into each investors Patch of Land account online.
This deal has gone a bit better than expected.
Originally the investment was set up to pay:
- 11.25% for 12 months (ending on Nov 2017)
Turns out the borrower needed more time to pay off his loan. As of this writing, we are on month #18 of interest payments. Heck, I’ll take 11.25% on my money as long as they’ll pay!
RealtyShares Utah Diversified Residential Fund II, Salt Lake City, UT
This was my first preferred equity investment which included properties in the greater Salt Lake City area invested in May 2017.
It promised a 11.5% return for 24 months ($25K min) and has paid (and currently is paying) like clockwork. It’s nice getting monthly deposits into our account.
RealtyShares Prescott Woods
This was my first preferred common equity multifamily investment which is an apartment complex in Tulsa, OK. The minimum investment was $50K and it promised a 9% three year hold which has yet to begin paying due to poor management.
Investing in this property was my BIG mistake due to lack of due diligence on my part with the sponsor.
Latest update: Despite some of the encouraging leasing activity we’d recently reported, this property in fact continues to struggle; tenant departures and evictions have now brought the occupancy rate for the property down to 86%. The lower-income, higher crime profile of the area that was earlier disclosed has turned out to present a bigger hurdle than the sponsor had anticipated.
They plan on attempting to sell the properties without paying out any distributions. (I’m learning from my mistakes.)
RealtyShares Westwick Apartments
This was another preferred equity multifamily investment which happened to be in a town I did a one year hospital residency, Biloxi, MS.
I was familiar with the area and decided to take a leap of faith with this investment which has worked out nicely.
This was a three year deal, $10K minimum which is currently returning 13.5%.
Apartment Syndication Deals
Out of the five investments I’ve discussed thus far:
- two haven’t turned out too well
- three are continuing to perform as expected
After making these initial five investments (with the mistakes I’d mentioned), it was time to up the game and look into something a bit larger.
Again, as a dental specialist, becoming a landlord was NOT too appealing to me. I liked the idea of continuing to add to our passive investments.
The original goal was to convert 10% of current holdings into passive real estate investments.
Researching led me to something called apartment syndication deals.
What is an apartment syndication?
An apartment syndication is a temporary professional financial services alliance formed for the purpose of handling a large apartment transaction that would be hard or impossible for the entities involved to handle individually (i.e. doctors), which allows companies to pool their resources and share risks and returns.
In regards to apartments, a syndication is typically a partnership between general partners (i.e. the syndicator) and the limited partners (i.e. the investors) to acquire, manage and sell an apartment community while sharing in the profits.
My First Apartment Syndication Investment
Deal #1 – The Avery
The first deal involved an apartment complex in Denton County, TX formerly Mira Vista Ranch.
- Purchase price: 40.8 million
- 350 Units
- $50 K minimum investment
- Projected annual Cash on Cash (Coc) returns: 9%
- Internal Rate of Return (IRR) of 18.6% over a 5 year hold period
The CoC and IRR are two important metrics to evaluate. If you’re unfamiliar with them, here’s what they mean:
Cash-on-Cash (CoC) Return
The cash-on-cash (CoC) return is the rate of return, expressed as a percentage, based on the cash flow and the equity investment. CoC return is calculated by dividing the cash flow by the initial investment.
For example, a 216-unit apartment community with a cash flow of $330,383 and an initial investment of $3,843,270 results in a CoC return of 8.6%
Internal Rate of Return
The internal rate of return (IRR) is the rate, expressed as a percentage, needed to convert the sum of all future uneven cash flow (cash flow, sales proceeds and principal pay down) to equal the equity investment.
IRR is one of the main factors the passive investor should focus on when qualifying a deal.
- Initial investment $50
- Year 1 cash flow of $5
- Year 2 cash flow of $20
At the end of year 2, the investment is liquidated and the $50 is returned.
*The total profit is $25 ($5 year 1 + $20 year 2).
Simple division would say that the return is 50% ($25/50). But since time value of money (two years in this example) impacts return, the IRR is actually only 23.43%.
If we had received the $25 cash flow and $50 investment returned all in year 1, then yes, the IRR would be 50%. But because we had to “spread” the cash flow over two years, the return percentage is negatively impacted.
The timing of when cash flow is received has a significant and direct impact on the calculated return. In other words, the sooner you receive the cash, the higher the IRR will be.
Deal #2 – 98Fifty
The second deal involved an apartment complex in Richardson, TX formerly Arbor Vista.
- Purchase price: 13.3 million
- 196 Units
- $50 K minimum investment
- Projected annual Cash on Cash (Coc) returns: 11%
- IRR of 22.6% over a 5 year hold period
So far, both investments have been paid as promised. Each month, distributions are automatically added to the checking account associated with each property.
One of the best parts of these deals has been how quick the distributions were started. Roughly about a month after each of the properties closed, the distributions started flowing in like clockwork.
Overall, I’m cautiously optimistic about the real estate (and alternatives) portion of our portfolio. We’ve had winners and losers and not only have I learned from my mistakes, hopefully others reading this will too.
Be aware that these investments have risk and are not that different from the stock, bond, and publicly traded REIT markets these days too.
What do you think? Do you invest in real estate? I’d love to hear your stories and thoughts too.