A typical investor is expected to anticipate the potential returns on the investment they are about to make.
As you were navigating through the investment options available in real estate, you probably came across the idea of real estate crowdfunding and wondered how much you can make through crowdfunded real estate investments.
To be honest, that depends on so many factors, among them the type of investment, the market conditions, etc. Before we explore that, let us get to understand what real estate crowdfunding is.
What is Real Estate Crowdfunding?
A crowdfunding venture is an undertaking where a group of people pools funds together to accomplish a common goal or fund a certain project.
Crowdfunding does not have to yield profits. In some cases, crowdfunding is used to fund a charitable venture, for instance, in catering for the medical needs of people who have been affected by an earthquake.
Crowdfunding can also be used in investing, and real estate is one of the ventures that has utilized this form of funding. Real estate is often expensive, creating a high financial barrier to entry.
With the introduction of real estate crowdfunding, this barrier has been removed or at least flattened. On some real estate crowdfunding platforms, an investor can invest with as low as $500. That was previously unheard of.
This is typically how real estate crowdfunding works. A developer or a savvy real estate investor identifies an investment opportunity.
Since in most cases they will not be able to fund the investment working on their own, they create an opportunity for individual investors to contribute towards the execution of the plan by raising part of the capital.
There are three parties involved in real estate crowdfunding. The first one is the sponsor who seeks the investment, plans it, and oversees its execution.
The sponsor will arrange for the acquisition or purchase of the property, facilitate the financing, and organize for the various works to be completed on the property.
The second part is the crowdfunding platform where the sponsor finds the investors to fund the project. The platform collects funds on behalf of the sponsor.
The last party is the investor who raises some of the capital required to accomplish the project in exchange for a share of the profits, which is usually proportionate to the portion of the capital they contribute towards the project.
How Much Can You Make?
The answer to this question depends largely on the type of offering you are investing in, whether it is equity offering or debt offering. Before investing, you need to conduct due diligence on the sponsors and the property they are investing in.
Investing in an equity offering makes you a part-owner of the property or the portfolio. To have an idea of how much you can earn from investing with such a crowdfund, look at its projected Internal Rate of Return (IRR).
IRR is the projected return the sponsors of the crowdfund expect given the cash flow generated by the property and the income that is likely to be earned from the sale of the property at the end of the period for which it would be used.
How much you can earn from an equity offering is also dependent on the performance of the property or portfolio. These include the vacancy rates, the expenses, and whether or not the property is sold at the earlier predicted price.
Equity offerings are typically riskier than debt offerings. Therefore, the potential returns from equity offerings are generally higher than debt offering interest rates.
In real estate crowdfunding, these are more common than equity offerings. As an investor, you lend money to the sponsor. The sponsor uses this money to purchase or renovate the property. This mostly applies to fix-and-flip investments, majorly involving single-family units.
Debt offerings usually have varying interest rates. These are made clear at the beginning of the engagement. Therefore, the investor would know how much they would get in return. The risk here is that the sponsor could as well default for various reasons.
The Income Component
Quite a several real estate investors make the assumption that real estate will automatically produce income. This is not always the case with real estate crowdfunding. You must familiarize yourself with the deal’s distribution plan before investing.
In most crowdfunded deals, the income projections are just predictions that may not end up materializing. Some real estate crowdfunded deals do not pay dividends to investors for the first few years.
Crowdfunding websites such as Patch of Land focus on debt offerings. An investor can earn up to 12% return on investment annually while investing with them. Fundraise report up to 13% net average return.
Once you have the target or projected IRR, take into account other features of the deal as well. Higher return projections are not always better than lower return projections. You would rather celebrate a lower return from an experienced sponsor than a higher return from an inexperienced sponsor.
It is also worth noting that many deals list two target IRR levels (the project level IRR and the investor IRR). You should be keen on the investor IRR since this is the sponsor’s projection of how much you are likely to earn after deducting any applicable fees.
It is important to note that many of these crowdfunded real estate investments do not offer liquidity. They cannot be publicly traded. You may have to wait for a liquidation event, for instance, the sale of a property, or sell your shares to other investors on the platform.
How to Evaluate Crowdfunded Real Estate Deals
Here’s what you need to know to evaluate the success and the potential of a crowdfunded real estate investment to earn substantial returns.
1. The Risks Inherent
Crowdfunded real estate deals vary in the level of risk involved. Before you get excited by the projections, you need to assess the risks. Consider the economic sensitivity of the property you are about to invest in. Some real properties are resistant to recession while others are cyclical.
For instance, a commercial property used for entertainment purposes may experience a drop in revenue during tough economic times compared to office spaces that usually have longer leases.
Consider if the property is already occupied or it is yet to be leased out. The risks are lower when the occupancy rates are higher.
2. How Experienced is the Sponsor?
As we have already seen, the sponsor is the person or company that is directly involved in the acquisition, planning, and the actual execution of the actual investment project.
This entity’s experience is of great importance when evaluating a real estate crowdfunding deal. This is the party that will negotiate the purchase price of the property, assigns contracts, and take charge of the daily operations of the property.
If they are inexperienced in this, the property’s outgoings may be relatively high, causing a reduction in the potential profits. This in turn reduces your income as an investor.
What is their level of expertise in the field? What experience does the sponsor have in that field? What is their track record as shown by their completed projects?
Seek answers to these questions for you to determine if you can trust the sponsor with your money. This information is not difficult to get. A sponsor with experience will be more than ready to showcase it. The absence of this at the public’s disposal is a warning sign.
3. What is the Projected Internal Rate of Return (IRR)?
This information is usually made available on the real estate crowdfunded platform’s website. IRR is the total projected returns of a given investment, expressed on an annualized basis.
Different properties produce returns in various ways. Some deals have their income distributed throughout the year.
Others produce a large profit as a lump sum from the sale of the property at the end of the holding period. By assessing the properties’ IRR, these income structures can be compared to one another.
When assessing the IRR, make sure it is realistic. Many Commercial Real Estate deals report an IRR of between 12% and 18%. This is a normal and realistic range.
A very low IRR rate means the potential returns on that investment are generally low. A very high IRR reported by the crowdfunding could have been misreported, hence false.
4. How Does the Deal Produce Income?
You also need to consider how the deal you are about to get into produces money and if that is in line with your investment goals.
There are two main ways through which crowdfunded real estate deals make money. That is through producing passive rental income over some time, and by producing profits from the sale of the property at the end of the holding period.
Most of the deals produce passive income regularly, say quarterly. Some, however, do not start paying off right away. For instance, the sponsor may acquire multi-family rental apartments and renovate them for some time before they are rented out to tenants.
The rental income produced by the property is proportionally distributed to the investors in the form of dividends.
Some deals involve the sale of property for a profit. The sponsor may use the funds to acquire and renovate the property. The property may be sold two years later at a higher price than the purchase price. The profits are then proportionally distributed to the investors.
5. What is the Sponsor’s Contribution?
This may sound petty at first, but it has great implications. The sponsor’s funds usually form part of the pool of funds. The sponsor is also an investor in the deal, a situation referred to as co-investment.
The more the sponsor contributes towards the crowdfunded deal, the more dedicated they are likely to be in the project and the more motivated they will be to ensure the project is a success.
So all factors kept constant, the more a sponsor contributes, the better the deal. The typical range for the sponsor’s contribution ranges is usually about 10% to 25%.
There are several other aspects of real estate crowdfunding deals you can consider as you evaluate crowdfunded deals.
They include the fees payable, the type of crowdfunding deal, and the general performance of the real estate industry and the economy at large.
There are no stringent rules for evaluating the performance of a real estate crowdfunded deal. Additionally, there is no specific amount of income you should expect to earn from a real estate crowdfunded deal.
All these vary from one deal to another. As an investor, you need to use these aspects to create a bigger picture and analyze the deals individually.