[Editor's Note: This is a guest post from Lawrence Fassler at Realty Mogul. We have no financial relationship at this time.]
Credit markets are continually evolving. The peer-to-peer lending businesses like LendingClub and Prosper, which sprang up to better service some consumer credit markets, showed that profitable financial sub-markets (like credit card re-finance) still exist. Real estate credit markets offer a familiar appeal to individuals whose house is often their largest single asset. Mortgages might be securitized and bundled in multiple ways, but most individuals can still grasp the concept of a house, commercial building, or raw land as “real” collateral – something tangible that has a real (though still somewhat fluctuating) store of value.
This familiarity makes “crowdfunding” particularly viable as a financing source for real estate — and while the homeowner lending market has become more regulated in the wake of the problems encountered during the Great Recession, there remain plenty of other, less regulated sub-markets that are under-served by traditional financial institutions. “Hard money” lending to companies or individuals needing only short-term financing for renovation projects remains an attractive arena, and “crowdlending” is beginning to change the dynamics of that sector.
Defining Crowdlending
Real estate “crowdlending” is, at its core, just another way of pooling money together from a group of investors in order to make a loan. The difference now is that the ease of communications made possible by the internet has increased the potential reach of such pools so that they can extend out to investors across the country – investors who can review investment projects at their convenience. Crowdlending also allows for such investors to participate in larger commercial real estate projects – opportunities that were previously limited to financial institutions or a few very wealthy individuals – at lower minimum investment amounts than were ever before possible.
Accredited Investors Only
The Securities and Exchange Commission (SEC) still imposes some limitations on who can make these investments (unless an expensive registration statement is filed with that agency). Most commonly, this means that investors are limited to those who are “accredited,” meaning that they (generally) make over $200,000 in annual income, or have over $1 million in net worth (excluding their primary residence). This group, however, includes about 8 million Americans.
For such accredited investors, a single $100,000 investment into a large commercial real estate project (the minimum that is often otherwise required) might still be beyond their means, but a smaller investment of $10,000 may be quite workable. Crowdlending has brought to these investors not only increased accessibility to larger commercial loans, but it also gives them the ability to customize their real estate portfolios with interests in properties that they choose themselves (as opposed to investing in a “blind pool” portfolio) and to directly monitor those investments once made.
Hard Money Loans
Debt investments tied to secured real estate loans (similar to bank loans) can be quite attractive to investors. The hard money loan market usually involves loans of relatively short terms that can provide investors with consistent monthly income streams. While equity investments in real estate can be attractive for other reasons (namely, they generally provide greater anticipated rates of return), the debt investments involve less volatility and risk – and can offer rates of return that are still quite favorable when compared to bank CDs or other shorter-term investments.
The Realty Mogul Experience
In 2013, the real estate crowdfunding site that I lead began to show how crowdlending can really work. Entrepreneurs buying a fixer property at auction can now utilize crowdlending as their source of “bridge” financing to get funds needed until the property is stabilized and conventional bank financing can be installed. While individual hard money lenders may be plentiful in some regions, in others an entrepreneur may need more than the $100-200,000 that many individual lenders are accustomed to loaning. These larger commercial properties in need of renovation have turned out to be great candidates for alternative sources of financing.
Crowdlending investors have literally seized on these opportunities. We at Realty Mogul have had some debt investments in the $100,000 range sell out in 20 minutes after they appeared on our website. A larger loan of nearly $500,000 was fully funded within a few hours.
For entrepreneurs, the attraction of this speed is evident. Time is money, and the quicker they can get a loan processed then the faster they can get started on the planned renovation, get the stabilized property back on the market, and move on to the next project.
For investors that now have newfound access to these commercial lending opportunities, crowdlending also provides them with greatly increased investment transparency. Investors can view information about the specific property that is the subject of the loan – information in sufficient detail that they can make an informed investment decision about that particular property. To the extent they have funds sufficient to make several of such investments, they can themselves diversify their own lending portfolio — in multiple property types and across different geographical areas. Finally, they are now in a position to track their investments – our site, for example, allows them to stay abreast of their account value (divided between debt and equity investments), cumulative earnings, and cash and earnings activity.
Results
[Editor's Note: I asked Lawrence to include this section as I thought readers would be interested. It may sound a bit more “advertisy” than I allow most of my guest posts to be. Feel free to blame me.] What have the results been like? The crowdfunding industry is still quite young, so there aren’t reams of data available − but at Realty Mogul, as of the end of January 2014, we’ve financed loans on 34 different properties, of which 14 have now been fully repaid. These lending opportunities have been offered to investors at interest rates varying from 8 to 10% annualized, with terms varying from 6 months to 2 years. None of the loans has defaulted or even threatened to default, so we haven’t yet had to deal with any foreclosure proceedings (which vary by state). Perhaps unlike other crowdfunding sites, though, we have historically curated the opportunities that are brought to us, so that proposed loans must meet certain criteria before we post them to our website.
2014 will likely see a greatly expanded use of crowdlending. House-flippers in Kansas will be able to access money originating from investors in Florida or Arizona. Hotel entrepreneurs buying a fixer property at auction may be able to utilize a crowdlending site as their source of “bridge” financing to get funds needed until their property is stabilized and conventional bank financing can be installed. In almost every market, crowdfunding sites like Realty Mogul are already disrupting the way that many real estate properties are financed – and 2014 will likely see a big ramp-up in crowdlending as a new financing source and investment opportunity.
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What do you think? Have you done any hard-money lending, either on your own or through an organization like this one? What was your experience like? Comment below!
Featured Real Estate Partners
I’ve been seriously considering getting my feet wet in the crowdfunded real estate world. I’m curious as to your thoughts on investing through a self-directed IRA. I specifically wonder whether the tax benefits of real estate investing and the potential for UBIT tax on an IRA make IRAs an inefficient vehicle for this type of investment.
Aside from REITs, I prefer having my real estate investments in a taxable account. The hassle factor is not inconsequential, plus there are significant tax breaks available to real estate investors which would go away in an IRA.
JApath —
It’s true that UBIT is an issue on equity investments, but it shouldn’t effect debt investments such as those discussed in this article. Self-directed IRAs can thus be used in these cases, but in the crowdlending world you must be aware that electronic signatures and transfers via automatic ACH transfers are the norm, and some IRA custodians have difficulty with those requirements. Speak with your custodian; if it can’t work with the brave new world of internet-based crowdlending, there are other providers out there who can.
Remember readers that Realty Mogul offers two types of investments- an equity investment where you own the property and a debt investment where you loan someone else money backed by the property. This article is about the debt investments. They are very different types of investments with different risks and different expected returns. I would consider the debt investments to be a relatively risky type of fixed income (when compared to treasuries or a bond index fund), not a real estate investment. I think if you want to dedicate a portion of your portfolio to real estate, then you should be looking to be an owner, not a lender. If you wish to lend money, then that investment fit into your fixed income side, similar to other relatively risky fixed income like junk bonds or peer to peer lending (although at least it is backed by a real asset.)
Disclaimer – I am not an accountant, but I did take tax courses in business school, but please check with your own accountant for specifics.
UBIT comes into play on real estate rental income to the extent that the property is financed with debt in some way. A straight equity deal with no leverage is not going to be subject to UBIT from my understanding. And if you are in a real estate deal using self directed 401K/IRA Funds that has debt, UBIT will be paid proportionate to the amount of debt on the property.
http://www.irs.gov/publications/p598/ch04.html#en_US_2011_publink1000269930
Curious if anyone who reads this site has looked further into this. Is this something for those of us who don’t have a strong background in real estate investing but are looking for more real estate exposure besides REITs?
WCI – what is your take?
Cautiously optimistic about Realty Mogul and other crowdfunding for both equity and debt. It’s easy to see the positives. The question is whether they are worth the loss of diversification, loss of liquidity, additional risks, and extra fees in order to get high returns and minimal correlation with the rest of your portfolio.
Also wondering about tax implications of the payouts. As an employed physician, I haven’t learned the ins and outs of LLC partnership income, and this is apparently the business structure of your buy-in. Is this essentially taxed at the dividend rate, or would this qualify as earned income?
Thanks!
It depends how these are structured, but at Realty Mogul the interest payments on debt investments is straight interest income, i.e. it’s reported on Form 1099-INT. LLCs are useful on equity investments so that depreciation and other deductions are passed through to investors, but on debt investments involving interest payouts there’s no real need for that approach.
I believe the following is correct. Rental income is taxed as regular income with investment tax surcharge of 3.8% added on top if >$250,000 AGI (the income is passed through the LLC to your individual income tax/rate). The income can be offset with depreciation or even accelerated depreciation, but this will eventually be recaptured when you sell, unless you do a 1031 exchange which some of the sponsors are starting to do or get a step-up basis when you die and pass it on. You can avoid income tax by using an IRA, but it is very cumbersome and potentially expensive if there are regular payouts. This potentially can be avoided by using a “checkbook IRA LLC”, but there are some concerns out there that the IRS may crack down on their use.
Good point WCI, my comment was geared toward an equity investment.
You should always ask why this opportunity is left open to you. Why don’t the borrowers just get a loan from the bank(s)? Why doesn’t the entity that organizes the loan pool get on the deals themselves versus being content with only a small fee for organizing?
While that’s always a question worth asking, there are some possibilities other than the obvious one that the investment is far riskier than it first appears. One may be that the entity organizing the loan pool doesn’t have any capital or access to it at a rate good enough to allow some arbitrage. The second is that, yes, there are free lunches out there. I had a family member who took back a mortgage on a property he sold. It was backed by the property and if payments stopped he could foreclose. There is some risk there as you lose money in the foreclosure process. But it may be worth taking that risk if the investment has a yield 7% higher than a treasury bond. At a certain interest rate, I’m willing to take a lot of risks. P2P Loans are a good example. I have people stop paying on these unsecured loans all the time. But when they’re paying 20% interest, I can afford for A LOT of them to default while still allowing me a double digit return. Take 100 loans of $100, all at 20%, for instance. I’ll get $2000 a year in interest on that $10K in capital. That means I could still break even if nearly 1 out of every 5 stopped payments at the beginning of that year. If only 1 out of 10 default, I have a double digit return.
Finally, a business model is much more sustainable with guaranteed payments. Those organizing the loan pool are basically guaranteed a return. This allows them to make payroll, borrow at a low interest rate from the bank etc. If the business is making 12-20% on its capital, why would it want to loan money at just 8 or 9%.
I’m a simple person. I follow a simple rule — “I’m not special.” This rule has served me well. Following it no doubt had me pass up some great deals and free lunches but it also saved me from serious troubles.
It’s a good motto. There is no doubt that one can be very financially successful without ever investing in something like this.
Excellent response WCI. Have been looking at this sector for a while. Never jumped into the P2P lending game as it just seemed like more trouble than it was worth. I have created an account in Realty Mogul to test the waters. Had to enter information showing I was accredited investor which was not a big deal.
Only one offering which is for a Hard Rock Hotel in Palm Springs with minimum investment of 10k with a proforma estimating 15-17% IRR which they describe as “Annualized total estimated return to Realty Mogul investors, including cash flow and appreciation after expenses and fees.”
They estimate 8-15% cash-on-cash which they describe as “Annual estimated cash flow after fees and expenses.”
While this is certainly more risky than plowing money into a REIT to gain more real estate exposure, but for those of us without the time to be research actual property or who don’t want to become a land lord, this might be a viable alternative if you accept the increased risk. Not sure if I am going to jump into the Hard Rock offering – it is the second highest percentage rate that has been offered (first being a mobile home park) so obviously they view this as a riskier venture than the majority of their offerings. But I may do the minimum on a few properties to start off to spread it around.
apologize if this posted twice – had some issues with the comment section.
Hey TBell,
Putting money into the private real estate deal is not necessarily more risky than plowing it into a REIT.
Just because the rates of return are projected to be higher, doesn’t necessarily mean it is riskier. What you have to remember is that the closer you are to your investments the less people are “eating” along the food chain so to speak. So those returns can be passed directly on to you.
The REIT’s have not only the risk inherent in real estate investing, but they also have principle risk because they trade on a stock exchange. This means that even though their underlying assets may be performing well “the market” may not have that sector in favor and the mutual fund flows may roll money to another sector in the market. If this happens the stock price drops and you lose your capital. You also have the risk that the owners of the REIT may overpay for properties in their portfolio because they are using “wall street” money. As a REIT shareholder you are not going to have access to the people who run the REIT, but as an investor in a private deal you have the ability to speak with the sponsor and get a good understanding of the drivers of the investment.
So if the managers of the private deals you are looking at have experience and a good track record you may be safer with them.
I don’t necessarily think this is the right forum to discuss individual investments on RealtyMogul, but perhaps I can phrase my question in a more general way. The stated goal of investment in the Hard Rock Palm Springs property is “to operate and stabilize the hotel before reselling the property.” A brief look at their Yelp reviews indicates a bunch of unhappy travelers (likely skewed by reporting bias inherent in Yelp-type sites), and tripadvisor rates it in the middle of all hotels in the area. How does one do the due diligence necessary on these properties, outside of what we can only assume are rose-colored summaries from the website, to feel comfortable that the cash-on-cash and other estimates of return are not just made-up figures to attract your hard-earned investment dollars? Does anyone here have a method that works in this kind of crowd-funding scheme?
There is more to being an accredited investor than having a high income. The assumption is that you also know how to evaluate an investment. For a large sum of money, it’s probably worth flying out, meeting the guys putting the deal together, running the numbers past your accountant, walking through the property etc. For $5K, that will eat up a lot of your investment. The good news is you don’t stand a lot to lose and it is easy to come up with the investment. The bad news is that with small investments, you can’t afford to do real due diligence and still have an acceptable return.
But I’d start with participating in their webinar and asking the hard questions there.
I can not speak to crowd funding, but I have invested in private deals in the past, and due diligence is one of the more important aspects of the deal. I have been and am involved with investing in the hospitality industry so I will give you what I look for.
Going back to the Hard Rock deal, one way to verify the numbers is to take the proforma that they give and look at the nightly rate assumptions as well as the occupancy assumptions, those are the revenue drivers in the hospitality industry. You can verify the nightly rate numbers on sites like tripadvisor/travelocity/orbitz etc… Just take the address of the Hard Rock project and take a one mile radius around it making sure that what you are comparing are similar hotels to what the Hard Rock is or will be.
The occupancy numbers can usually be found using a google search if it is in a large metro market, or you can call the local chamber of commerce and they should have the information on hand. With that you can be sure that the potential revenue side of the project is solid. Next comes vetting the construction and management side of the Project.
The good thing about owning a piece of an income producing building in a place with good revenue drivers is that you can always bring in good management to make money, so I am less concerned about the 3rd party management team unless they are also part of the development team, but we are getting off in the weeds a bit.
The next piece is the construction side, if there are not cost over-runs, this to me is the most important piece once you have established that the potential revenue numbers are solid. Once the building is built, that is your investment basis, and if it comes in on budget, you are now fixed at that point. Add on top good revenue numbers and you can see why management is fungible, you can’t really change a market’s occupancy,nightly rental rates, or cost of construction, but you can bring in better management to get your investment returns.
I disagree with the notion that you have to go out and see the Project to invest necessarily, as long as you have met the developers, seen photos, know their track record and understand the market well, you can make an informed decision. That would be like saying if you have stocks you have to go and see the site of each company. Somehow real estate deals get held to a “higher” investment standard than stocks and bonds because they are perceived as more “risky” but I will tell you something, the wealthiest people I know are buy and hold real estate investors.
If you buy 3000 of them, you don’t need to go out and visit the companies. If you only own 2 stocks, I suggest you do. That’s why individual, private real estate gets held to a higher standard; you’re losing the diversification that is easily obtained in seconds with stocks.
I think your comment demonstrates why one needs to be careful with these kinds of investments. The hotel business is very different from the multi-family housing business. All real estate is not the same.
That assumes:
1) the private investment is a large part of your overall portfolio
2) you think diversification is a way to wealth
You imply diversification is a bad idea. Former Enron employees who had 100% of their 401(k) in Enron stock disagree. Are you suggesting it is impossible to become wealthy with a diversified portfolio? Because if so, I know of literally thousands of Bogleheads who disagree. A good strategy is to diversify where you don’t have any special skill or advantage, and concentrate where you do. For most doctors, their concentration should be their practice. For someone like you, you concentration should perhaps be on a few real estate properties. But suggesting a busy doctor ought to put half his retirement portfolio into a single property isn’t very good advice and is much more likely to hurt him than help him.
That is why I love this forum and appreciate you creating it. We can have intelligent dialogue on substantial topics and all of the readers can learn and make decisions for themselves.
I am not trying to imply that diversification is a bad idea necessarily, but I live my life trying to emulate those that have reached a level of success that I am aspiring towards. So here are a couple of my mentors from a far and THEIR take on diversification –
“Concentrate your energies, your thoughts and your capital…. The wise man puts all his eggs in one basket and watches the basket.” Andrew Carnegie
“The men who have succeeded are men who have chosen one line and stuck to it.”
Andrew Carnegie
“Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
― Warren Buffett
So my personal belief is that once you have figured out a way to invest that gives you above average returns, you continue to do that to the exclusion of other things. I know of very few people (outside of walls street) who made their wealth investing in stocks and bonds, now some people hold their wealth in those vehicles, but it is not where their wealth was created.
The stock and bond markets are only intended to maintain one’s purchasing power against inflation, not create new wealth (unless of course you are selling stock through an IPO). And remember I define wealth as the ability to maintain your standard of living without touching your principle, wealth is your money generating money.
So you bring up a good point with Enron, I actually live in Houston and the first business course that I ever took was in Business School here. It was a financial accounting course in the year 2000, guess whose books we studied from the years 1997-1999, Enron’s. At the time Enron had not made $1 from core operations for those previous 3 years, but it’s stock price peaked in the Fall of 2000 at around $90 a share.
This was the point at which I personally sold all of my stocks and bonds. So yes, concentrating in a vehicle (Enron stock) whose sole way to make a return was speculation (capital appreciation) where your investment capital is completely dependent on what the “market” says its worth is very risky we agree on that wholeheartedly.
Now I disagree that diversifying into things that you do not know, somehow makes you safer. I am a firm believer that when you invest your hard earned dollars, you should know exactly what it is that you are investing in, how they make their money, who the management team is, and how stable the industry is. That does not take a high level of expertise, nor a huge amount of time. That is why we like private investments, the closer you are to your investment, the higher you individual returns will be in a successful venture (very few middlemen).
Lastly, I never said that someone should put half of their “nest egg” in one individual project, but again in my world, having any large % of your investment portfolio in companies that you know nothing about, do not know their management teams, do not understand their market and expense drivers is about the riskiest thing that you can possibly do with your money.
I recently invested in a debt deal on Realty Mogul. Here are some of my thoughts.
– RM only shows investments that have been completely funded. This is VERY misleading since some investments never get fully funded and the investments are then returned back to the investor without any interest payment. This could amount to a few weeks of cash drag, ie. lost interest. There is no record of these deals for members to see. There is also no disclaimer mentioning that these deals on not shown. User is led to believe that all investments fund and they get interest right away.
– Actual loan period for previous investments is not mentioned either. User is led to believe that standard loan period of 12 months is what is received by the investor. However, most loans are completed in 6-8 months and investor would then need to invest the funds into another deal. RM should provide historical data for the user.
Just a caution to people who are thinking of investing that not everything is as it appears to be.
Thanks for sharing your experience.