[Editor's Note: This is a guest post from Kenyon Meadows, a practicing oncologist and self-described “alternative investments enthusiast.” He is the author of Alternative Financial Medicine: High-yield investing in a low yield world and blogs at AlternativeFinancialMedicine.com. Although this is not a paid post, he is a paid advertiser on this site. While I do have some investments that would be considered “alternative,” at least 85% of my portfolio is invested in boring old index funds. In this post, Dr. Meadows explains why that isn't the case for him and details his experience with real estate crowdfunding. Some links in the post are WCI affiliate links (meaning if you sign-up for an account through the link I get paid.)
As a full time practicing physician with a strong interest in alternative assets, podcasts have been an indispensable tool in cutting my learning curve with BiggerPockets.com leading the way in the arena of real estate. I had the honor to be a guest on Episode 219 where the hosts and I focused on some of the more passive investing strategies suitable for time-constrained professionals including things like turnkey single family rentals, private mortgage lending, and real estate crowdfunding.
Of these three arenas, real estate crowdfunding (RECF) certainly elicited the most follow up questions from listeners. I have been an early adopter in this asset class having participated in my first deal in 2013 and many wanted to know what platforms I have used and what my results have been.
Real Estate Crowdfunding
Kenyon Meadows, MD
As a brief introduction, this asset class represents the largest sector of equity crowdfunding that has emerged after the 2012 JOBS act.
Some of you are probably familiar with sites like Indiegogo and Kickstarter. These are known as rewards-based crowdfunding whereby people could make small monetary contributions in exchange for early or special access to various items like independent movies, books, music, and consumer products.
A key restriction was that contributors were not allowed to participate in any financial return or have an ownership stake in the product. The JOBS Act lifted this restriction and ushered in a wave of new online platforms offering a wide spectrum of new crowdsourced opportunities with a clear expectation of profit for the investor. It is now possible to take relatively small amounts of money and purchase a small stake in a Silicon Valley startup, loan money to an established small business, and — yes — participate in real estate deals.
Real Estate Flipping – Debt Investing
Remember the plethora of “Flip This House” shows on HGTV that were wildly popular particularly before the 2008 financial crisis? What many of us may not know is that when a real estate entrepreneur needs money for a house flip project, they don't go to a bank but commonly to a private network of high net worth individuals (read: You!) for financing.
In a traditional private mortgage investment, typically one investor would provide a short term, high interest rate loan commonly in the 8%-15% range for 6 to 18 months. This is usually an adequate time frame to acquire, renovate and ultimately sell the property at a profit sufficient to both service the loan and provide enough return to make it worth the entrepreneur's efforts.
Obviously the number of people who can write the high five-figure to mid six-figure checks needed for the initial acquisition of even a modestly priced property is limited; even among physicians. Herein is where the real disruptive capacity of RECF comes to the fore.
The online platforms function essentially as brokers between the real estate entrepreneurs, also known as sponsors; and the crowd of investors willing to fund their deals. With investment minimums ranging from $50,000 to as little as $100, private mortgage lending is steadily becoming more convenient and accessible to a much wider pool of individuals.
Equity Deals
Besides debt, there are abundant equity or fractional ownership opportunities with multiyear investment timeframes. Additionally, some platforms have developed specific niches around different property types or geographic regions.
Out of the 9 different sites I am currently on, (RealtyShares, Patch of Land, Groundfloor, RealtyMogul, Fundrise, iFunding, FixandFlip, Realcrowd and Peerstreet)
I am going to highlight three platforms that have distinct profiles in terms of the types of deals they offer and meet the following criteria:
- The platform has been in existence for a minimum of 3 years
- I have been investing on it for at least 2 years
- I have had at least 1 successful exit on a deal
RealtyShares
We will start with Realtyshares.com which I consider a sort of jack of all trades in RECF in that they offer a wide variety of deals including single and multifamily residential as well as commercial projects.
They offer first as well as second position debt and also plenty of equity opportunities. Depending on the type of project and deal size, their investment minimums vary greatly and while their website banner says the minimum is $5000, in actuality they have projects you can participate in for as little as $2,000 and ranging up to $30,000. This is been my number one site by volume and they have an ample diversity of offerings that can suit a number of investing styles.
Check out an in depth interview with the CEO to learn more about the backstory of the company and their selection criteria for deals.
[Editor's Note: If you are interested in investing with RealtyShares, go through this link and use promotional code “PARTNER100” to earn an extra $100 with your first investment.]
Patch of Land
Next up is PatchofLand.com and from the beginning they have been focused exclusively on single family residential properties with first position debt for fix and flip projects.
Accordingly, these are all short 6 to 18 months duration loans with typical interest rate in the 9 to 12% range. The minimum investment is $5,000. Patch of Land is a particular favorite of mine because, when it comes to crowdfunding, I only do first position loans. First position is synonymous with the senior debt which means that legally we have top priority in getting paid back; even if the property has to be foreclosed upon and sold to accomplish this.
For now both Realtyshares and Patch of Land are limited to accredited investors. According to the SEC that means you either earn more than $200,000 annually as an individual, $300,000 as a married couple, or have a net worth of 1 million dollars minus the value of your primary home. While this is not an issue for many members of the WCI community, only about 4% of the general population meet this criteria.
Ground Floor
The vast majority of RECF sites currently have the accredited investor limitation, however one exception that I know of and have used is called Groundfloor.com.
Their mission has always been to cater to the non-accredited investor with residential fix and flip projects using both first and second position debt with an investment minimum at an unbelievable $10 to participate! They advertise average returns of 10% since their founding in 2013. A BIG non-financial restriction for Groundfloor however is that you must be a resident of these 9 states to invest: CA, IL, MD, MA, TX, VA, WA, GA, DC.
It is a long and complicated regulatory issue as to why this is the case, but I know they are working to get a 50 state exemption so check back for updates.
How I Evaluate a Deal
When I'm going on a site looking for a debt deal there are some pretty standard elements presented to you in the user interface. Besides the standard array of pictures, you will see the overall loan size which in this case is $147,000 with an interest rate is 10.25% and 12 month term. You will also be presented with the after repair value or ARV percentage which ideally should be below 65% to 70%. There's a graph indicating what percentage of the loan has been funded and from my experience most projects will fund anywhere from a few days to a week from the time they are listed.
The platforms also provide an abundance of electronic documentation allowing investors to perform a thorough “digital due diligence” prior to committing any money. Items typically included are the developer’s track record of past projects, renovation scope of work, and some form of price analysis such as an appraisal or market comparable. On the more long term equity projects, the capital structures can get complex including components like preferred equity and mezzanine debt.
I have certainly seen many projects get funded in a matter of hours; particularly if it's in a hot geographic location or the interest rate offered is very attractive. Of course this sometimes makes it impossible to go through all of the due diligence documents and highlights one of the fundamental limitations about real estate crowdfunding – you have to trust the platforms underwriting processes. When it’s all said and done, you must have confidence that all of the deals listed have been scrutinized thoroughly. The platforms certainly have the incentive to do this because if too many deals fail to perform, investor confidence and capital would be quickly lost with very little chance of earning it back.
My Experience
Gold Level Scholarship Sponsor
Thus far I think my experience validates solid underwriting. Out of the 35 projects I participated in I've had 17 successful exits, 15 are current and performing as expected while 3 are in some stage of the foreclosure process. My overall returns have averaged a very satisfactory 11% annually for 3 years. With the foreclosures I'm getting regular email updates from the platforms; and in all cases they are confident that my original capital will be returned after taking possession and a subsequent liquidation sale. These relatively few negative experiences reinforce my original decision to stick with first position debt as ultimately this is the safest place to be in the capital stack when inevitably some deals don’t perform as expected.
This dovetails into the important and recurring theme regarding investment styles and risk tolerance. Due to my early adoption I am by default on some of the larger, more-established platforms in the industry that trace their origin from late 2012 to early 2013. Consequently many of them have completed several debt projects and have strong relationships with both repeat sponsors and their investor network. Anytime I see a new debt deal with a sponsor with which I have had a successful exit; I give that project priority-even if the interest offered is a little lower. Many new platforms and sponsors have proliferated over the past 2 years in particular, but I have not seen a compelling reason to migrate away from the more established players.
As mentioned, I am relatively conservative when it comes to RECF by limiting my investments to first position debt. It follows then that the platforms that offer these types of deals exclusively have a higher priority. Keep in mind that unless you invest with your IRA, there is no particularly favorable tax treatment for the interest earned on a private mortgage. Equity returns by contrast, can be shielded by the expenses associated with ownership as well as depreciation resulting significant tax savings. If this is important to you and the longer investment timeframes are not an issue, there are certainly sites that skew heavily towards these offerings. If your preference is to deploy larger chunks of capital per project, you will likely favor equity as well as the investment minimums are routinely 3-5 times that of a debt offering.
In summary, real estate crowdfunding represents an exciting and emerging asset class that is bringing an unprecedented level of access to the retail investor by leveraging the power of the internet. It deserves a serious look for any accredited investor looking to gain alternative exposure to either high yield, short term secured debt or fractional ownership of income property.
[Editor's Note: WCI has an affiliate relationship with the following crowdfunding sites. If you choose to invest with them, please go through these links as it helps support the site and sometimes gets you a special deal:
- Invest with RealtyShares! Use promotional code “PARTNER100” to earn $100 with your first investment.
- Invest with RealtyMogul!
- Invest with FundRise!
- Invest with Equity Multiple! Management fee on your first investment waived when using this link.]
What do you think? Have you invested with any of these crowdfunded companies? Why or why not? What has your experience been like? Any tips for someone considering these investments? Comment below!
Interesting post. I admit I am naturally skeptical of these sites, but I am interested in learning more about them. A few questions:
–Why do you want to take platform and other idiosyncratic risks to get exposure to an asset class that you can easily get exposure to through other means?
–There are a lot of investment firms out there that will make these types of investments. You mentioned a good point in that these investments can be quite large, so they do attract people or institutions with bigger pools of capital. Why aren’t investors on crowdfunding sites getting an adverse selection of sponsors that cannot get institutional funding? How does the investor have any idea whether the return is appropriately priced for the risk?
–Who is representing that the information in the digital diligence pack that you are relying on to make your decision is accurate? What is your recourse if it isn’t?
1) I think because “easily get exposure” means different things to different people. If you’re talking about publicly traded REITS, I would expect more control and lower correlations with your stocks. If you’re talking about buying real estate directly, I’d argue that isn’t “easily” compared to the relatively low amount of effort available through crowdfunding.
2) They likely are getting an adverse selection of sponsors. The question is how much more adverse.
3) While you do get some assistance from the site in due diligence (since they have their good name to protect) in exchange for their fees, the responsibility for due diligence still falls on you.
Easy in the sense that REIT’s, direct, or local syndicates are all options. Agreed, crowdfunding is easier than all but investing in public REITs.
My question regarding reps is that you need to rely on certain information when doing DD. You can do your own DD, but ultimately some combination of the seller, the sponsor, and the site should rep that certain things are true.
What is the typical fee/promote structure on these sites and does the crowdfunding site put any capital into the transaction?
There’s a fair amount of variability of the fee/promote structure. It really varies by the deal. I think most of the time the site isn’t putting capital into the transaction, at least not permanently.
How does the tax filing work with these profits/losses? I swear if I have to wait for one more K-1 in April or fill out another tax form, I’m going to go crazy. Last year I filed in six states and my paperwork was six inches thick.
How do you think things will change if/when there is a market crash, deep recession, housing market decline, etc.
If you don’t like K-1s, you probably don’t want to go into this space. You can minimize the number of state returns by only investing in states that do composite returns or are income-tax-free (plus your own and maybe in your case the other five you’re already filing in.)
I expect that if the real estate market crashes, it will affect the returns of these investments. I think correlation with the overall stock and bond markets, however, will be much lower than what you see with something like the Vanguard REIT Index Fund.
Building off of this — is there a primer somewhere on how the profits/losses etc. from these crowdfunded sites are taxed/reported? I am not ready to jump into these yet, but it would be helpful understand in advance the tax consequences/paperwork associated with doing so.
There are a few sites/blogs that focus on this. Here’s an example: https://www.therealestatecrowdfundingreview.com/
Good questions from Wealthy Doc and Donnie. I too wonder about the tax treatment. I finally have no K-1s and do not want another one. I might check out these sites tho.
Thank you for writing this article.
I have followed this space for awhile but have never found a suitable investment that didn’t fill up immediately. I read somewhere that hedge funds and investment banks are also interested in this space. Further, it feels like there was a time after the mortgage meltdown that qualified borrowers couldn’t get bank loans (i.e. the opposite of the NINJA loans) necessitating crowdfunding, but that has since eased off as the pendulum has started swinging back again leaving (relatively) less desirable candidates. The net result is that you are looking at the leftovers from Goldman or Bain in an already small pool. I guess I’ll keep checking, but I’m not hopeful that past performance predicts future returns.
Very nice post! I have looked into real estate crowdfunding a few times, but for some reason it just hasn’t gained my trust yet. Since you eluded to it toward the beginning of your post, I’m curious if you also participate in non-real estate crowdfunding? If so, has your experience been as positive?
If you consider peer loans as form of crowdfunding – then yes I have to both individuals as well as to small businesses. My experience has been generally very positive with returns as advertised for the amount of risk I was willing to take on. I use Lending club for my peer to peer loans (unsecured) and stuck mostly to good credit risk borrowers (7-8% returns) . On the business side, since the owners would pledge either business collateral or personal guarantees, I was willing to take more risk (12-16% returns)
Never ventured in this area of investing. It seems like a good way to become involved in real estate without a lot of the hassle. Thanks for sharing.
I’ve also been involved in real estate crowdfunding and have seen some good returns over the last few years, so I’m definitely a fan. The one concern is that these platforms have never been tested in a declining real estate market. There have to be over 100 different ones at this point. The advice I have is if you decide this is something for you, stick to the larger, more established platforms and diversify your funds over a few projects.
You bought a house through HomeUnion too, right? How did that work out so far. Will you be blogging more on that? I’m considering that. I made out well back when I had residential property. The tenants kept calling my wife though since I was busy at work. She is so over that. I would need a management company if I ever go residential again. I still invest in commercial property and other (e.g. senior living housing development). So far my commercial real estate investments have been more hands off.
I did invest through them. I only have one property through them, but so far so good. I’ll definitely do a few more posts on my experience. No way do I want to be answering plumbing calls on Sat nights, a property manager is an essential expense in my book.
Agreed with sticking to larger more established platforms. I think many of the newer players will be tempted to compromise a bit on their underwriting standards in an effort to have sufficient deal flow to attract investors.
It’s a concern for sure.
Interesting seeing how crowdfunded has evolved to start replacing traditional hard money lenders. Those are the “private network of high wealth individuals” he mentions earlier in the post. The pool is actually pretty large since all of my hard money lenders were investing from retirement assets. They didn’t necessary have or need $150K cash sitting in a savings account. The loans were made from IRA or 401K plans.
One thing I don’t understand is how crowdfunding can provide 1st lien position.
Unless you’re taking over the entire note, other people are involved and only one lender can be in first position. Maybe the platform itself acts as the lender after pooling together the investor funds, but that means the platform (e.g. Patch of Land) is has the lien not the individual lender. That’s a minor semantic difference with a big difference in legal rights. You wouldn’t have any ability or right to recover your money directly from the borrower, not get the added collateral protection available as a direct lender.
It’s not clear to me who the “borrower” is when using a crowdfunding platform.
The crowdfunder forms an LLC of which all the investors are members and the LLC has first lien position.
Clever, thanks!
I have been invested in three crowdfunding sites for about a year and a half, Peerstreet, Patch of Land and Real Crowd. I have not lost any money yet but have one property in foreclosure and multiple late payment situations. I have averaged just over 10% with the debt instruments in Peerstreet and Patch of Land. I have been putting more money into a fund called Broadmark in Real Crowd, this is essentially the same debt instrument as Patch of Land or Peerstreet but utilizing a large fund, therefore, you don’t see the foreclosures or late payments. The return has been about the same, 10%. I also have money in a fund called Trion through Real Crowd. This one is a longer hold investment of 3-5 years. The goal is to purchase undervalued apartment complexes and fix them up to sell or rent. This fund has not yet given any returns, I was told this fall is when I would start to see some money coming in on this investment. So far I’m happy with these alternative investments, but I concur with others above in that I wonder how this stuff will fare in a down market.
Thanks for sharing your experience. We’ll all follow along as the years and market cycles go by.
I’ve wondered whether the hassle of extra K-1’s and risk justifies an average pretax gain of 9%, which my passive indexes are getting maybe 6-7% pretax.
I have seen some crowdfunding projections to be more like 15% annually, but I’d imagine that there is much higher risk involved.
9% is pretty typical for a debt deal and 15% is pretty typical for an equity deal. Now, whether you actually get that or not is the question.
And what passive index gives you “6-7%?” My passive index funds gives me 25%, 2%, -6%, 12%, 4%, -18% etc. It might average out around 7%, but I certainly don’t expect that in any given year as it is actually a very rare year I get that exact return. And “getting” implies that you know what your future returns are going to be. I would argue you have no idea what your future returns will be. Impossible to predict in the short term and at best a range of predictable outcomes in the long run (and the range is far wider than 1%).
Seems similar to lending club which didn’t work out too well right? For these debt deals, wouldn’t it all be ordinary income so you’d be taxed at marginal rate? For me in CA, that’d be 50% so don’t see how it’s worth it. Would rather invest in equity deals, where I can offset cash on cash return with depreciation and take advantage of equity and leveraged appreciation.
You mentioned equity deals on these platforms but didn’t really elaborate. How would that work?
That’s a big reason all my hard money loans came from retirement funds. Couple of people even had enough saved in tax free accounts to fund deals. Great position when you’re getting 4 points upfront and 15% interest on short-term notes or have an equity split on a rental property.
Yea I’ve thought about that – but not sure the premium is that much better than stocks long term on the lending side of RE.
If you’re funding entire deals from tax free accounts, doesn’t that defeat the point of depreciation deduction that offsets your earnings?
RE is naturally a very tax efficient investment which is why it makes the most sense to do it after tax imo. You always have to weigh the opportunity cost (money AND time) of just dropping your tax free money into a 2040 fund 🙂 I don’t see a premium to justify the risk – do you?
Depreciation is recaptured at sale, so the tax advantages still apply in the long term. I came around to the perspective that real estate is best viewed as a non-transferable asset. You buy and hold forever, perhaps upgrading to a larger property with a 1031 exchange.
Stocks are typically much better in terms of annual returns, but that’s an extremely narrow perspective of overall returns. Real estate has far better tax advantages, generates monthly cashflow and you can increase the value substantially with renovation, expansion, rent increase and add-on (e.g. parking, laundry facilities). None of those benefits are available with stocks.
I view buying RE much like buying a business because of the cashflow aspect. Although it’s much less passive than putting together a portfolio, it’s excellent for diversification and I’ve met countless RE investors who retired early and live on the cashflow from a small number of properties (5-15). Hardly anyone retires early and lives off stock portfolio cashflow. Even guys in the tech startup world that sold their companies for millions still work off the standard 4% withdrawal rate formula. Different mindset more than anything else.
Chris… I echo a lot of your sentiments. Depreciation in particular can be a wonderful thing in terms of providing a tax shield for your earnings… As I am sure you are also aware of the tremendous benefit of the “stepped up basis” provision that allows you to pass on the property to your next generation and avoid any recaptured depreciation essentially extending the tax benefit into perpetuity.
Potentially very powerful and certainly a tactic employed routinely by the uber wealthy
I haven’t laughed this hard in a long while. Most of you really do not know what RE is. let me give you a hint. It is no where as lucrative as stocks. Crowdfunded RE is stupid, when you have REIT’s to invest in. Yes, REITS. If you buy REIT in taxable account, you get to shelter about 30 – 80% of the income b/ it is either taxed as qualified dividend or ROC. When you sell REIT, you can take advantage of long term capital gains. 1031, 1031, 1031, 1031 exchange, yes, how long are you going to do that. You gonna be hit one day with a tax bomb when you sell your property / recapture of depreciation and all. Many a folks, but dumb and smart have made big mistake by doing 1031 exchange to postpone taxes, and bough a crapy property.
If tax efficiency is of utmost importance, buy AMT free munis, and you will beat these debt deals with less risk.
You can shelter 100% of the income of any investment, including REITS, in a retirement account. When the money is withdrawn, it is taxed at your ordinary marginal tax rate.
Properties can be exchanged until death when the step-up in basis occurs, although, yes, you can lose what you save in taxes by purchasing a bad deal trying to avoid taxes.
While I agree that AMT free munis are less risky than hard money loans, I would not expect better long-term returns if you invest in both intelligently.
My RE investors were earning 4 points up front and 12-15% interest on hard money loans. Six month term. First lien position. Fully collateralized @ 65-70% of appraised value w/straightforward foreclosure process available upon default.
Not much interest in AMT free muni funds or REITs from those folks.
I’m interested in those too! I haven’t been able to get into that range, but there’s lots in the 9-11% range.
I find discussions like this bizarre. This “either/or” and “stocks vs real estate” debates are kind of silly in my opinion. Take what is good about both of them, invest in both, and get the extra benefit from the the low correlation between them.
https://www.whitecoatinvestor.com/real-estate-vs-stocks-an-investing-showdown/
On the lending side, you’re not getting the depreciation deduction anyway. So while the equity side CAN be pretty tax-efficient (I wouldn’t call it “very” tax-efficient), the debt side isn’t at all.
Always a concern with anything new, but even index funds were new once, right?
Yes- for debt it’s all ordinary income and at 50%, it would certainly be better for you to put stocks in taxable than hard money loans if you get into this in any kind of a big way.
You can do debt or equity on crowdfunded deals. Each deal is unique and must be evaluated on its own merits.
For those who have tried crowdfunded RE deals, are you typically investing out of a taxable account? Or are you setting up a self-directed IRA (traditional or Roth)?
Philip
I haven’t seen the exact mix quoted for crowdfunding sites on after tax money versus self-directed IRA money. I would be willing to bet that the individual platforms you are considering would be happy to share that information with you. I read a statistic that only 2 to 3% of all eligible people actually have self-directed accounts so I don’t see why those figures would be drastically different for those participating in real estate crowdfunding.
Thanks for the benchmark stat. Helps me get a sense for whether people who are dipping their toe into crowdfunded real estate go to the trouble of first establishing a tax- deferred / tax-free account
All taxable so far in my case, but may do a little in a Roth IRA eventually.
Thanks.
Especially at the capital amounts I’d consider starting out at, it feels like the set up and maintenance costs of SDIRA custodians might offset the tax savings (or come close).
Now that I think about it many of the crowdfunding sites initially were not even set up to take IRA money. They always made a big deal announcement about it when they would hit that milestone which often times was a year or two after they started operations. So I’d imagine the vast majority of their money is after tax.
Thank you for sharing your experience with crowdfunding, I’ve been looking all over the net for personal accounts like yours. Great post!
Crowdfunding seems the way to go these days.