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What is Real Estate Crowdfunding and How Does it Work?

In recent times, crowdfunding has gained real traction as a viable way for businesses to raise money. Under the crowdfunding model, you don’t have to rely on a single investor, instead reaching out to a large pool of investors who each contribute a small amount of money towards a business venture.

The basic premise is that people are willing to invest a small sum and, as a result, large amounts of capital can be raised quickly. Those looking to raise cash through crowdfunding usually do so online, making use of social media platforms to reach a wide audience of potential investors.

It’s a popular model that’s been used to raise funds for artistic and creative projects, community-focused ventures and start-ups, to name a few.

Following the introduction of the Jumpstart Our Business Startups (JOBS) Act of 2012, private investments could be marketed to the public for the first time. While previously you could only invest in real estate development through private equity in a development company or through a REIT, the JOBS Act opened the doors for crowdfunding in the real estate market, and now this investment model is a major disruptor in the industry.

You can start a crowdfunding project by first investing a small amount in a property through a crowdfunding platform. The platform will take an upfront charge, a recurring fee, or both for providing this service. You then receive a return on your investment, which is guaranteed against the property’s rental income or mortgage loan.

Why use real estate crowdfunding?

Let’s looks at the benefits of crowdfunding from both an investor and borrower perspective.

For borrowers, you can raise capital in a relatively short amount of time since you don’t need to wait months for a bank to approve your loan and can often raise your desired capital in a few weeks. The transaction costs and interest payments are usually lower compared to a bank too.

The crowdfunding model allows investors can diversify their portfolio by directly investing in a tangible asset class that offers a stable income, good rates of return and a hedge against inflation. Compared to direct investment, it’s also a hassle-free option where you do not need to spend excessive amounts of time, money or labor managing a property.

However, as with all investments, there is a level of risk and a lack of liquidity with real estate crowdfunding. If you want to play an active role in the management of your real estate holdings, then crowdfunding may not be for you.

Crowdfunding platforms are not regulated as traditional real estate investment trusts (REITs) and so there may be more risk. Furthermore, research reveals that real estate crowdfunding websites are not required to distribute 90% of the rental income to investors. So, if you’re accustomed to above-average yields from your REITs, you may be disappointed.

Equity versus debt investing

It is possible for an investor to buy shares of a crowdfunded real estate project or to loan funds to the venture, allowing one to decide between investing in equity or in debt.

Equity investments offer a stake in a property, making every investor a shareholder. In this case, the return will be based its rental income, minus the fees of the crowdsourcing platform.

The good news is that equity investments do not have caps on them and there are reports of  annual returns of as much as 25%. Also, the fees are lower as you’ll usually have an option of paying an annual fee and you can deduct expenses on your share in the property from your annual income tax. However, an equity investment is a riskier because you may not get any return if your property fails to attain a profit and the holding period is longer, usually between five and 10 years.

Debt investing allows one to lend funds to the property developer, and in return one receives a fixed return, which is based on the mortgage loan of the property and the investment amount. In this case, you can expect annual returns of up to 10% and there’s less risk compared to an equity investment – if the developer fails to pay their mortgage, for example, you can recover your loss via a foreclosure action. The hold terms are also relatively short – usually between six and 24 months. However, the fees tend to be higher from the crowdfunding platform if you use debt investing, as opposed to an equity investment.

Real estate crowdfunding platforms

If you decide to borrow or invest by using real estate crowdfunding, you’ll need to do this through one of the many diverse platforms.

RealtyShares lets you invest with a minimum of $5,000 in either equity or debt. With RealtyMogul, you can start investing with just $1,000. Both have stringent standards as to what properties they allow to appear on their platforms – RealtyShares only accepts 10% of its investment applications, for example.

There are many different platforms available and you should always apply due diligence when choosing which one to use. Speaking in a statement, Jillienne Helman, chief executive officer at Realty Mogul, said: “First, work with a crowdfunding company that will survive. That means well-capitalized. What scares me is the number of crowdfunding companies out there that are headed up by two students who just graduated from college, and who aren’t capitalized themselves.”

So, make sure you use an established platform and, preferably, one with experience of the type of property you want to invest in. Also, use platforms that act as broker-dealer, apply an appropriate level of due diligence themselves and stay away from sites that function as nothing more than listing services.

However, as long as one does the research, then real estate crowdfunding can give investors and borrowers easy access to the industry and a viable alternative to traditional lending models.

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