Real estate crowdfunding investors should know the differences between the two types of deals
The JOBS Act of 2012 enabled a new form of investment called securities crowdfunding. Unlike its older cousin, donation and rewards based crowdfunding, this new vehicle provided for the purchase of debt and equity by investors without requiring the sponsor to undergo the burden of a full blown initial public offering. The skyrocketing demand for private capital to fund real estate investments around the world has created a unique opportunity for investors to participate directly in the growth of the real estate industry.
Donation crowdfunding has been popularized by platforms such as Kickstarter. The formula is simple: anyone can donate money to a project and in return receive a token thank-you reward: a T-shirt, CD, even some homemade potato salad. The JOBS Act created securities crowdfunding, which replaces the potato salad with securities. The Act created two securities-crowdfunding methods, but only one, Title II has been implemented to date, while the other one is awaiting final SEC regulations:
- Title II Crowdfunding
Title II, as implemented by the SEC in Rule 506(c) of Regulation D, allows private issuers to publicly solicit and sell securities to accredited investors — organizations, pension, trusts and individuals that have assets or income above certain thresholds. The issuer, or the issuer’s marketplace, must take reasonable steps to verify that all investors are accredited.
- Title III Crowdfunding
When implemented, this will allow any investor to purchase private securities through a special website called a crowdfunding portal. The rules limit an individual’s annual Title III investment based on income, with a ceiling of $100,000 a year. The issuer can raise no more than $1 million in a 12-month period through this method. The SEC has been very deliberate about issuing enabling regulations for Title III – some have accused it of dragging its feet.
The appeal of crowdfunding is that it avoids the clunky process by which private placements have operated for decades. Under the older provisions, issuers could sell securities via private transactions only after receiving a registration exemption from the SEC — a process not as onerous as an IPO but not trivial either. In addition, the older rules prohibited public solicitation, and some exemption rules placed limits on the amount that can be raised.
Real Estate Crowdfunding
In the real estate industry, issuers, known as sponsors, can use Title II crowdfunding to sell debt and equity participation in properties and real estate projects. This opens the doors to accredited investors who in the past may not have had enough wealth to participate in this market. Crowdfunding disrupts the status quo and expands access to the solid returns available from many real estate investments.
Real Estate Debt Crowdfunding
Under this form of peer-to-peer lending, investors lend money to property development projects rather than assuming partial ownership. The usual maturity periods on debt issued this way can range from 6 months to 18 months, but longer periods are sometimes available. The debt sponsor typically pays a stated fixed rate of interest over the lifetime of the debt and repays the principal at maturity. Nothing prohibits sponsors from issuing more esoteric debt instruments, such as floating-rate and zero-coupon bonds.
Investments are secured by the underlying property, and in the case of bankruptcy or default, lenders have priority in receiving liquidation payments. Real estate debt investing typically involves lower risk and lower returns than potentially available from real estate equity investing. The investment fee depends on the sponsor and is usually deducted from the interest payments. The types of properties involved in debt crowdfunding include single homes, multi-family homes and apartments. About 20 percent of all real estate crowdfunding takes the form of debt offerings. Some sites, such as Patch of Land, focus exclusively on debt transactions.
Real Estate Equity Crowdfunding
The remaining 80 percent of real estate crowdfunding investments involve equity shares that provide partial-ownership positions to investors. The return on an equity investment is a portion of generated net profits, and is not capped. The shares are not secured, and in the case of bankruptcy, receive the residual value of the investment after debt-holders are paid off. Holding periods can last from 6 months to 10 years or longer. Sponsors subtract fees from the cash flows generated by the investment properties, which can include homes, apartments, hotels and commercial property.
Many equity investments, include most PeerRealty offerings, provide a “preferred return” to investors. In those deals, the first cut of any profits (after project costs) is returned solely to investors, up to the specified preferred return. After the preferred return is paid out to all investors, any remaining profits are typically split between investors and the sponsor by a specified percentage. Equity offerings also offer potential tax benefits to investors in the form of property depreciation, which investors can sometimes use to offset other income. Of course, the terms of different deals will vary, so investors should be sure to carefully review all deal terms.
Accredited investors can buy shares in, or lend money to, private real estate projects and properties via real estate crowdfunding portals like PeerRealty. Debt crowdfunding will appeal to investors desiring fixed returns and reduced risk. Those who prefer equity crowdfunding seek the possibility of higher returns, albeit with greater risk. With a minimum investment of $5,000 for some deals on the PeerRealty platform, crowdfunding investors don’t have to be real estate moguls to invest like them.