If you're an active real estate investor, you're probably familiar with investing through real estate investment trusts (REITs). These sell shares in a group of real estate investments similar to mutual funds. Many investors prefer these to outright real estate ownership because their investments are more diversified. However, the two biggest drawbacks are all of the fees charged to manage the trusts and the fact that investors have no say in what real estate is purchased by the trust.
Today, a new investment model is emerging in the form of crowdfunding. The crowdfunding concept is for people to pool their money together for a specific project. The concept has been around for a few years but is just now gaining momentum for real estate investing. Pooling funds enables investors to invest in bigger properties than they otherwise could or would want to as individual investors. Typical projects include properties with existing cash flow, such as apartment buildings, office buildings, retail shopping centers, self-storage facilities, and pools of single-family homes.
With REITs, investors have little information available about the actual investments being made. You have no opportunity to select properties that you are familiar with or invest in your own geographical location. Crowdfunding is much more transparent and gives investors much more control over where and how their money is invested. You can invest in smaller or larger investments depending on your personal choices. You can put together a crowdfunding group to buy an apartment building in your town or city.
Federal securities law requires that securities issued by private companies to their investors be registered with the Securities and Exchange Commission (SEC) unless the offering qualifies for an exemption from registration. Crowdfunding is an exception from SEC registration.
The exception that crowdfunding falls under is only offering investment opportunities to accredited investors. The SEC defines an accredited investor as having $200,000 of annual income per individual ($300,000 per couple) with the expectation of that continuing, or a net worth of more than $1 million, excluding the value of the primary residence.
As with any emerging new business model, you can expect the crowdfunding model to be refined and changed over time. The most common current model has investors purchasing shares in a LLC that in turn invests in a particular property or pool of properties. This model provides investors with liability protection to shield other investments from the operations of this specific LLC.
LLCs are governed by an "operating agreement". Each LLC operating agreement is slightly different but typically a manager is put in place to make day-to-day operating decisions. Other members of the LLC are "limited members". For the most part, the income from the LLC is passive income.
However, the operating agreement will require all members to vote on certain activities. Typically, this includes buying or selling a property within the investment portfolio. It can also be removing the manager for not operating within the guidelines of the operating agreement or for gross negligence. Expect this business model to change as crowdfunding gains in popularity.
Please leave a comment if this article was helpful or if you have a question.
Author bio: Brian Kline has been investing in real estate for more than 30 years and writing about real estate investing for seven years. He also draws upon 25 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest in the Olympic Mountains with the Pacific Ocean a couple of miles in the opposite direction.
I have been looking at ways to raise capital for a real estate investment for some time. What are your thoughts about using the current kickstarter.com and others out there to raise the capital for a crowdfunded real estate project? Do you think there is a site for this already out there I could use? Or that site is not built just yet?
Thanks for your comment. In my opinion, Kickstarter is more focused on the arts than on real estate. There are sites out there that specifically focus on crowdfunding real estate projects. However, Due Diligence is needed because this is a relatively new funding source. There are also many other sources for private funding. I don't personally make recommendations because it could create a conflict of interest.
Okay, how about this idea?
1) Certificates of Participation: Individuals gather together funds which are loaned at a reasonable rate to an entity, such as a small business or an association. For example, many homeowner associations are required to have Reserve Fund Studies on a regular basis to insure that adequate funds are available for capital improvements. However, due to the low returns on Money Markets and CD's many HOA's are faced with little or no growth. As such, their Reserve Fund Study projections are flat and many Associations are falling behind as the result of Deferred Maintenance.
With a Certificate of Participation, the Associations are not engaging in equity shares. Under a Certificate of Participation the Association agrees to pay a fixed rate of return for borrowing the funds. Because of Crowd Funding, the funds are not FDIC insured and there is risk involved. However, very many banks are reluctant to issue Association Loans. Instead, they prefer that the HOA issue a Special Assessment and the owners obtain a Home Equity Line of Credit. This serves as collateral for the bank. In addition, the bank controls the terms of the loan etc. In addition, some banks are seeking to collateralize the properties contained with the HOA communities.
With Crowd Funding and Certificates of Participation, the HOA borrows at a fixed rate of return for a fixed period of time. The investors receive a fixed rate of return during the loan period and it includes both the principal and interest. With Crowd Funding the HOA (for example) only pays a fixed rate to the Investment Advisor (usually in the form of an origination fee of 1.0 to 1.5% of the loan) at the time of the loan.
Associations borrow at a lower rate than banks are offering with less paperwork. HOA's borrow funds at a lower rate for major Capital Improvements, and the investors seeking a fixed rate of return that is better than the bank or equities markets are offering will benefit also.
Unlike equities based Certificates of Participation, shares in this case are not sold. A person, no matter the size of the investment at the time of the Project or Loan, receives the same as a person making a much larger and sizeable amount. The benefit of a Certificate of Participation is that it is much cleaner and more transparent than a REIT or a separate LLC. What say you?
Thanks for the well thought out response. Other readers will definitely benefit from your insight.