Crowdfunded real estate has really taken off over the last couple of years and is slowly becoming more mainstream. There are 100+ sites, each trying to differentiate themselves from the others. Most look slick, have great property pictures, make promises of due diligence and provide loads of documentation on the sponsor, the risks, appraisals, ARVs etc.
To an unsophisticated investor like me who’s not familiar with that world, it can be overwhelming. I suspect that’s also the challenge that these portals face, and they’re trying their hardest to make it easier for wannabe investors.
While this post will lay some of the groundwork for CrowdFunded Real Estate out for you, there are posts by others that do a far better job than I will. All I’m going to attempt to do is walk you through the process I went through.
I am an unsophisticated investor who just happens to eligible to meet the accreditation criteria. Needless to say, follow at your own risk and I am not your financial advisor or a crowdfunding real estate expert.
Why CrowdFunded Real Estate?
I am a strong believer in index funds and have regularly and consistently invested in them for the last 10-15 years. They form the majority of my net worth and it’s going to stay that way.
However, I also want to diversify into real estate. Currently, I spend some time lurking around the BiggerPockets forums and reading posts by Guy On Fire, Cash Flow Diaries, and others. I devour Paula Pant’s Afford Anything podcast for the same reason and am waiting for her course to be (finally) released. I remember reading somewhere that it’s in progress with a few beta users now and naturally she wants it to be perfect. Paula, in the 0.0000001% chance you’re reading this how do I get in? 😉
So yeah, I’m that classic first-time real estate investor who’s too scared to get started investing out of state and their local city/county/state (California anyone?) is way too expensive. Plus, it ain’t easy trying to get a mortgage when both spouses are self-employed.
Even with all the inaction on my part, I kept coming across posts talking about crowdfunded real estate and mentioning their experiences with a few of these portals. I decided to direct any new savings towards a few different crowdfunded real estate platforms in order to try them out. Generally speaking, I would expect these investments to have a lower correlation with my index funds and thus provide some downside protection.
It’s only been ~4 months so time will tell how it plays out in the short (1 yr) and long-term (5-7 yrs+).
One of the first criteria you’ll read about is that you need to be an accredited investor for most of these portals. That said, some are definitely open to non-accredited investors as well.
Per Wikipedia in the United States as an individual,
“one must have a net worth of at least $1,000,000, excluding the value of one’s primary residence, or have income at least $200,000 each year for the last two years (or $300,000 combined income if married) and have the expectation to make the same amount this year.”
Note the part about the value of one’s primary residence being excluded from the net worth for the purposes of accreditation. I’ve never met the second criteria although I’m sure many do.
In any case, if you satisfy the criteria of being an accredited investor then you have a lot more options open to you. If you don’t there’s still a few you can go for, like X, Y or Z. I don’t have any personal experience with any of these, just happened to come across them when I was doing my ‘research’. There are new ones popping up every day, so do your own research (*cough* Google *cough*) as well.
Taxable or Self-Directed IRA?
I was originally interested to see if I could set up a self-directed IRA and then use that for all my crowdfunded real estate investments. This was attractive as I could easily move a bunch of IRA money over and get started sooner and with a slightly bigger impact.
I then had to consider the approach I would take and questions related to it:
1. Convert my Roth IRA to a self-directed one?
I don’t have a Traditional IRA anymore – I used to in the past, but had rolled that over into a Solo 401(K) when I was switching providers. The primary reason for doing so was because I wanted to have the option to do a backdoor Roth conversion without the Traditional IRA getting in the way.
The Roth has limited, after-tax space in that one can only put in $5500 a year. As far as crowdfunded RE goes, I’m only going to invest what I can afford to lose. If I lost all of it, it would hurt but it would not impact my net worth significantly. However, my Roth space would then be zero – which would limit any further tax-free growth in that account.
Second, my Solo 401(K) is the biggest account I have and it’s also one where theoretically I could put up to $53,000 a year (if I made that much). I wouldn’t be able to access those funds before retirement age anyway, at least not without a penalty. So a loss – while still the same from a financial perspective – wouldn’t be as restrictive.
2. Get a self-directed 401(K)?
I’m currently with Vanguard, and I like my experience so far – low/waived fees, low expense ratios – you know the drill.
Any provider I go with for a self-directed 401(k) that let me invest in crowdfunded or physical RE will not be as cheap. In addition, there are other switching costs (read: headaches) with forms to fill out, formalities, figuring out if I’m doing everything correctly and so on.
For these reasons, I’ve put this option on hold for the time being. I will probably pick this up again once I get a better sense of how much of a viable strategy crowdfunded RE is for me over the long term.
3. What about UBTI / UDFI?
It’ll take an entire article and a session with your CPA to figure this one out. I’ve linked to a couple of posts below that will help you get started.
Suffice it to say these are special federal income taxes:
- UBTI applies to any unrelated business income exceeding $1,000 earned by tax-exempt organizations and IRAs. I’ve read that all UBIT income over about $12,000/annum is taxed at the 39.6% maximum rate, plus my State tax.
- UDFI is unrelated debt-financed income. I don’t understand this well enough – yet – to comment on it.
- https://www.physicianonfire.com/irarealestate/, especially the comments
There are others as well, but to fully understand how it may impact you, speak to your CPA (or find one who knows).
I’ll be honest – I anticipate this coming into play as I increase my investment in future years. I like keeping my investing life simple so I can sleep easy at night. I don’t want to make it more complicated just yet by using a self-directed IRA and then having to owe taxes.
In the big scheme of things, this is a minor point but still worth consideration. SD IRA’s do have some additional fees that normal IRAs don’t. They’re not that mainstream and until they are, companies like Fidelity, Vanguard etc will not offer them and the fees will stay as they are.
I don’t like paying monthly service fees to my HSA provider either. However, those fees are outweighed by the benefits of being able to invest those funds vs. leaving them in a bank account earning 0.5%. The same will be true of the SD IRA when the time comes.
Types of Investments Offered
I’ll keep this short, as there are a plethora of articles out there explaining the various forms of investments. The way I see it, there are three broad types:
A loan is issued to the developer or sponsor who then agrees to pay a certain interest rate. The platform keeps the cut and the rest is for the investors. In other words, we act as a lender, and the short-term loan is secured by the property. Generally the safest investment of the three, but keep an eye on the loan-to-value (LTV) ratio.
2. Preferred Equity
This is effectively a riskier option than senior debt but less so than common equity. LIke debt, it usually involves a fixed term but with a higher rate of return to compensate for the higher risk. In most cases, you have a direct equity interest in the property and hence your investment will suffer if the property’s value decreases. From what I’ve seen over the last few months, this generally applies to commercial investments.
3. Common Equity
You will get shares corresponding to your investment in the property. The highest upside, but also the highest risk. They also tend to be longer term, and potentially take advantage of economies of scale realized by an experienced developer/real estate investment firm managing the project.
Here’s a diagram illustrating the risk vs reward of the real estate capital stack:
My preference would be to invest in debt or preferred equity investments only, with a focus on commercial REI as much as possible. I did break this ‘rule’ for one investment, but I’ll go over that in a later post.
- This post on the Physician On Fire blog
So to recap my journey so far, I decided to:
- Start investing in crowdfunded real estate in order to diversify my portfolio some more. For now, it’s money that I can afford to lose but substantial enough that it will hurt a little if I do.
- Use portals that are only available to accredited investors and stay away from the eREITs
- Not use a self-directed IRA
- Focus on a balance of Debt and Preferred Equity
In a subsequent post, I’ll walk through how I selected a few of the platforms I went with, and what my experience with them has been so far.
What about you – have you ventured into crowdfunded real estate yet? If so, what has been your experience so far?