Although these types of projects used to be reserved mainly for institutional investors, now small investors can participate in them through crowdfunding.
Whether you’re an investor looking to dip their toes in commercial real estate or a developer seeking capital for a crowdfunding project, there are a few key things to consider before getting started.
How does crowdfunding work for real estate development?
Developers often fund projects with a combination of crowdfunding capital and bank financing for their down payment. This allows the developer to retain control of their project, while allowing investors to earn passive returns.
There are two main types of crowdfunding campaigns:
- Short term—developers sell or refinance their project after completion, paying back investors their principal, plus return
- Long term—the investors earn returns generated by the property after completion, typically with monthly or quarterly distributions
In both cases, investors will have an exit strategy that will let investors receive their capital back. This exit window could be as short as six months or as long as ten years.
Debt crowdfunding vs. equity crowdfunding
Crowdfunding raises capital from private investors either through debt or equity. The biggest difference between these two strategies is how investors will earn their returns. Both ways have pros and cons, which we’ll look at now.
Debt crowdfunding at a glance
With this type of crowdfunding, developers pay back investors on their initial capital, plus a predetermined interest rate. This is similar to p2p lending, and investors receive no equity in the deal.
Debt crowdfunding is attractive for developers because it doesn’t dilute project equity, especially with many investors or partners involved. For investors, debt crowdfunding has a clearly defined return on investment.
One downside of debt crowdfunding is that raising funds is more difficult unless the developer already has a deep portfolio of assets and a solid track record.
Equity crowdfunding at a glance
Equity crowdfunding, on the other hand, gives investors a piece of equity in the real estate project. Investors are taking a share of the profits from the deal, which could take the form of:
- Rental income
- Equity build
- A combination of any of the three
Equity crowdfunding is riskier for investors, but potentially more profitable. Failure to complete the project by the developer could mean losing your entire investment. But successfully completed projects often have big upside.
Conversely, equity crowdfunding tends to be less risky for developers. The downside for developers is that their potential cut of the profits tends to be smaller.
What real estate crowdfunding regulations are there?
Crowdfunding allows developers to raise capital without the huge expense of becoming a publicly traded entity.
However, there are still numerous rules that must be followed, created by the SEC (depending on the chosen exemption).
Rule 506(c) is one of the most widely used real estate exemptions used to secure crowdfunding.
Developers are allowed to solicit the general public for investment capital, and may even advertise their project. The developer must only ensure that anyone who invests in their project is an accredited investor.
Rule 506(b) is a common exemption as well, and the main difference between this exemption and Rule 506(c) is that developers ARE able to raise funds from non-accredited investors. However, they cannot advertise their offer or solicit the general public.
In addition developers may only accept investments from people who already have an existing relationship with the investor.
If the developer wants to both advertise their offering AND raise capital from both non-accredited AND accredited investors, they’ll have to go with a Regulation A exemption. However, there are additional regulatory hurdles and costs to the developer.
There are two tiers of Regulation A exemptions, with Tier I allowing up to $20 million worth of investments in a 12-month period, while Tier II raises this limit to $75 million.
Tier II exemptions require even more regulatory compliance than Tier I.
Regulation Crowdfunding (CF)
Regulation CF is the newest source of crowdfunding exemption, which is typically used for smaller projects. That’s because developers using CF are limited on the amount of capital they can raise.
However, CF has the benefits of Regulation A without the expenses or red tape. That means advertising, plus raising capital from non-accredited and accredited investors. The downside is that the developer may only raise $5 million per 12-month period.
Regulation CF transactions are required to go through an intermediary registered with the SEC, typically online through a crowdfunding platform registered with the Financial Industry Regulatory Authority (FINRA) or through a broker.
Is crowdfunding for me?
Crowdfunding is an attractive gateway for new investors wishing to get into the commercial real estate market (or other real estate asset classes with a high barrier to entry). It’s just as attractive for developers looking to fund their next project.
However, investors need to know that crowdfunding investments don’t offer the same level of protection as REITs or similar investments. For that reason, we have the SEC-imposed limitations on investment for the various types of exemptions listed above.
As with any investment, due diligence is vital—on the project, the developer, and the investing platform being used for the project.
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