The real estate investing world is vast and has many layers. There are many players in this world, different in shapes and sizes. While a novice investor is trying to figure out how to buy their first real estate property and find $300,000 to $600,000 in a mortgage or another type of investment to buy it the bigger investors are trying to raise millions of dollars to buy multiunit houses or build another townhouse complex. However, regardless of the size of the investor, there is one key thing that is common - the need for money. Money is the lifeblood of real estate investing and the bigger the investor the more cash is needed. Also, bigger, more affluent, experienced investors, who constantly look for their next investment property, need new cash injections very frequently.
This is where you, a novice investor, can benefit by entering the world of real estate investing with your limited money and with lower risks for you.
In discussions with real estate investors who have already scaled up, we can see that they constantly think about the next investment project (you can find interviews with these investors on our website). Very often they have several projects in different stages. They have completed their previous investment: bought a house, found tenants, now they move on to a new project, usually bigger, requiring more cash. However, cash is not easy to get. Banks will provide mortgages to investors, but for up to a certain amount, and usually at a higher interest rate. That's why the big real estate investors come to small private investors such as you for cash. They will borrow your money to cover their development costs or to buy the next property for a share of equity or for a share of their return. Thus, this way of raising capital for their projects very much resembles crowdfunding. The key point in this real estate crowdfunding is that you get part of the equity in this project or otherwise get a return.
There are a few overall benefits to you for participating in real estate investing crowdfunding:
Learning from experienced real estate investors. As you invest your money, the investors will share with you all the details about their planned project, the total investment, financial calculations for income, expenses, and return on investment for them and for you.
You usually can start with a smaller investment than would be required for you to invest on your own despite buying a much smaller property. As big investors aim to borrow hundreds of thousands of dollars, they realize smaller investors don't want to risk all their savings. Thus, they will borrow smaller amounts from several private investors.
Access to big projects that are usually less risky and can provide higher returns. If you decide to invest in real estate on your own, your choices are limited to maybe buying a condo or a house, in the best-case scenarios you would invest in a duplex or triplex. Investing with the bigger investors opens your choices to multi-unit buildings consisting of tens or even hundreds of units, commercial properties, early-state developments for multi-unit condos or townhouse complexes.
All types of real estate crowdfunding investment that we will discuss below are more passive than doing it yourself. There are varying degrees of your involvement, but usually, the key, big investor who performs crowdfunding will manage the property.
There are a few risks for investing this way. They differ depending on the type of real estate crowdfunding you pick. We will discuss those when we discuss the different ways to invest in real estate crowdfunding below.
Types of real estate crowdfunding. Real estate crowdfunding pros and cons.
There are a few ways you can invest your money with real estate crowdfunding:
Investing in a project for a share of the equity
Investing as a first mortgage
Investing as a secondary mortgage
Investing in promissory notes
Leasing the property and sub-renting it with property management from the key investor
Let’s go into more detail about each of the types of real estate crowdfunding, discuss their pros and cons for you as a real estate investor.
#1. Investing in a real estate crowdfunding project for a share of the equity
With this type of crowdfunding, the key real estate investor (we will call them "big" investors from here on) and each person funding the project get a share of equity in the real estate property. This is usually done through a joint venture contract and this means that, as a participant, you own a share of the property. With that, you will get a share of future rental income and a share of the profit after the sale of the property. Usually, the share of your equity in the project is equal to your share of investment. For most cases, the key “big” investor will come up with the most investment to make sure they have control over the property. The rest will be shared equally among the rest of the investors. This equal split of investment and equity is done to avoid clashes in discussions for the future of the investment with one private investor having a bigger voice due to higher shares.
It is all becomes clear in the example below.
A “big” investor found a multi-unit property, has done the analysis, and the property is a great long-term investment for both rental income and long-term property appreciation. The previous owner of the property wants $2,000,000 for the property. The “big” investor can secure a $1.2 million mortgage from a bank for the property purchase. Thus, the bank wants the investor to provide a downpayment of $800,000. The “big” investor currently has $200,000 cash to invest. The investor decides to find 6 partners, each with $100,000 to invest to get the additional $600,000 in cash for the downpayment.
Once the partners are found, the group signs a joint venture agreement that states the share of equity in the property for each investor, responsibilities for the key “big” investor, and the smaller partners, and the split of future rental returns after expenses. Also, the contract involves notes on how the group makes decisions about the property down the road, the split of profits after the sale of the property, etc.
In our case, all investors came up with an $800,000 cash investment. The key “big” investor will have a 25% share of equity, a 25% share of rental income after expenses, and a 25% share of profits from the sale of the property down the road. The 6 private investors will each have a $12.5% share of equity and returns/profits.
Before finding private investors, the "big" investor puts together a proposal for the property with a proforma cash flow and the calculation of ROI (return on investment) for each investor.
Usually, the "big" investor will actively manage the property in terms of finding the tenants, running the property, doing the banking, legal work, etc. The "big" investors usually have special management companies with a few employees to do that. In most cases, the key investor will charge a management expense to be taken from the rental income. For this property, the key investor predicts 95% occupancy through the year and estimates the annual rental income for this 100-unit property of $220,000. The total expenses for running the property (electricity, maintenance, utilities, garbage removal, repairs, taxes, insurance) and mortgage repayment for the $1.2 million amount $130,000 per year. This leaves $90,000 in net income per year. Thus, a private investor with 12.5% share will get $90,000 * 12.5% = $11,250 return. This provides for ROI of 11.25% per year ($11,250 / $100,000 investment).
Now, let’s say, 5 years down the road the price for the property went up to $2.5 million. During this time, the partnership paid $150,000 in mortgage using the tenant income. The joint venture participants vote and decide to sell the property. The net income from the sale is $2.5MM – $1.2MM original mortgage + $.15MM paid mortgage = $1.45MM. The original cash investment by the partnership was $800,000. The net profit from the sale is thus $650,000 which is shared according to the share of the equity each participant owns. An investor with a $12.5% share who originally invested $100,000 would get $81,250 in profit from the property sale.
The key additional benefits of investing in a real estate crowdfunding project for a share of the equity are:
You are a partner and have a share in the equity. This gives you a voice in deciding on what to do with the property.
You own a part of the asset and participate in the split of the profit from the sale of the property. If the real estate project is very successful you may rip returns that are much higher than any other real estate crowdfunding investment may provide.
You meet other investors and learn from them in discussions about the future of this property.
The drawbacks of investing in a real estate crowdfunding project for a share of the equity are:
Some people may be difficult. As you get to vote about the future for the property, different opinions and strong characters can slow down decisions.
As a partner, you share both the benefits and risks. If anything goes bad and the investment ends up in a loss, you would be liable for the share of the loss equal to the share of your equity.
#2. Investing in a real estate crowdfunding project as the first mortgage lender
Another way of how “big” real estate investors raise capital is by getting a mortgage from private investors. Yes, in fact, if you have the cash to invest, you may act as a form of a bank and issue a mortgage to another person. In this case, you would need to hire a layer, which is actually a good idea for all kinds of investments and contracts. The contract with the “big” real estate investor will be the same as you would be using for a mortgage with a regular bank. You will put a charge on the property, meaning the investor cannot sell or do anything with the property that is not written in the contract before paying off your mortgage and interest.
When you form a contract, make sure you are in a position of the first mortgage, meaning there are no other mortgages from a major bank or private lender registered against this property. If there is already a first mortgage registered against the property, you will stand in a position of a second mortgage, meaning if anything goes wrong and the investor will be forced to sell the property, the proceeds from the sale will be first used to pay off the principal and interest on the first mortgage, and only then the second mortgage.
The mortgages for investors are usually short-term, ranging from 1 to 3 years. Also, usually, the contract is set so that the mortgage is fixed for a year; after a year, the investor may pay off the mortgage in full at any time with little or no penalty. These mortgages are usually taken for the "big" investor to buy their investment property, renovate it, or tear it down and build a new property. Once they are done, they would be prepared to pay the mortgage off earlier.
Given the provided security for you in a form of a charge on the property, the interest you would usually get is lower than for the other types of real estate crowdfunding but are still higher than the rates offered by major banks. Usually, you would expect a 7 to 10% interest return per year.
Benefits of investing in a real estate crowdfunding project as the first mortgage lender
Added security of your investment as you put a charge on the property, meaning the borrower cannot sell the property before paying off your mortgage and interest.
You are not bearing the risk for failure of the “big” investor's plan. If the investor fails to make a profit, they still must pay your mortgage and interest before they pay any other lenders.
Drawbacks of investing in a real estate crowdfunding project as the first mortgage lender
You don’t own equity in the property. The investor is the one who will receive the future profits from renting out the property or selling it. Your return is limited to the interest rate set in the contract no matter how successful the "big" investor's project is.
Usually, mortgages are required for substantial amounts of $100,000 or more. the hassle of going through legal to form a mortgage contract defeats the purpose to raise small amounts with mortgages.
While this type of crowdfunding investment is more secured, there is still a risk of the investor going into deep loss and being unable to repay the mortgage after the sale of the property. To mitigate this risk, you must study the business plan of the "big" investor, what they want to do with the property, their projected property sale price. Also, depending on your assessment of the perceived risk for the investor’s business plan, you want to set a certain loan-to-value ratio (LTV). This term means the ratio of how much you want to lend to the future value of the property. For example, the investor who obtains the mortgage plans to sell the property for $1,000,000 after they renovate it. You may set the LTV ratio at 65%, meaning you will only give a mortgage for $650,000. This secures your mortgage: if anything goes wrong, and the investor sells the property for $800,000 or even $700,000, you will still get your money back.
#3. Investing in a real estate crowdfunding project in the second mortgage lender position
This type of real estate crowdfunding investment is very much like the first mortgage position we discussed above. The only exception is that the investor already has the first mortgage on the property (usually from a major bank). This increases your risk as the first mortgage lender has the priority right for the proceeds from the sale of the property. Once the first mortgage and interest are paid in full, the remaining money is used to pay the second mortgage. However, with the increased risk, the lenders always demand a higher rate of return which may be as high as 13% or more per year. Usually, the borrower (investor) will want to pay off your mortgage first before they pay off the first mortgage as the interest rate on the second mortgage is so much higher. Thus, the second mortgages are usually even shorter-term (6 months to 2 years). As with the first mortgage, you must do your due diligence and study investor’s project, validate their projections and financial calculations. As with the first mortgage, you will want to secure your position with a strong LTV ratio.
#4. Investing in a real estate crowdfunding project with promissory notes.
A promissory note, sometimes referred to as a note payable, is a legal instrument, in which one party promises in writing to pay a determinate sum of money to the other, either at a fixed or determinable future time or on demand of the payee, under specific terms.
In real estate crowdfunding, promissory notes are another way to raise capital for big real estate investors for their projects.
With promissory notes, the “big” investor looks to raise capital for real estate development, or any other real estate project by issuing a few promissory notes to several lenders. Given the promissory notes do not need as much legal involvement, it is easy to issue those. Thus, it is common that the “big” investor will issue 10 promissory notes, each with a $25,000 face value. The promissory notes are usually issued for a term of 6 months to 3 years. During this term, the “big” investor will pay monthly, quarterly, or annual interest (depending on your negotiations). At the end of the term, the borrower will pay off the face value of the promissory note along with any outstanding interest that accumulated since the last interest payment.
For example, you bought a 2-year promissory note for $25,000 with 15% annual interest, payable quarterly. Every quarter, you will receive an interest payment of:
$25,000 * 15% / 4 quarters = $937.50
Your total annual interest return will be $3,750. Over 2 years, you will receive a total of $7,500 in interest and at the end of the 2-year term, your original face value of $25,000.
Benefits of investing in a real estate crowdfunding project with promissory notes
Higher returns. With increased risk, the expected rate of return for the lender is higher than for the primary mortgage type of crowdfunding. Usually, you can expect a return of 15-17% or above depending on the perceived risk of the project.
The relative ease of making the contract as it can be done with minimal legal involvement.
Smaller amounts are required for investment. As discussed above, the “big” investor can take only one first and one second mortgage on their real estate project. The investor can issue multiple promissory notes with a smaller face value.
Depending on the investor’s needs, the term of promissory notes can be as short as just a few months. If you have the cash to invest for the short term, this may be the best way.
Drawbacks of investing in a real estate crowdfunding project with promissory notes
Not owning equity in the project. Like with mortgages, you just lend the money and don’t participate in sharing of potential profits of the project. E.g., if the project is very successful and earns a 50% annual return, you still get just your contractual interest.
Higher risk. The risk associated with promissory notes is higher than with the first mortgage type of investing. If the “big” investor has a first or even second mortgage on the property, the investor will have to first repay those mortgages before paying on promissory notes. However, in some cases, the promissory note can have a clause of the ability to register the obligation to repay the promissory note on the title of the property. This will provide some security for the lender as the borrower will not be able to sell the property without paying at least the face value of the promissory note. However, even with this clause, the associated risk is higher as the borrower may simply not have enough cash after the sale of the property to repay the money. In this case, you would have to go to court to claim your money back. Due diligence on the history of the investor, the number of successful projects is key here. Every "big" investor that has been in the industry for a long time likely has a few projects on a go and they can shift money between projects. Coupled with the desire to maintain a good name to be able to borrow in the future will force them to pay their lenders.
#5. Investing in a real estate crowdfunding project with lease-sublease
A much rarer way of real estate “big” investors raising cash for their projects is when the “big” investor leases their property to you for a set annual amount. Then, they work with you to find tenants for this place, and you sublease it to tenants. In this type of crowdfunding, the “big” investor usually takes the role of a property manager who is responsible for managing the place, financials, and the search of tenants. Every month or quarter, the “big” investor will repay you part of your initial investment together with part of the profit from the property.
Here is an example to illustrate. The investor has just renovated a fourplex that they bought a while ago. They lease it to you for $35,000 paid in a lump sum. Then every 3 months the investor pays you the rent of $35,000/12*3 months = $8750. In addition, the investor will pay you a portion (amount depends on your negotiations) of any additional profit they will get from the renters. Let’s say the occupation rate for the property comes to 90% that year. The renters pay $2000 per month. The total rental income for the year is $2000 * 4 units * 12 months * 90% = $86,400
The expenses for running the place (heat, water, garbage removal, insurance, management fee from the “big” investor amount to $40,000 a year. The net revenue for the property is $46,400. In addition to $35,000 you invested upfront you will get half of $11,400 ($46,400 - $35,000). This amounts to $5,700 which is a 16.3% return on your money.
The key benefit for the “big” investor is that they get cash today interest-free. They can use the $35,000 they got from your lease for other real-estate projects.
The key risk for you is that you may receive just your principal (the money you originally invested).
To summarize, there are a few ways to invest in real estate with real estate crowdfunding. These ways have varying levels of capital required for the investment, as well as different levels of risks and potential income. Each way of real estate crowdfunding investing has its pros and cons. Make sure to know them and invest wisely.