Follow these five steps to analyze real estate crowdfunding for double-digit returns
Investing in real estate crowdfunding deals is easy enough but do you know how to do it right?
You can be in a property within a few minutes with the click of a mouse but how do you know it's a good investment? Real estate crowdfunding is still a new asset class and most investors haven't put together a good process for separating the winners from the losers.
By the end of this video, you’ll have the five criteria I used to analyze real estate investments as a commercial property analyst.
This video is part of a series on real estate crowdfunding and building a property portfolio. Click through and subscribe to the Let's Talk Money channel to get all three videos.
How to Invest in Real Estate Crowdfunding Deals
We’ve spent the last two videos talking about different real estate investing strategies and how important it is to use at least two of these strategies to limit the risks in each but still keep those returns high.
I think real estate crowdfunding has the most potential among the four and I’ve gotten a lot of feedback and questions from all of you. It’s a very new way to invest in real estate so I understand there are a lot of questions and I wanted to make this video to go further into the investment.
Just like any investment, you can’t take another person's recommendation as your sole reason to invest. Just flipping the channel to CNBC and investing in the first five stocks you hear about is going to have half of your money going to fees and the other half lost to bad investments.
And it’s the same with real estate crowdfunding, you have to know what to look for in these deals and how to find the best opportunities.
I started my professional career as a commercial property analyst and have been investing in real estate for decades. I’m excited about this new way to invest but crowdfunding properties is just as risky as traditional real estate if you don’t use some smart criteria to pick investments.
That’s why I wanted to share my five criteria, my five-point checklist of what I look for when I’m looking to invest my money in real estate crowdfunding. Some of these are from the same criteria I used to analyze traditional commercial properties while others are new to crowdfunding but all will help you get the highest return and limit your risk in the asset.
5 Keys to Analyze Real Estate Crowdfunding
Let’s get started on these five criteria to look for when analyzing real estate crowdfunding investments. After I run through each of these, I’m going to highlight two deals from the EquityMultiple platform to show how to apply everything.
First here, and this is specific to real estate crowdfunding, is that you need to assess the platform and the underwriters. There are hundreds of property crowdfunding websites but only a few have staff with the necessary experience that is going to vet these deals.
This is important because developers submit their deals to the platforms and it’s the underwriters and analysts that perform the first level of due diligence to protect investors. The platform is going to look into the developer’s history, into the property and the financial documents for the project to make sure it’s a legitimate deal.
On good platforms, the number of submitted deals that make it in front of investors is usually less than one-in-20, that’s about 5% of the deals getting approved. That helps protect investors from the bad deals, the bad investments and the outright scams.
This is something you’ll only have to do once, looking at the experience of those running the platform but it’s something you can’t neglect. Look for how long the founders have been in real estate, especially if they were active in investment management before crowdfunding. It also helps if the company has outside advisors that can help guide the platform with their own experience.
How Important is Developer History in Real Estate Crowdfunding?
Next is developer history, that’s the person or company that is running the individual property project. I’m not saying that someone with their first project on a crowdfunding site can’t be successful but I like to see developers with at least a few years and a few deals under their belt.
Some of this is going to be done for you by the platform when it runs its own due diligence. I rarely see projects on the legit platforms where the developer doesn’t have at least a few years’ experience but it does happen.
Besides just experience in real estate, watch for developers that have specific experience in the property type or the region relevant to the project.
What Kind of Properties Should You Buy in Real Estate Crowdfunding?
After the developer’s history, I look at the property itself.
How many times has ownership changed hands in the last decade. Who are the tenants and what has turnover been? You also want to look at the surrounding market and things like population growth, economic growth and rents for comparable properties.
This is one of the more difficult criteria because you’ll have to do your own homework. Most of these deals will spell all this out but you really need to verify it on your own. The county assessor’s website will have some of the information and you can search commercial real estate sites like loopnet.com for sales history.
Analyzing Financial Data on Real Estate Crowdfunding Investments
Our fourth real estate investing criteria is you have to look at the financial projections in the deal. This doesn’t mean you have to become a full-time analyst or numbers nerd like myself. You just need to do a sanity-check on the numbers provided.
This means checking the assumptions like rent growth and cash flow projections against comparable properties in the area. There’s a very important concept in investing, in fact it’s a key part of the curriculum for the Chartered Financial Analyst designation, it’s the concept of conservatism.
Conservatism just means that the estimates used on an investment should be reasonable and not optimistic. I saw this idea to the point it was almost funny when I worked as a venture capital analyst. Entrepreneurs and startups would come presenting their investment case for funding and their numbers would be so optimistic that it just destroyed all their credibility.
In real estate crowdfunding, look for the deals where all the facts are laid out like historic rent growth and comparable sales prices. Then look at the developer’s estimates for future rents and other numbers.
The investments you want to be involved in are the ones where the developer could easily make the case for higher estimates based on those historic facts but they give a ‘most likely’ scenario as their projections. They might be optimistic about the upside but they’re being honest and conservative in what they present.
How to Estimate Returns on Real Estate Crowdfunding
Last here for the criteria I use to analyze real estate crowdfunding deals is a check on the exit valuation and cap rate for the property. This is similar to that last criteria, looking for conservatism in the estimates but since that sales price estimate is so important to your real estate returns, it really deserves its own check.
There are two ways to double-check the developer’s estimate on what they think the property will go for in a sale, the cap rate and comparable properties.
The cap rate is an important number in commercial real estate. It’s the net operating income divided by the sales price. Net operating income or NOI is that cash flow from the property, so the rents minus expenses and interest on debt. So if you take that NOI over what someone would pay for the property, you get an annual return.
Cap rates are going to differ by property type and by region. Generally for commercial property, you can expect a cap rate between 6% to 12% but you need to check this. The developer is going to estimate how much they can get for the property in three or five years by estimating a cap rate and the net operating income.
They’re going to say something like, sales price is estimated on an 8% cap rate and $300,000 in annual NOI.
Your job is to question these two numbers. Given the property’s history of rents, expenses and the market, can it get that estimated net operating income? Looking at similar properties for sale in the area, is that cap rate realistic?
It takes a little homework but nobody said making returns of 15% plus annually would be easy. If you want easy, invest in index funds and be happy with your 7% long-term return.
Two Example Real Estate Crowdfunding Deals
With those five criteria for real estate crowdfunding investments, let’s use two projects as an example. Both of these were listed on the EquityMultiple platform, one of the crowdfunding sites I watch.
As a side note, both of these two projects are now closed so I don’t want you to think I’m trying to promote them. I’m just using these two as examples of what to look for when you’re reviewing other deals.
First we have the Tacoma office property deal by Hubris Capital and Stone Advisors as developers. The two firms have done $744 million in real estate and asset management since 2002. Their new strategy is acquiring value-add commercial office buildings around state capital cities with past deals including properties in Tallahassee and Nashville so they definitely pass the developer test.
This project is a two-property Class B Office building, Centennial Place I and II in Tacoma about 31 miles from state capital of Olympia. The properties are 235,000 net rentable square feet with 87% occupancy, primarily to state government tenants. Now I like that because state government tenants tend to stay put for a very long time.
The State of Washington Employment Security Department has just signed a new 10-year lease for 20,000 square feet which will bring occupancy to 96% and a letter of intent has been signed by another tenant for a seven-year lease that will occupy rest of property so we’re looking at 100% tenancy for a few years.
The developers are targeting a $10 million capital improvement plan with $1.8 million funded by the seller. The project is under contract to buy the property out of foreclosure for $34.5 million or $146 per square foot against a market average of $178 per square foot.
The total project costs are estimated around $46.7 million. The developers plans on bringing in professional management, completing the project improvements and then exiting after three years.
Current rents of $19 per square foot are below the market average of $23.13 per square foot so we see some upside potential there. Cash return alone is 7.5% in the first year and 8% in final two years on rents. The Seattle-Tacoma-Bellevue market is doing very well with just 10% vacancy, the lowest since 2007, and commercial building sales up over 23% in the last year.
The strength of the developers here have enabled financing through fixed-rate debt on interest only terms for ten years. The developer group is also putting in 11% of the total funding for the project with 70% from financing and 2% from investors on EquityMultiple.
The developers plan on selling the property at a 7.5% cap rate on projected year four NOI of $3.75 million which would mean a sale price of $50 million. Combined with the annual cash return from rents, that would be a 56% total return or 16% annualized.
So here you have a project with solid developers that are estimating a property sales price that is still below the market average, so we check the conservatism box. Tenancy looks very good and that $10 million in property improvements should mean rents can increase faster, that’s something that will attract a buyer in year three. The cap rate is realistic if not a little low so they may find they can get more for the property when they go to sell.
The next example is a mixed-use acquisition loan in Boston. So where the prior example was an equity investment, an ownership in the property and return potential in the sale, this one is a debt investment to the lender.
I split my real estate crowdfunding about equally between debt and equity investments. Equity deals offer higher returns while debt is lower risk and higher cash flow so it’s a great way to even out your portfolio.
This is the third crowdfunding project for the lender Private Capital Group. It’s a 12-month first priority loan to acquire three properties along Dorchester Avenue in South Boston.
The properties include four vacant industrial buildings that have been re-zoned for residential/mixed-use in December 2016. Mixed-use is just a commercial real estate term for buildings that have both retail stores and residential living. It’s very popular in downtown areas and a great way to diversify a property.
The developer, Dot Square Partners, is planning to process the project through the final stage of re-zoning, codification of height limits and density, before selling it to another developer for construction. The developer is already in talks with several potential buyers and may decide to continue the development as well, in which case a new construction loan would be used to pay off EquityMultiple investors.
The loan will be used to acquire three of the properties and pay off the existing loan on the fourth which the developer already owns. The developer has already spent $1.8 million in earnest money on the three parcels and acquisition of the fourth and will invest $650,000 with a total project cost estimated at $22.9 million.
As for the market, Boston Planning adopted a re-zoning of the neighborhood in 2016 to allow mixed-use development and the Washington Square project is really revitalizing the area. The six-block mixed-use project is constructing 98,000 square feet of retail and 656 units of apartments and condos. The four industrial buildings are right in the middle of the action, equal distance from the Andrew Square and Broadway Station stops on the red line.
The loan from EquityMultiple investors was 12-month with a prepaid interest reserve and one six-month extension option on 11% annualized interest. Investors also received an equity participation of 8% of sale proceeds so potential for 14% annualized return. Appraised value of the properties is $31 million so approximately 64% loan-to-value. The lender Private Capital Group has serviced over 300 loans in 38 states since 2005 focusing on special situation lending.
Now I’ve followed this project and the sponsor was able to refinance earlier, paying off EquityMultiple investors for a 24% annualized return. You had experienced underwriters on the loan, a strengthening market in the Downtown Boston area and conservative financials.
How Important is a Portfolio in Real Estate Crowdfunding?
Those are the five criteria you need to be looking for when investing in real estate crowdfunding, but I want to make one more point, just one more point in this series on real estate strategies and this is important.
Just like in stock investing, the what you invest in is far less important than the how you invest. You can try to pick ten-bagger stocks all day long but if you don’t have a solid portfolio of names in different industries and sectors, you’re just going to see your returns melt away.
It’s the same way in property investing. If you’re just trying to pick deals here and there, you’re going to get nowhere. You might make a good return here and there but your overall wealth will go nowhere.
Having a portfolio, a real wealth creator, is about having investments with different risks so they smooth each other out. In real estate, doing this means understanding where the risks are; in property type, equity versus debt and by region.
So building that portfolio means you want investments in each of the five property types (office, retail, multi-family, storage, hotel) with each of them in equity and debt and in different areas. I would say aim for at least 20 to 30 deals to really diversify but that doesn’t mean you need to jump at the first 20 or that you have to invest in a deal because you need a specific property type.
Take your time and plan on getting up to that level of properties and real estate crowdfunding investments within two or three years. Real estate is an investment best when it's planned for the long-term so don't get in a rush to add properties. Follow the five criteria for analyzing crowdfunding deals and you'll diversify your portfolio but not at the expense of returns.