There are a lot of different ways to get involved with real estate but the two ways for the average investor to own investment real estate have been to directly buy an investment property or purchase shares of a publicly traded Real Estate Investment Trust (a “REIT”). That changed a few years back and a third way became available after Congress passed the 2012 Jobs Act and allowed companies, including real estate developers, to fund projects by raising small amounts of money from a large number of small investors. The Jobs Act reduced the regulation around raising money from a lot of different investors, called crowdfunding, and today participation in different types of real estate deals can be offered to investors on internet sites, referred to as Real Estate Crowdfunding platforms. Before crowdfunding many of these real estate projects would be funded through private placements that were offered only to a smaller number of wealthy investors. But is crowdfunding the best way to invest in real estate even for the average investor? Today, I am going to discuss the pros and cons of investing in real estate through 1) directly purchasing real estate, 2) owning shares in a REIT and 3) participating in real estate deals through a Real Estate Crowdfunding platform.
I directly own investment real estate and I also own shares of different REITs but I have not invested in real estate through any Real Estate Crowdfunding platforms. Do I see a benefit to owning real estate through a Real Estate Crowdfunding platform? Yes, but in limited circumstances and I will explain what I mean after evaluating these three real estate investment options.
The Evaluation Criteria
To evaluate these three different ways to own investment real estate, I am going to use the following criteria:
- How much capital do you need to invest?
- Can I select the real estate I want to own?
- How much control do I have over the underlying real estate?
- Is it easy to build a diversified set of real estate holdings?
- Is my investment liquid – meaning is it easy to sell my investment?
- Can I passively manage my investment?
- Do I directly benefit from the tax advantages of real estate?
- How are the historical total returns and cash flow for these types of investments?
How much capital do you need to invest?
Directly owning your own property – How much capital you need to have to directly purchase an investment property depends on the value of the property you want to acquire and the financing you can obtain. Let’s assume you want to buy a small single family home to rent out, you purchase it for $150,000, and you need to put down 20% of the purchase price to qualify for a loan. Based on those assumptions you would need $30,000 of your own money to purchase the investment property. I tend to be conservative and also put in place an emergency fund for an investment property in case I have trouble renting it or there is a significant maintenance issue. That emergency fund usually adds a few thousand dollars (at a minimum) to my initial capital requirement to purchase a property. The actual amount of capital you will need to directly purchase your own investment property will vary but you can see how the capital requirements are significant and tens of thousands of dollars (if not more).
Category Winner: REIT – There are over 200 REITs registered with the Securities and Exchange Commission that also trade on a major U.S. stock exchange. For most REITs you can purchase as little as one share of the REIT stock. Therefore, you can get access to different parts of the U.S. real estate market with very little capital by owning REITs. You can increase your capital invested over time by purchasing additional shares.
Real Estate Crowdfunding – The capital you need to participate in a real estate project offered through a real estate crowdfunding platform depends on the project and the platform. Fundrise, a real estate crowdfunding platform that offers three types of real estate portfolios to invest in, has a minimum investment requirement as low as $500. That is the lowest amount I have seen. Other platforms have minimum investment requirements ranging from $5,000 to $30,000. So, the capital required to invest in these projects is not insignificant but it will typically be less than if you directly bought a property.
Can I select the real estate I want to own?
Directly owning your own property – Subject to capital restraints, yes you can select the real estate you want to own. However, most investors are going to be limited to single family or small multi-family units and access to larger commercial and multi-family properties will not be possible.
REITs – You can choose to invest in a REIT that invests in a certain type of real estate but you do not have any say on the properties that will be part of the real estate portfolio that the REIT owns. REITs have active managers that run the REIT and its real estate portfolio.
Category Winner: Real Estate Crowdfunding – I actually think Real Estate Crowdfunding provides the greatest opportunity to invest in specific properties that you consider to be attractive. Many investments offered through the Real Estate Crowdfunding platforms are projects on specific properties. The investment may be to develop a property, upgrade, or just run it better to increase cash flow, but you as the investor get to choose the deals you want to invest it.
How much control do I have over the underlying real estate?
Category Winner: Directly owning your own property – You have all the control in this investment. You can hire a property manager or do it on your own. If you own the property directly you get to select the tenants, choose how much rent to charge, etc.
REITs – You have no control over the real estate. You are a fly on the wall and no one at the REIT will pay any attention to you. You can listen to management calls and read public filings to receive updates on the REIT and the underlying portfolio. That is about it.
Real Estate Crowdfunding – Once you select the investment you have limited control over the investment. Some platforms allow you to speak directly with the developer/sponsor of the project but all that does is give you direct access to getting updates. You have no control over the actual project/property.
Is it easy to build a diversified set of real estate holdings?
Directly owning your own property – This is the hardest way to diversify you real estate holdings. Owning one property has the highest capital requirement so trying to own 5-10 properties to diversify you risk takes time and significant capital. Further, since you are actively managing the property or the property manager it becomes difficult to own individual properties throughout the country and still be effective. So lack of diversification is a real issue with owning real estate this way.
Category Winner: REITs – It is really easy to diversify your real estate holdings with REITs. You can diversify your investment by holding multiple REITs that cover different types of real estate and geographic areas. There are also REIT ETFs that create a diversified portfolio of REITs for you. If you want diversification within the real estate market REITs offer a very easy way to get it done.
Real Estate Crowdfunding – Owning a part of 5-10 projects offered on a platform is possible but it still takes time and some capital. Assuming the minimum investment on a project is $5,000, it is going to take $25,000-$50,000 to diversify your portfolio amongst 5-10 projects. These projects also tend to roll over every few years and therefore you will need to periodically identify new projects to invest in in order to keep your diversification at the levels you desire. Some platforms also offer investors the opportunity to invest in a portfolio of projects which further increases your ability to diversify your holdings.
Is my investment liquid – meaning is it easy to sell my investment?
Directly owning your own property – Well, you can sell the property whenever you decide it is time to do so but the process is costly and relatively slow and therefore everyone directly holding rental real estate should know that it is a relatively illiquid investment. Closing costs can be 2-6% of the property’s value and it is not uncommon for the process to sale your property to take 2-6 months.
Category Winner: REITs – Yes! One of the main advantages to owning real estate through a publicly traded REIT is that there is an available market to sell your shares. I literally could go and sell my REIT shares in the next few minutes and have the cash ready to invest into something else the next day. REITs offer transparent value (the market price of the shares) for the investor and an ability to convert the investment into cash right away.
Real Estate Crowdfunding – Most of these projects have 2-5 year investment horizons and getting your money back before then is challenging. Some platforms offer the option to sell your ownership stake early if you need the cash but you will likely be selling at some kind of discount.
Can I passively manage my investment?
Owning your own property – This is the flip side to control. You have control of your property but it is an investment that needs to be actively managed by you. The amount of time you need to spend managing the property will vary on the type of property, its age, the quality of your tenant, etc. Plus, you can hire a property manager to reduce the active management requirements but it costs about 6%-8% of your monthly gross rent to have a good property manager.
Category Winner: REITs – REITs are a very passive investment. You can read the quarterly updates but beyond that there is not a lot to do if you are planning to hold the REIT for cash flow and long-term appreciation.
Real Estate Crowdfunding – I would say you need to do a lot of diligence when you are selecting the individual project to invest in but once you are invested you do not need to do much except monitor your distributions and any updates you receive from the developer/sponsor of the project.
Do I directly benefit from the tax advantages of real estate?
Category Winner: Directly owning your own property – Yes!!!! This is probably the greatest benefit of owning your own property. You can often see positive cash flow from a property without paying any taxes on it due to the depreciation you can take on the investment property. You can also use things like a 1031 exchange to defer paying taxes on any gains when you sell the property. Even if you owe gains on the sale of the property they are usually taxed at the long-term capital gains rate which is typically lower than ordinary income rates.
REITs – REIT income, for tax purposes, can be allocated to ordinary income (usually the highest tax rate for an investor), capital gains (lower tax rate) or return of capital (no taxes due). The majority of REIT dividends are taxed as ordinary income but dividends generated from the sale of a property in the portfolio can qualify for a capital gains tax rate and REITs can use the advantages of depreciation to pay a “non-taxable return of capital” which means no taxes are paid. Overall, REITs are the least tax advantaged of the three types of investment.
Real Estate Crowdfunding – It depends but if you are investing in projects where the investors own the underlying real estate then you benefit from things like depreciation which will reduce the taxes you own on any distributions you receive. You will also receive favorable long-term capital gains rates when the property is sold if the property has been held for at least one year. Most Real Estate crowdfunding projects do not qualify for a 1031 exchange so you will have to pay taxes on the gains from the sale of the property.
How are the historical total returns and cash flow?
Real estate has done quite well over the past 10 years so everything looks promising right now. Crowdfunding platforms will promote annual average returns in excess of 8%-10% while REITs commonly have 3%-5% dividend yields (you can find higher yields, too) in addition to whatever change in market value that occurs over time. Your return on a directly held property will depend on the property you pick, the price you pay, how you manage it, and the performance of the local real estate market over time. I think the take-away is that all three types of investing in real estate can see positive returns if you make good choices.
Does Real Estate Crowdfunding have a Place in Your Portfolio?
I believe the answer is possibly but in a very limited and targeted manner.
- Publicly traded REITs are probably the best way for the average investor to invest in real estate. REITs are a passive investment, they are a liquid investment so they are easy to sell, you can easily diversify your real estate holdings with REITs, you can get consistent cash flow, and you access the economies of scale and expertise of a REIT that you probably do not have access to on your own.
- Directly holding and managing your own real estate can be great if you want to focus your investment efforts in real estate and become in expert in acquiring and managing real estate properties. Many people have built wealth by focusing on directly investing in real estate so it has a proven track record if you build the expertise to acquire and manage properties effectively. However, it takes time and capital to build a portfolio of assets this way and initially you will not be diversified.
- I think investing in projects through Real Estate Crowdfunding platforms can be a good thing if you learn to identify value in specific real estate projects. With less capital and a certain level of diligence, you can select several projects to diversify your portfolio of real estate holdings. A portfolio of REITs supplemented by a portfolio of high quality projects selected through a Real Estate Crowdfunding platform could be a good way to gain exposure to real estate.
For me, I am researching specific Real Estate Crowdfunding platforms to select one or two platforms to join so I can begin to diligence specific real estate projects to invest in. In the next few months I will write about the criteria I used to evaluate different Real Estate Crowdfunding platforms and which platforms I joined.