I’ve been studying the emerging crowdfunding phenomenon and evaluating it as a potential source of funding for commercial real estate deals.
I had a chance to interview Dan Miller, co-founder of Fundrise, one of the first crowdfunding companies out there. My conclusion is that crowdfunding is becoming a viable funding alternative for commercial real estate deals, but it’s got to be the right kind of deal.
Before we talk about the best kind of deal to use crowdfunding for, let’s talk about what kind of terms you can expect from equity crowdfunding.
How to Analyze a Real Estate Deal
Deal analysis is one of the best ways to learn real estate investing and it comes down to fundamental comfort in estimating expenses, rents, and cash flow. This guide will give you the knowledge you need to begin analyzing properties with confidence.
Typical Terms of Equity Crowdfunding
Depending on the company, equity crowdfunding typically requires a preferred rate of return of somewhere between 8% and 12% and a small amount of equity as a kicker.
Let’s say the preferred rate is 10% for easy numbers. If the crowdfunding company invests $100,000 in your deal, then that means you need to pay out the first 10% — or $10,000 — to them as a preferred return.
This may exhaust most or even all of the available cash flow. To address this, some crowdfunding companies defer some of the preferred return until sale or refinance. For example, the company may require a 6% preferred rate of return paid annually and another 6% upon liquidation.
I think that you’ll see a decrease in the relatively high rates of return that equity crowdfunding requires currently. Until that time, let’s understand for what kind of commercial real estate deal it may be best suited for.
The “Right” Kind of Commercial Real Estate Deal for Crowdfunding
Because of the relatively high preferred return required by most equity crowdfunding companies, it isn’t suitable for a pure yield “buy and hold” investment because the cash flow or returns aren’t there to support it.
Instead, use equity crowdfunding for value-add or development opportunities for which you can add significant value in 2-3 years. This allows you to build value and finance the crowdfunding out, replacing it with more conventional (and cheaper) financing.
In this respect, crowdfunding is a bit like hard money, but it typically doesn’t require the high points at closing, and it’s much more flexible in terms of how it plays with other kinds of financing you may also have in the same deal.
How Equity Crowdfunding Fits into the Capital Stack
“Capital Stack” is a fancy term for “what your financing consists of.”
In the case of a value-add deal you’d like to finance with equity crowdfunding, the capital stack may look like this:
- The first 65% of the appraised value is financed by a traditional lender at 4.25%
- The next 65% to 85% is financed by equity crowdfunding
- The remaining 15% is cash from you and/or your investors
This arrangement still allows you to use significant leverage AND reduces the amount of cash you need to bring to the table.
While equity crowdfunding may not be ideal for every buy and hold commercial real estate deal (right now), it deserves strong consideration for value-add or development deals for which you can finance out the crowdfunding equity in 2-3 years.
In combination with cheap traditional debt financing, crowdfunding can provide a way for you to raise unlimited funds with reasonable terms for your next commercial real estate investment.
Have you ever used crowdfunding? How have you financed your commercial real estate investments in the past?
Join in on the conversation below!