Fundrise, Realty Mogul, RealtyShares All Suffer 3 Major Flaws

Summary

• Real estate crowdfunding is increasingly seen as an alternative to REIT investments for individual investors.
• Crowdfunding websites argue that they are able to cut fees, increase diversification and boost risk-adjusted returns.
• From the lens of a professional REIT investor, I consider crowdfunding to be the worst way to invest in real estate. In this article, I explain why.
• Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Start your free trial today »

Please Note: when reading this article, keep in mind that exceptions do exist. This article applies mostly to equity-based real estate crowdfunding websites. While we generally have a negative view on real estate crowdfunding, we recently recommended one particular website that allows to make Hard Money Loans with yields up to ~14% yield to the subscribers of High Yield Landlord. We consider this one website to be an exception because it focuses on short-term loans rather than traditional equity investments. We favor REITs for most of our real estate investments but use this one crowdfunding website for diversification purposes.

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In the recent years, real estate crowdfunding has experienced significant growth and is now often compared to REITs (VNQ) as a superior alternative for the small investor. For the ones who are unfamiliar with real estate crowdfunding companies, simply put, they are online platforms that allow investors to directly invest in certain specific real estate deals. Three of the most popular websites include Fundrise, Realty Mogul and RealtyShares.

On the other hand, REITs are most often publicly traded companies that invest in real estate and as such, by buying shares of REITs, investors can participate in the return of large real estate portfolios.

Increasingly, many investors consider crowdfunding to be the better alternative because the "technology" behind it is supposed:

• Reduce fees.
• Allow for greater diversification.
• And ultimately boost risk-adjusted returns.

While there may be some truth to that, we are not buying it. Crowdfunding websites are very good at selling this concept to unsophisticated retail investors, but they do less of a good job at presenting the risks in a fair manner. We see many big flaws in real estate crowdfunding, and generally speaking, we consider it to be one of the worst ways to invest in real estate. Below we explain why:

#1 Questionable Quality of Deals And Large Conflicts of Interests

Great deals do not need crowdfunding to get funded. There has never been as much private money chasing deals as there is today and the best deals never even hit the market.

Raising money on a crowdfunding website takes more time and is less efficient than selling to one buyer, and so, to convince a property seller to give you a property under contract and wait for a riskier non-traditional financing; the buyer (the crowdfunding investor) will likely pay a premium to the seller. Put yourself in the shoes of a property seller: Why would you want to sell on a crowdfunding website? You believe that you can get an even higher price from unsophisticated investors and/or you are having trouble selling to more sophisticated investors in the private market. This does not mean that all deals on crowdfunding websites are poor per se, but it does put it into question.

Moreover, there exists large conflicts of interests between crowdfunding websites and investors. The website’s interest is to maximize assets under management and get deals done as fast and as many as possible in order to earn fees. This incentive will often lead to sub-par results because to raise money from unsophisticated investors crowdfunding websites need good stories to tell and good-looking properties to show.

If property A has an expected return of 12% per year except that it looks horrible and will be difficult to market to crowdfunding investors, but property B has a great story, it's in the interest of the crowdfunding website to market property B despite a lower expected return.

It's rare for institutional or professional investors to invest in crowdfunding deals. They generally prefer to invest in REITs or directly in the private markets. Maybe there's a reason to that?

#2 No Liquidity Combined With No Control

Generally speaking, the main argument in favor of REITs is its higher liquidity, and the main argument in favor of private real estate is greater control. With real estate crowdfunding, you get to combine the worst of both worlds and get no liquidity and no control in most cases.

Just try to exit your crowdfunded deal. Is it complicated? Is it costly? Well, yes, it is, and this is a huge problem. In many cases, it won’t be possible for many years, and if it is, then it will come a steep cost.

Remember that when you invest in real estate, on day 1 you may lose up to 5%-10% in transaction cost alone. Transacting in an illiquid market is costly and there may be additional costs charged by the crowdfunding website itself.

In comparison, with REITs you directly invest in a diversified portfolio of assets, and the transactions costs of buying the underlying properties are already paid off - avoiding large dilution on day 1 of your investment. If you want to exit the investment, you are in control and can do so with minimal cost in one click of mouse with REITs.

#3 Diluted Returns for No Control and No Liquidity

Since property sellers are likely to demand a premium to agree to sell on crowdfunding websites, your potential returns will be diluted by this higher price. You are essentially paying a premium for having no control over your investment in comparison to buying the property yourself with a traditional financing.

Moreover, since publicly traded "liquid" REITs are today selling at a discount to the underlying value of their properties, you also are paying a premium for the illiquidity of crowdfunded deals.

With REITs, you are essentially getting liquidity and the control of your exit at a discount to the price that you would pay for an illiquid crowdfunding investment with no control.

Numbers Don't Lie: REITs Outperform Private Real Estate

The better quality of deals, lower conflicts of interests, and greater liquidity of REITs have historically led to massive outperformance over the average returns of private market real estate investors.

From 1992 until 2017, REITs returned more than 11% per year. In comparison, private equity real estate investments returned just 7% on average, or a ~4% annual underperformance. In other words, if you had a million dollars 25 years ago and invested it in REITs rather than in private equity real estate, you would have nearly two and half times more today.

source

The private returns here are from professional private equity investors who are arguably less conflicted and better managers than sponsors of crowdfunded deals. We would not expect better results from crowdfunding websites - making the outperformance of REITs potentially even greater.

Now, it's clear that in specific cases, certain crowdfunded deals may manage to beat the average returns of REITs. There's no question about that. But the same can be said about active REIT investors. Certain investors have managed to generate up to 22% annual returns by following a value approach to REIT investing since 1993.

Source

Many crowdfunding investors commonly point out that they are able to earn higher cash flow as compared to buying low yielding REITs such as Realty Income (O), Simon Property Group (SPG), Public Storage (SA), or Prologis (PLD) with 3%-5% dividend yields.

But they ignore that they could easily earn higher yields with REITs if they adapted their investment strategy towards that goal.

Our Core Portfolio at High Yield Landlord is designed to generate high, sustainable and growing cash flow with an ~8% average dividend yield. We aim to hand-pick only the REITs offering the greatest return potential and have built a diversified portfolio of 17 positions. The numbers and historical data suggest that our strategy is set to perform much better than the average crowdfunding investor, and therefore we see no reason to investing in illiquid crowdfunded real estate deals.

Disclosure: I am/we are long ALL STOCKS IN CORE PORTFOLIO AT HIGH YIELD LANDLORD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.