Photo Credit: An Incredibly Blue Building by Quasic
Recently, I stumbled upon a financial blog and devoured its contents. Pretty good and entertaining reading. I noticed that this blog kept covering the crowd funded real estate (CFRE) space, touting its benefits and profits. I can only guess that the affiliate links were that juicy!
I don’t want to single out any particular company, so I’ll keep things as generic as possible. Just what is crowd funded real estate?
Genteel Introduction to CFRE
Imagine you have dreams of owning a profitable real estate empire. However, you’re just one person. How much can you do, realistically? If you wanted to get into real estate, you’d have to do a lot of work, securing loans, buying properties, fixing them up, selling or renting them… You are basically buying a business.
Or, you could press the ‘EASY’ button and go online. Use your favorite search engine, look up reviews, etc. The leading companies in the CFRE space are actively seeking investors. You will find them. There is a company (or two) that cater to ordinary investors – you don’t need to be accredited. They offer low minimums to get started.
You find a CFRE company, open and fund the account, and select the real estate you want to invest in. Boom! You’re now a bonafide real estate investor in huge properties. The magic happens largely behind the scenes – the company pools all funds, including your funds, into selected real estate ventures. They collect rent/sales and distribute them back to you and other investors. Of course, they’ll charge a small fee for their efforts.
Introducing Blucre
Blucre is a fictional crowd funded real estate company, a play of words on the various Greenacre, Blackacre, Whiteacre themes and the word lucre, a negative connotation on earning money. From that, I guess you can tell I don’t like the concept of crowd funded real estate all that much. 🙂
Anyway, down to brass tacks and wall accents… Blucre is open for business! Blucre would line up real estate projects and sponsors. It would be a pure fintech play – all contained on the internet and in a phone app. Live customer service, individual investor meetings, and handholding are for suckers. Buy search terms and do targeted advertising on the Internet. Set up affiliate links to spread the good word.
If you build it, they will come. The investors are coming, with millions of dollars ready to be invested in real estate properties. Blucre acts as an agent, collecting funds, depositing them into real estate plays, collecting proceeds, and distributing them to the investors. Everyone gets a little richer. Life is good!
The Path to Riches is Paved With Risk
Obviously, without risk, there can be no reward. I wouldn’t want it any other way! In Bluecre, there are some risks from what I can discern from this investment model. The first risk comes to mind is the real estate project itself.
What if the project is a residential project and is located right next to an airport? A residential project built next to a waste treatment plant? A commercial project built on a cleaned-up SuperFund site? What if there’s an environmental study and a lawsuit pops up? I don’t have the expertise or knowledge to invest in specific far-flung locales.
There’s also the sponsor risk. Ideally, I would rather have the sponsor have a huge equity stake, i.e., 20% in the project. It tells me this person(s) have skin in the game and want to see it succeed. Is the sponsor a well-established real estate businessperson? Is he/she well known? A track record of successful real estate projects?
Crowdfunded real estate is like herding cats, plucking dollars from retail investors. Maybe it’s more expensive and time consuming. Makes me wonder if the sponsors are not as sophisticated and capable as investors are led to believe. If they were, they would have gone through the traditional bank financing route, securing millions of dollars in financing from a single source on favorable terms.
What happens to a project that is 25% funded by retail investors? 50% funded? Obviously, the project cannot proceed. How is the initial NAV set? There may be some pressure to manipulate initial NAV to cover the hidden sales load fee and to attract more investors. Need to get to that 80% funded rate.
There’s the platform risk in the company providing CFRE services – what if it goes bankrupt? A bank run of sorts, where investors are demanding their funds back en masse? Are the investments SIPC insured?
CFRE businesses also tout low management fees. Just how low are these fees? Self-dealing behaviors may manifest in the real estate project level. The sponsors may choose to do business with friendly subcontractors such as accountants, appraisers, etc. The sponsors may choose businesses based on kickbacks they receive. The sponsors may choose the pay themselves higher than prevailing wages. And so on…
There’s other risks inherent in real estate such as rental income collections. Tenant damages and lawsuits. COVID-19 also showed the risk of lengthy tenant non-payments. The WFH boom showed risks of owning rental office space. ESG concerns. Etc.
Redemption – It’s Not a Bug, it’s a Feature
All of those risks pale in comparison to redemption risk. You buy shares of a real estate fund. You’re collecting dividends. Great. After a while, you decide to sell. You won’t get your money right away – it may take up some time or NOT AT ALL. Your money is locked up.
With the VNQ stock, you click on the sell button in your brokerage account. There are buyers ready to buy up your shares. The same cannot be said for Blucre shares – they need to be redeemed. Blucre has to find buyers or cash out equity from the project. Here’s how I imagine things may go-
A person clicks on the sell button, Blucre records it. It may aggregate all other sell orders at once. Then offer them for sale on the secondary market they control. They collect the sales, and then issue funds to the sellers. This process may take up quite some time. Worse, they may use accounting gimmicks to record sales, and use existing investor inflows to pay departing investors, a la Ponzi scheme.
Another approach is that Blucre will record the redemption request. They will aggregate all redemptions from other sellers. Then, they will request the sponsor of the real estate entity to buy back these shares. The sponsor will have to come up with money to buy back these shares. It could come out from their pocket. It could come out from revenues from their real estate project. They could get another loan to pay back these shares.
If some people put in small redemption requests each quarterly period, Blucre probably can handle them. There may be a small penalty involved. They can get the funds needed to redeem such shares. But if there’s a huge redemption request or a bank run, Blucre will simply lock up all shares for an indefinite amount of time. Of course, Blucre will claim that the share lock up is to protect other investors and the values in the shares they own.
Lastly, there may be an ‘exit event’, i.e., the CFRE property is sold. The proceeds are collected from the sale, and all shares are redeemed. The income streams stop. The final NAV may be lower or higher than previously reported NAV’s. You may not have any control over this exit event.
The Downsides of Blucre
So, with your investment in Blucre, you gain access to real estate investments. You do not have liquidity – you cannot sell your shares at any time. And another drawback – they are non-marginable. A significant portion of funds are locked up. You may need quick access to funds w/o having the need to redeem shares, and it’s not possible.
You get quarterly dividends. They are taxed as ordinary income. One nice feature about conventional real estate is that the owner can treat it as a business, deduct expenses, take in depreciation, etc. to reduce taxable income. With Blucre, you don’t get these tax advantages. At the CFRE level, the project may enjoy these tax advantages which may be passed along to retail investors.
Lastly, you cannot enjoy the benefits of leverage commonly associated with conventional real estate loans. Such real estate properties are funded 100% in CFRE schemes.
Passive Investments in Real Estate
You still want to diversify your investments to include some real estate, but don’t want to invest in actual properties? Here’s one example: The best known ETF is VNQ – Vanguard Real Estate Fund. This is a liquid fund that is sold on the stock market. It has ordinary dividends, which is tax-inefficient. It may be marginable – check with your brokerage.
There are other many other REIT’s that you can invest in, covering a variety of commercial and residential properties. However, if you want to invest in the very best REIT? It’s hiding in plain sight – just invest in a total market index fund such as VTI. Most of the total stock market funds already own some REITs at market weight.
Conclusion
Hopefully this will serve as a useful counterpoint to the glowing stories and testimonials you may read across the Internet regarding CFRE schemes. Unfortunately, CFRE investment is an ill-suited investment vehicle for my needs.
The usual disclaimer applies; This blog article is for entertainment purposes only. No express or implied warranty is offered, regarding any actionable information contained in this article. Laws governing investing are complex and varied. Personal finance is personal to you – no one else knows about your financial situation intimately. I encourage you to read and study information from other financial sources to gain the knowledge and expertise needed to manage your finances.
