Note: when reading this article, please keep in mind that exceptions do exist. While I 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.
Put simply, real estate crowdfunding companies are online platforms that allow small investors to directly invest in certain specific real estate deals.
REITs, on the other hand, are most often publicly traded companies that invest in real estate and as such, by buying shares of the REITs, investors can participate in the return of large real estate portfolios.
Real estate crowdfunding is the hot thing in real estate right now. There exist already 100s of websites worldwide, and new ones continue to emerge all the time. Increasingly, many investors consider it to be a better alternative to other forms of real estate investing, including REITs. The "technology" behind crowdfunding 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.
When searching for "Real Estate Crowdfunding vs. REITs" on Google, one can quickly find many Crowdfunding websites trying to sell their product in a very biased manner. According to them, REITs are not real estate, REITs are riskier, and crowdfunding are set to outperform. All highly questionable statements, to say the least, and outright deceiving to prospecting investors, if you ask me.
The funniest thing is that while crowdfunding websites like to bash on REITs to gain their business, when it is time to present a historical performance, they often like to show off the returns of real estate by using the track record of REITs (which is exceptional by the way):
This is a very deceiving thing to do because private real estate has historically underperformed REITs by a large margin, and crowdfunded deals are arguably even worse than average.
We see great drawbacks to real estate crowdfunding and consider it to be one of the least attractive forms of real estate investing:
- Not only is it illiquid, but you do not have control either.
- The quality of deals is very questionable.
- You pay for not having liquidity and not having control.
- There are large conflicts of interest.
- I could go on and on.
- Success in real estate is a function of management.
- Private sponsors use too much leverage.
- Cost inefficiencies from start to end.
#1 No Liquidity, No Control, No Problems?
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.
In the case of real estate crowdfunding, you get to combine the worse 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. On day 1 of your investment, you may lose up to 5-10% in transaction cost alone when buying a property and costs reoccur when you someday sell the property. Transacting in an illiquid market is costly, and this just the cost of buying/selling the underlying property. There may be additional costs charged by the crowdfunding website itself. Moreover, if you needed to get out of your investment and needed to sell your ownership of a crowdfunded deal, you better believe that the cost will be very steep.
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.
#2 Questionable Quality of Deals?
Put in one sentence: great deals do not need crowdfunding, they can find capital in a more traditional and efficient manner. This does not mean that the deals on crowdfunding websites are poor per se, but it does put it into question.
Raising money on a crowdfunding website takes time; and so, to convince a property seller to give you the property under contract and wait for a riskier non-traditional financing; the buyer (the crowdfunding investor) is likely going to have to offer a premium to the seller.
Moreover, how good are the investment management skills of the crowdfunding website really going to be? I don't want to bash any of these people; but let's be real: great investment managers go work at REITs or large private funds; not at crowdfunding websites (exceptions exist). It makes the quality of deals even more questionable.
And, this is especially true when you consider the large conflicts of interests of crowdfunding website. Their interest is to maximize assets under management and get deals done to earn fees, not to maximize your performance. To raise money from unsophisticated retail investors, they need a good story and a good-looking property that will easily create interest.
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 is in the interest of Crowdfunding website to market property B despite a lower expected return.
REITs, on the other hand, are managed by professionals who are the very best of their field, have the greatest resources for identifying the best deals, and often own a sizable portion of the shares themselves - aligning interests with shareholders.
#3 You are Paying a Premium for Both: No Liquidity and No Control
Because the buyer of a property who uses crowdfunding is likely to need to pay a premium to the property seller, 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 historically low valuation with discounts to the net asset value, you are essentially paying a premium when investing in illiquid crowdfunded deals.
It really makes no sense and proves my point that REITs are much superior investments than Crowdfunded investments. At the very least, you should be getting compensated for taking the risk of high illiquidity in crowdfunded deals, and yet you are doing the opposite: paying for it.
#4 There are Large Conflicts of Interest
This goes back to the question over the questionable quality of deals. I believe that crowdfunding exists mainly for companies to extract value from unsophisticated retail investors. The interest of websites is to do as many deals as fast as possible. This is how most of them make their money after all.
It is borderline unethical, in my opinion, because there is no way a non-professional real estate investor can even perform adequate due diligence on most crowdfunded deals anyways, so selling them on a story is very simple.
The fact that it is rare for institutional money or professional investors to invest in crowdfunding should be a massive red flag. I am not implying that REITs have no conflicts of interests, but here, at least, we have big institutional investors and board of directors looking over managers to keep them in check.
Numbers Don't Lie: REITs Outperform
The higher efficiency, lower conflicts of interests, better management teams, and greater liquidity of REITs have historically led to stronger results with massive outperformance over the average returns of private market real estate investors.
From 1977 until 2010, REITs have returned more than 12% per year, according to EPRA. In comparison, private real estate investors returned between 6.4% and 8.7% per year on average depending on their underlying strategy. (Core, Core+, Value-add, Opportunistic)
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.
Interestingly, REITs outperformed private real estate by such large margin despite taking less risk with lower leverage, better diversification, and greater liquidity. So much for the supposedly "higher risk-adjusted returns" of private deals.
Now, it is clear that in specific cases, certain crowdfunded deals may manage to beat the average returns of REITs. There is no question about that. But the same can be said about active REIT investors. As an example, GSA has managed to generate 22% annual returns on its BUY picks by following a value approach to REIT investing since 1993.
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 HYPO Portfolio 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 16 positions. The numbers and historical data suggest that our strategy is set to perform much better than the average crowdfunding investor.
Two More Lies of Crowdfunding Websites
Lie #1: REITs are not real estate
Crowdfunding websites make sure to quickly point out that REITs are traded in the form of stocks to try to scare investors away from these supposedly "highly volatile and risky" investments. On the other hand, crowdfunded real estate investments are independent of the stock market and are hence pure real estate.
While this is true, it is, in my opinion, very unreasonable to assume that REITs are less of a real estate investment than crowdfunded deals simply because of how they are traded. This is the equivalent argument to saying that Exxon (XOM) or Chevron (CVX) do not provide exposure to oil and gas markets because the firms are publicly traded. The argument that REITs, which own nothing but real estate, are not real estate, is nonsense.
In fact, research from Cohen & Steers (CNS) shows that over full market cycles, the returns of REITs and private real estate are almost perfectly co-integrated.
Lie #2: REITs are much more volatile
It is easy to say that private real estate (crowdfunded deal) is not volatile if you never receive a quote on your property. A direct and fair comparison of volatility is not possible as the valuation methodologies between REITs and crowdfunded deals differ materially. That said, in an analysis by Brad Case, PhD, CFA, it was concluded after adjusting for leverage, return calculation methodology and liquidity, private real estate come up as more volatile than public real estate:
Is it believable that public real estate is actually less volatile than private real estate? It's not just believable, it's to be expected. Volatility is a measure of uncertainty regarding asset values. Think of a crisis: people trade assets at lots of different values because they have so much uncertainty regarding the factors that determine the asset values: the future stream of earnings, and the appropriate discount rate. A market in which more transactions give investors greater information about those underlying factors-that is, a market that is liquid and information-efficient, such as the stock market in which listed equity REIT stocks trade-SHOULD be less volatile than an illiquid, information-inefficient market such as the market for properties or (worst!) the market for private equity fund shares. Brad Case
You cannot say that private real estate is less volatile simply because you have no information on the daily value of the property. Similarly, you cannot say that private investments are less correlated with the stock market if you are not even valuing your property on a daily basis.
Bottom Line
The main selling points of crowdfunding real estate are flawed when you dig deeper. Investments are high illiquid, you have no control, the deals are questionable in quality, and the conflicts of interest are high.
I believe that for most people, the best long-term strategy to real estate investing is to invest in a basket to potentially undervalued REITs with above average yields such as W.P. Carey (WPC), EPR Properties (EPR), Iron Mountain (IRM), Brixmor (BRX), or even Washington Prime (WPG) for the more aggressive investors.
Moreover, REITs are today historically cheap trading at high discounts to NAV, suggesting that the future returns could be even greater.
Source: Lazard Real Estate
Our real estate portfolio holds today many positions trading at their lowest valuations in years. We consider these to be massively undervalued by the market and expect upside to materialize in the next years, in addition to the generous ~8% dividend yield. With the majority of the marketplace starting to look expensive, our portfolio appears to be particularly well positioned for 2018 and beyond.
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