Commercial real estate online fundraising has experienced explosive growth in the past three years with dozens of platforms emerging to offer investment opportunities to investors. In a sector that has become increasingly crowded, it is all the more important for both investors and sponsors to understand the key differences that exist between the leading business models that can have a big impact on “the three Rs” – returns, risk and relationships.
Firms operating online real estate marketplaces – also known as CRE crowdfunding – typically use either a direct-to-investor platform or a newly formed special purpose vehicle (SPV) entity such as a LLC. CrowdStreet was one of the first commercial real estate crowdfunding firms to adopt the direct-to-investor fundraising model, which works much as its name suggests. The online marketplace serves as a technology intermediary that facilitates online capital raising between commercial real estate sponsors and investors. Accredited investors invest directly with the individual CRE firm or sponsor and not with the online marketplace.
Investors who choose a online marketplace that uses an indirect investing model (ex: RealtyShares or RealtyMogul) participate via a newly formed special purpose vehicle entity – typically an LLC that is created and managed by the . For example, if a online marketplace commits to providing $100,000 in debt or equity to a sponsor, they write a check to the sponsor and then create a LLC specifically for that investment property. Essentially, the online marketplace is making a gamble that they can fill that commitment, and then they go to work raising capital by bringing investors into an entity created specifically for that deal.
Comparing Returns: Direct-To-Investor vs. SPV
The first important difference between the direct-to-investor and SPV models is the fee structure, which can affect costs for the sponsor and returns for individual investors. Generally, online marketplace that utilize the direct-to-investor model charge no fees to investors. CrowdStreet, for example, charges fees to the sponsor for hosting an offering, including marketing and management services. CrowdStreet does not charge fees to investors to join its network or invest via the CrowdStreet Marketplace.
Companies that operate a SPV model assess fees differently. Some firms charge fees to both sponsors and investors and may charge fees in up to three different areas – placement fees or front-end fees, ongoing asset-management fees and a percentage participation that the crowdfunding firm collects at the exit as a back-end fee. For investors in particular, it is important to be aware of where those fees occur and how much they could detract from the overall return on investment. Fundamentally speaking, since SPV platforms are forming and managing an entity that is then invested into a sponsor’s entity, an additional layer of investment structure now exists that brings fees and costs with it. This may result in net-to-investor returns that are lower than if the investor had invested directly into the sponsor’s entity.
Comparing Risk: Direct-To-Investor vs. SPV
Investing in commercial real estate, much like any other investment in stocks or commodities, entails risk. When participating in a direct real estate investment via an online platform, there are three primary levels of risk to consider:
- Property-level risk
- Sponsor risk
- Platform risk
Under the direct investing model, the investor accepts the first two levels of risk. In the SPV model, the investor accepts all three levels of risk. Here’s why:
Under the direct-to-investor model, investors are exposed to property-level risks (e.g. tenant performance, catastrophe and market cyclicality) and risks associated with the sponsor’s ability to deliver upon the business plan, but it stops there. Because the platform, in this model, is providing the technological infrastructure as well as services to facilitate the transaction and is not an investment manager, investors assume no risks associated with the long-term viability of the online marketplace itself.
In contrast, under the SPV model, investors are investing with the online marketplace and not the sponsor – hence the online marketplace is your investment manager in the same fashion as Fidelity or Morgan Stanley. The online marketplace, in turn, invests your dollars with the sponsor or, in essence, has the same type of relationship (see below) with the sponsor that the investor would have under the direct investing model. As a result, the investor, in addition to relying upon the sponsor, is also reliant upon the online marketplace. Since cash distributions and returns are paid to the investor by the marketplace, there is an extra link of funds transfer which inherently adds risk for investors. If that marketplace should have financial difficulties or go out of business, investor’s capital may be lost or returns diminished – even if the underlying real estate asset and sponsor continues to perform well.
Investor Relationships: Direct-To-Investor vs. SPV
One of the big advantages in the direct-to-investor model is the ability to build relationships. Sponsors not only gain access to capital, but they also establish a direct connection to new investors and can use the platform to expand their investor base. The online marketplace plays the role of matchmaker to connect sponsors and investors. The marketplace also can help to manage those investor by streamlining communications and reporting through integrated investor relationship management capabilities. Yet sponsors have full access to investor information, and they have the ability to forge direct relationships. In addition, investors in the direct model are often co-investing in real estate opportunities right alongside the sponsor. In private equity commercial real estate, operators have historically lived by the axiom of “know your investor”. This applies to investors as well. It is valuable to “know your sponsor” and the only way to do that is to become a direct investor.
In the case of the SPV, it is the online marketplace behind the SPV that reaps the benefits of forging relationships with the sponsors and investors. The marketplace is the gatekeeper or proverbial Chinese wall in an opaque system of raising capital. The sponsor gets paid in a single installment, but the actual source of those dollars is not shared with the sponsor. If an investor takes a particular liking to a certain sponsor and ends up investing repeatedly, that investor should accrue benefits (e.g. early access or exclusive access to future deals) with the sponsor. Sponsors also love to incentivize loyalty through preferential treatment of their best investors so this concept seems like a no brainer. However, under the SPV model this won’t occur because the sponsor has no idea that the investor has repeatedly invested or even invested with them at all for that matter.
Despite the technology that has made direct real estate investing more accessible to investors, commercial real estate is still an industry where relationships matter. It is important for investors to know and trust that sponsor, and likewise, it is beneficial for sponsors to know their investors to help cultivate and reward long-term investor relationships.
One of the guiding principles of CrowdStreet is to democratize private real estate investing and to bring greater transparency to the process for both investors and sponsors. CrowdStreet is unique in that it only lists institutional-quality commercial real estate investment opportunities and never charges fees for investors to join or invest.