Do site minimums put adequate diversification beyond many investors' reach?

Proper diversification

 

March 2018 update: since this article was written in 2015, things have improved dramatically for some investors. Many real estate crowdfunding sites have moved beyond single property investments, and now offer multiple property (pooled) investments.These allow an investor to very quickly and easily achieve 120+ property portfolios for effective diversification. For example, a single investment in BroadMark hard money loan fund puts an investor in hundreds of properties.

So the information below is no longer pertinent in all cases. However, I'm keeping it here for those continuing to invest only in single property investments (since this is still an issue for them).
 

In part one of this article ("How many properties do I need to diversify?"), we examined how many properties it takes to safeguard a direct real estate portfolio against geographic, property type and tenant risks.

 

Institutional investors indicate it's in "the hundreds" of properties. That's a shockingly large number. So we did a back-of-the-napkin reality check. And we confirmed it's 120 to "hundreds".

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So what does this mean to individual investors. And to the industry?

 

How much cash will it take?

 

How much cash will it take to diversify? It depends on the site. But even using the most generous numbers (100 properties instead of "120 to hundreds"), the "cheapest" site requires $500K of cash, and a minimum total portfolio size of $5 million. The most expensive requires $2.5 million of cash, and a minimum total portfolio size of $25 million..

 

I was a little stunned after I ran calculations. Before talking about what this means, here's how it comes out...

 

"This will only hurt a bit", said the dentist with his drill.

 

There are two types of investments, and most sites tend to cater to mostly one or the other.

 

One type allows you to invest in individual properties (like many investments on CrowdStreet, and Patch of Land). One type allows you to invest in funds, which invest in several properties (like many investments on RealCrowd). 

 

So how much does it take?

 

1. Individual property investments
    

   • Patch of Land: At this moment they list three individual property investments with a minimum of $5K.

     • *Proper diversification requires investor to devote $500k of cash to real estate.

     • Investor should have at least $5 million in assets, to safely invest that amount.

   • CrowdStreet: At this moment they list 4 individual property investments with a minimum of $25K.

     • *Proper diversification requires investor to devote $2.5 million of cash to real estate.

     • Investor should have at least $25 million in assets, to safely invest that amount
        

2. Fund investments
    

   • RealCrowd: At this moment they list 8 fund investments with a minimum of $25K or $50K. (So let's use the $37.5K average). Each fund seems average about 8 to 15 properties (so let's use 11.5 average)

     • *Proper diversification requires investor to devote $652K of cash to real estate.

     • Investor should have at least $6.52 million in assets, to safely invest that amount.

 

*Notes:

• Assumes 100 properties to diversify. I realize that this is much lower than "120 to hundreds of properties", so proper minimums are most likely higher.

• A total "safe" portfolio of real estate allocation of 10%, is taken from the average at: "How much real estate is ideal for my portfolio".

 

What does this mean?

 

As an accredited investor, I probably know a lot more other accredited investors than the average person. I can confidently say that the requirements for the cheapest sites are beyond the capabilities of at least half. The requirements for the most expensive sites, are beyond the capabilities of most.

 

And worse, at the high-end $2.5 million price point, the investor really doesn't need crowdfunding. For just $1 million, investors gain entry to the exact same billion-dollar private funds the institutions have used for decades. This is far cheaper due to their economies of scale (fees around 1%), and 99% less time-consuming than trying to manage dozens of micro-funds, or hundreds of properties manually. So this price point is simply not realistic.

 

I am a big fan of real estate crowdfunding. So it pains me to also say that in my opinion, the current model is badly broken for serious, long-term investors looking for diversification.

 

It's fine for pure speculative, "throw away money", where diversification is unimportant.

 

But, until minimums are drastically lowered, it is currently unworkable for the majority of accredited investors, who are long-term and looking for a  diversified and stable investment.

 

Mutually assured destruction? Or mutually assured success?

 

I completely understand how sites have to walk a fine line between sponsors/borrowers and investors. Many sponsors are actually funds, and they actually want the highest minimums possible. This minimizes the amount of paperwork and headaches they endure from dealing with multiple investors. And sites that deal with funds typically are paid by fees from those funds, so they tend to give them more credence than investors.

 

But ultimately, if the rules are structured in a way that one of the other cannot be successful in the long term, then the entire structure will collapse. It takes a balance for both sides to ultimately succeed.

 

What happens if sites don't change?

 

If things don't change, I don't think there will be any short-term problems. Times are great right now, and defaults are few.

 

However, in the medium-term (1 to 5 years) there will be significant problems. Once the business cycle begins a downturn, defaults will increase, and investors will truly understand how undiversified their portfolios are. People will lose significant amount of money, and the industry will get a black eye in the press and with its customers.

 

Perhaps in the next upturn, there might be enough new, fresh investors to begin the cycle again. But this will only last for so long, and after one or two more business cycles, the word will be out that this type of investment is too risky. And the sites themselves will become like penny stock industry companies, and never grow to close to their legitimate potential.

 

What happens if sites do change?

 

I feel there is legitimate hope, because any person or industry tends to change, once they experience pressure that threatens their long-term existence.

 

It would not take much. Minimums simply need to be cut by a factor of 10 from what's currently the low-end. If sites would change to a $500 minimum, it would require only $50K of cash, and $500K portfolio size. Virtually every accredited investor would be able to participate at these price points.

 

And if real estate crowdfunding, is ever allowed to be marketed to the average investor, the minimums need to be lowered by another factor of 10. A $50 minimum would require only $5K of cash and $50K portfolio size. This is completely realistic.

 

The Lendingclub has a $25 minimum, and is now $6.5 billion company. Real estate crowdfunding companies (in a market that's 46 times bigger than consumer loans) could realistically expect to grow to become $100 billion companies and larger.

 

Not all will change

 

I actually complained about the high minimums to one of the sites not included in this article (who I won't name). In their defense, I was talking to an account rep, who probably didn't understand the deeper issues. At the same time, what he said was disturbing. He told that their site is not going to change. It's a high-end site, and so minimums need to stay high.  He then said that low minimums were only for cheap "house flipper sites"...and then mentioned one of the other sites in this article by name as an example.

 

Hopefully, management at that site ultimately gets it, better than their staff.

 

As always, I gladly welcome your comments below.