Crowdfunding Experiment

One of my goals over the next 5 years is to build a diversified stream of passive income. I hope to use that stream to cover some of my expenses during my freedom years. One area I've been thinking about lately is alternative investments.

Alternative investments are basically asset classes other than stocks, bonds, and cash. That's a pretty broad definition…

Examples of Alternative Investments

It seems like this term is used to mean just about anything that isn't considered traditional. Here are a few typical examples:

  • Real Estate
  • Private Equity
  • Hedge Funds
  • Commodities
  • Precious Metals
  • Luxury Valuables & Collectibles

Real estate, in particular, surprised me since I would consider it a pretty traditional investment class. Apparently it can be listed as both a traditional or alternative investment class depending on how it's applied.

The underlying premise is that these types of investments provide good diversification since they have a low correlation to traditional assets.

Some of them also tend to generally be riskier than traditional investments, which is why I wouldn't be comfortable allocating more than ~10% of my net worth to alternatives.

Brief Introduction to Crowdfunding

It wasn't until early 2012 that crowdfunding became an option for smaller investors. President Obama signed the Jumpstart Our Business Startups (JOBS) Act into law on April 12th of that year. The law was meant to encourage investments in small businesses and entrepreneurship. This subsequently led to a number of online platforms designed to match entrepreneurs looking to fund their projects with investors.

Prior to that, crowdfunding was limited to exchanging funding for rewards, donations or other perks. Once the law was passed, it became legal for companies to use crowdfunding to issue securities. This is known as equity crowdfunding.

The law originally limited participation to accredited investors. Those with at least $1M in net worth (excluding primary residence) or at least $200K in income ($300K for couples) for the past 2 years. An additional amendment to the law (Title III) passed in early 2016 allowing for the inclusion of non-accredited investors with some strict limits on income.

Although there are some crowdfunding sites that now target non-accredited investors, the majority still prefer to limit themselves to accredited investors. However, that's beginning to change as the industry is adapting to the new rules.

Regardless of accreditation, investors should be disciplined about their exposure to these types of investments, given their risky and illiquid nature.

Why Choose Crowdfunding

So why am I even interested in this type of investment? There are a few things that appeal to me when it comes to crowdfunding, at least in theory…

Higher returns – This is the most obvious benefit of equity crowdfunding. It allows access to higher investment returns, with varying levels of risk.

Flexibility – I want to eventually be able to live the FIRE lifestyle anywhere, and don't want to be restricted to a particular location. This has kept me from investing in local real estate directly. Crowdfunding gives me the option to participate in real estate without the associated hassle.

Diversification – Many investments require a relatively low minimum investment, making it easier to diversify across multiple projects, and thereby spreading the risk. You can also choose to invest in different geographies, and investment types, which adds another layer of diversification.

Ultimately, I'm looking for investments that can generate income during my transition from early retirement to traditional retirement. Of course, this wouldn't be the sole source of income, only a sort of investment hedge that gives me exposure to real estate and other opportunities.

The Capital Stack

One thing that is critical to understand when looking at any investment from these platforms, is what is commonly known as the Capital Stack.

I'm not going to go into an elaborate explanation of this concept. At its core, it's a representation of the different types of financing sources that go into funding an investment, and their related returns/risks. The type of deal you invest in determines which position you're in, in case of default.

Here's a visual from ProHatch that helps explain the concept in a simple way.

capital stack

Each deal will be different and have different components of the above, which normally applies primarily to real estate funding.

The Senior Debt is the safest investment but carries the lowest returns. If the borrower defaults on a loan, this type of position is senior to all others and will get paid first. It is also typically tied to a lien on the property itself, which in case of default protects the investor from being completely wiped out.

The higher you go up the stack, the higher the risk involved, and of course the higher the return.

It's important to understand these positions when investing in any of the crowdfunding platforms. All the platforms will specify which position each project carries.

The Crowdfunding Experiment

After some research and discussions, I narrowed the field down to three online platforms. I plan on testing each of them out with a relatively small investment over the next 12-18 months.

Each of them has a slightly different twist to equity crowdfunding. I'm hoping that once I complete my experiment, I can narrow it down further, or perhaps I'll continue to split my investments across all three.

At this time, they all require accreditation, so they are not easily accessible.

Here's where I landed…

equity crowdfunding review

I've done a more detailed review of each these platforms, which you can access by using the links below. I'll be updating them as the experiment progresses.

In the meantime here's a really brief explanation of why I picked each one:

Peerstreet – This platform specializes in senior debt, and residential real estate. The returns appear to be lower, but that's due to the conservative nature of the team behind the investment opportunities. This should give me good exposure to real estate with lower risk relative to the other platforms.

Yieldstreet – This platform specializes in commercial real estate, and litigation. The returns are more aggressive, and I like the litigation opportunities. It should be a good way to diversify further and opens up more chances to access a market I haven't been exposed to before.

RealtyShares – This platform is similar to peer street, but appears to have more commercial real estate opportunities, as well as more geographic opportunities. They also offer positions other than senior debt, which means potentially higher returns.

From what I've experienced so far, there's been a pretty high demand for these types of investments. I've been monitoring the platforms for the past few months, and many investments often sell out in minutes.

Closing Thoughts

I've allocated $10,000 this year for each investment platform as an experiment of sorts. This should give me hands-on experience with how they operate, and a flavor for the types of investments available.

During my intake interviews with the various representatives, I learned that very few projects have defaulted. I think this gives a false impression of risk, especially since many of these platforms have only operated for a handful of years, and none of them went through the downturn in 2008/09.

It would be interesting to see how they survive a rough market drop. Since many of the projects have low liquidity, many investors could be caught with their pants down. Even the senior debt positions would have to wait months, and maybe years before they recovered any portion of their investment.

Having said that, many of the platforms appear to have competent management teams, and a great deal of experience in real estate. They also accept a small percentage of the opportunities that come their way, so the vetting adds another level of risk mitigation.

Check out my latest summary update for more.





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