Rental property investing is becoming democratized
When you purchase a rental property on your own, you need a good credit score to get approved. Additionally, you’ll likely need at least a 20% downpayment. On an expensive rental property, that’s no small chunk of change.
But if substantial portions of the population can’t get involved, it’s just setting up a bigger class gap. And that’s where real estate tech companies say they’re attempting to flip the narrative. Perhaps the most significant benefit of fractional real estate investing is the freedom it offers to newer investors. By allowing investors to pool their resources, it substantially lowers the cost of entry into the industry, giving underserved groups the opportunity to finally enter.
Previously, if you wanted to invest in a rental home, simply purchasing and/or financing the property yourself would be the first step. Then you’d need to renovate as needed, handle the inspections, vet the tenants, run the credit checks, and finally, rent out the unit(s). But by investing fractionally in that same home, you can likely save yourself all of that trouble.
“Purchasing a portion of a property entails paying less than the full price of the complete asset,” They save most buyers the time, trouble, and expense of furnishing the home, setting up the legal framework, and putting together the owner group,” says Hardy Selo of the online search platform Property Guru.
With fractional real estate investing, you’re just signing some documents and putting up the money for someone else to do it while you rake in the returns. And speaking of returns…
The Potential for Passive Income & Wealth-Building is Real
One of the many reasons investors like the idea of real estate investing is the passive income it can potentially create. With fractional real estate investing, earning passive income becomes even easier than owning the full property. There’s a property management team already built into the investment.
Plus, this shared ownership method allows investors to invest in multiple properties, all of which cost less than it would for them to operate a single vacation home on their own. Just like diversifying your stock portfolio, investing in several real estate assets comes with its benefits.
“Spreading your money over two or three distinct real estate markets reduces investing risk and raises the possibility of success,” says Selo.
Investors will need to be able to put up more money for multiple fractional investments, but if they can — and the properties perform well — they could be sitting on a substantial amount of passive income thanks to dividends.
Many of the recognizable names in the fractional real estate industry publish these returns you can earn, although none of them promise a certain dividend. Arrived, a fractional real estate platform that requires just $100, averages a dividend return between 3% – 7.2% annually. Say you initially invest $100 in Arrived and continue to put $100 towards the investment each month. With an average return of 7% over 10 years, you could earn $840 in returns within the decade.
Lofty.AI, another fractional real estate investing company with just a $50 minimum investment requirement, boasts double-digit returns over the life of the investment.
So the profits look pretty nice for investors. And with larger numbers of smaller investors, fractional real estate looks like a real solution to help everyday people narrow the investment gap.
But fees can eat away at earnings
As with most things in life, you’re not getting convenience for free. Fractional real estate investing is no different. To be able to invest low amounts of money into a property with no real background check, you may have to pay some pretty substantial management fees.
“Fractional real estate investing tends to come with fees that would never be charged to individual investors buying an entire property,” says Leonard Ang, CEO of iPropertyManagement.
Even some of the more trustworthy real estate investing companies charge high fees. Paying 1% of your portfolios seems to be the most common, but fees are often higher for luxury properties.
Management has to take care of these properties, after all, and fees are what pays for them to do so. Additionally, since investors are technically a part owner of the property, they may be expected to cough up extra money to cover maintenance and HOA requirements.
Delegating hassle also means forfeiting some control
One huge detractor for most people who are interested in getting into the real estate game (other than the high initial buy-in) is the idea of becoming a landlord. That includes all the stuff we went over above: the renos, the vetting, chasing rent checks.
So for some, not having to maintain the property and deal with tenant background checks sounds like a dream. But it’s important to remember that traditional real estate investors can also avoid these hassles by hiring a property manager while maintaining full control. Fractional investors, meanwhile, tend to have very little control over the properties they partially own.
“As opposed to exclusive ownership, fractional ownership doesn't offer individual shareholders as much authority over the property. Issues may arise if shareholders disagree on how to manage the property”, says Richard Mews, CEO of Sell With Richard. In these cases, investors who own a small portion of the property can easily be outvoted by those with larger shares.
And what if you’d like to exit the property altogether? Depending on which company you invested through, that may not be possible. Some of these newer real estate investing platforms have long investing horizons (e.g. 5+ years) and don’t offer early redemptions of shares. Some, like Fundrise, will allow you to make early redemptions but it may cost you an additional fee.
This potential lack of liquidity is something that would-be investors should bear in mind. To be fair, real estate is a fairly illiquid asset class all-around, especially when compared to the stock market. While you can sell your shares of Apple in seconds, listing and selling a home typically takes weeks at the fastest. And it can take even longer to sell a home in rough housing markets like we’ve seen in the second half of 2022.
Still, when you own a property outright, you’re at least allowed to sell it – even if that means waiting for the right price or dropping the price to get it off your hands faster. But when you only own a fraction of a property, that option may simply be unavailable to you, which means you may have to wait years to recover your capital.
Who stands to earn the most?
It should come as no surprise that many of these fractional real estate companies are the same people that invest in traditional real estate: multi-millionaires looking to profit.
One company that many people in media, real estate and business are watching is Flow, a new company created by Adam Neumann – yes, that Adam Neumann, the disgraced former CEO of WeWork.
Image credit: TechCrunch Disrupt NY 2015
The New York Times reported that Neumann purchased 3,000 apartment units across Miami, Fort Lauderdale, Nashville, Atlanta for it, and has earned the backing of Andreessen Horowitz to the tune of $350 million. The basic concept is to “disrupt” the rental and real estate market, possibly with crypto.
Neumann himself has a rough track record. Only three years ago, amidst criticisms of gross mismanagement, WeWork’s IPO tanked and he was ousted. Paired with his questionable irregular spending habits using company money, his resume as a whole isn’t very confidence-instilling.
Neumann isn’t the only millionaire or billionaire with a shady history looking to profit from the fractional real estate game. Fundrise’s big property buyouts were largely funded by Goldman Sachs —the same investment bank that was fined $5 billion in 2008 for selling securities to investors backed by mortgages they knew were going to fail.
What about the tenants & communities
But all industries have some shady players, right? And, remember, with fractional real estate, even small investors still get to reap some reward.
However, the damage of fractional real estate may extend beyond which investors earn the most (the big guys vs. the small guys). Perhaps a more important question to ask is, “How does the shift towards democratizing real estate investing affect everyone else (i.e. non-investors).”
For many, that’s where the larger concerns lie.
Owner-occupants may be priced out of the housing market
According to a study by Redfin, 25.3% of all low-priced homes on the U.S. real estate market were purchased by investors in the first quarter of 2022. In Atlanta, one third of homes on the market were purchased by investors. These weren’t just rich individuals picking up a rental property or two — the buyers listed all had letters like LLC, Corp., Inc. and Trust attached to their names.
“The global push to fractionalize real estate has caused a decrease in homeownership rates and an increase in the number of people who are investing in property,” says Cliff Auerswald.
To him, this is problematic for a number of reasons. First, first-time home buyers can get shut out of the market. Secondly, more competition for properties means higher rents. Lastly?
“It can result in communities that are dominated by investors, not homeowners,” he says.
Not only does homeownership decrease in general in response to investment properties moving in, but homeownership decreases among certain groups more than others. According to the National Association of Realtors, white people have a homeownership rate of 72%, but Black and Hispanic people have homeownership rates of about 43% and 51% respectively.
Introducing fractional real estate can, in part, create an additional barrier for marginalized communities to become homeowners. Homeownership is important for every community. Yet, communities that have been traditionally denied this portion of the American Dream continue to be the most ill-affected by real estate developers and investors.
Renters may face increasing unaffordability due to rising rents
While homeownership decreases, the options for renters often increase within communities that have a high investor count. Ask most people that live in a major city if anything has changed in the last few years. Those in emerging markets like burgeoning locations (i.e. Los Angeles, Seattle, Jacksonville, etc.) will surely point to a large increase in apartment and condo developments.
But as opportunities increase, rent prices generally do too. “Communities with a lot of real estate investment and development are seeing home prices and rents go up quickly,” Tomas Satas, Founder and CEO of Windy City HomeBuyer. “For homeowners, this is wonderful. For renters, it's not ideal. Especially in neighborhoods that are traditionally low-income.”
These communities often protest these developments, says Satas. But unaffordability in major cities isn't necessarily a new problem, and it's not one exclusively tied to fractional real estate investing. But with more and more real estate technology companies moving into places like Los Angeles, Cincinnati, and Indianapolis, residents and renters are likely to see this trend accelerate over the next few years.
In Florida, home prices have risen by over 30% since last year, much higher than the national average. This indicates that much of the state has seen an increased need for housing, which works perfectly for real estate investors looking to make a profit. With this in mind, it should be no surprise that Fundrise chose Jacksonville for its latest round of buys and now owns a total of 467 homes in the Sunshine State.
Underserved communities may be displaced by gentrification
Fractional real estate investing, at its heart, seems to have good intentions. Well-intentioned plans don’t always stay the course, though. And gentrification might be the worst unintended product of fractional real estate investing.
Gentrification happens when an urban area, often home to minority communities, is turned into a more desirable neighborhood with the help of real estate developers and investors. This often then leads to skyrocketing rents which causes locals to be supplanted by wealthier individuals and business owners.
The communities most impacted by the gentrification caused by an influx of investors are largely Black and Latinx communities. The National Community Reinvestment Coalition estimates that over 135,000 members of these communities were displaced as a result of gentrification between 2000 and 2013.
South Los Angeles’ Crenshaw is a great example of a neighborhood that’s long faced gentrification. This is apparent in the severe drop in the Black population. Back in the ‘70s, 80% of the neighborhood’s population was Black. That number stood at just 27.9% in 2017.
These types of trends may only accelerate as more land gets eaten up by investment companies, including fractional real estate investment startups. But the Crenshaw community has recently begun pushing back as witnessed by their fierce fights against Leimert Park redevelopment projects.
State and federal regulators are beginning to take notice too. Dallas (which has seen real estate values jump 27% in just 12 months) is considering enacting laws that would ban Wall Street and global investors from buying investments properties. And in July 2022, Representative Adam Smith (D-Wash.) introduced the Saving Homes from Acquisition by Private Equity (SHAPE) Act which would levy a federal real estate transfer tax on corporations with $20 million or more of assets that purchase single family properties.
Even some crowdfunding platforms are aware of how investment dollars can lead to gentrification and trying to mitigate these effects. PeerStreet, for example, began to step up for racial equality in housing after the murder of George Floyd by launching the Evolving Neighborhood Uplift Fund (E.N.U.F.), which provides mentorship and training for minority real estate entrepreneurs.
Where does rental property investing go from here?
Just a few years ago, the rental property investing industry consisted mostly of individual landlords who exclusively owned their real estate properties. For the most part, that’s still what it looks like today.
But real estate technology companies are attempting to break the clear divide within the industry. With the ability to invest in property without having to maintain it, investors with only a few dollars to invest can now get in on the game.
Ultimately, we think that the owners of these companies stand to gain the most from the “democratization” of real estate investing. And underserved communities may have the most to lose from the fractional real estate investing boom.
We’re still in the early days of this modern rental property investing shift and there’s a lot of land grabbing going on (quite literally). So in the short term, this sector is likely to grow even faster.
But over the long term, that growth may only exacerbate the already-pressing issues of home unaffordability and gentrification. And that, in turn, might lead to increasing regulatory (and societal) pressure down the line for companies that facilitate single family home investments.