When investors big or small seek a profitable real estate opportunity with little effort, their quest often leads to crowdfunding investments. But there are risks associated with crowdfunding that investors need to consider.
Real estate crowdfunding, along with crowdfunding in general, is creating a lot of media buzz and appears to be attracting the attention of an increasing number of investors. Real estate crowdfunding grew 156% in 2014, passing the $1 billion mark, according to Massolution’s “2015CF-RE Crowdfunding for Real Estate” report, which projected $2.5 billion in investments this year.
Crowdfunding sprang from the JOBS Act of 2012, whose stated purpose was to facilitate capital formation for small businesses. The law gave start-up companies, including crowdfunding firms, the green light to market directly, through social media and the Internet, to a large pool of accredited investors—those with a net worth of more than $1 million, not including their primary residence, or an annual income of more than $200,000 for the past three years ($300,000 with a spouse).
However, the doors to real estate crowdfunding have opened wider this year with the adoption of new rules—called Regulation A+—by the U.S. Securities and Exchange Commission that give start-up companies the ability to raise up to $50 million annually not only from accredited investors, but also from non-accredited investors—namely, ordinary consumers.
Under the new rules, non-accredited investors will be allowed to annually invest up to 10% of their income or net worth, depending on which amount is greater. Before this, only accredited investors (or non-accredited investors in a state with its own equity crowdfunding provisions) were allowed to invest in start-ups through equity crowdfunding. Regulation A+ does require issuers to have their offerings approved by the SEC. However, issuers are allowed to “test the waters” to measure investor demand before undertaking a full-blown offering.
Still waiting on the regulatory sidelines is one of the JOBS Act’s more controversial provisions. Title III would exempt from registration the offer and sale of crowdfunded securities under the Securities Act of 1933. This exemption would allow for the sale of securities on an Internet-based platform to an unlimited number of unaccredited investors without registration. The sales can be conducted through either registered broker-dealers or SEC licensed “funding portals.”
The loosening of securities regulations for online investment is expected to fuel the growth of real estate crowdfunding and related Internet sites, which still represent only a fraction of the capital raised for real estate debt and equity in the U.S.
The Pitfalls
While crowdfunding may have its upsides, it definitely has its potential pitfalls, especially for investors who are not experienced in the complex and risky world of real estate assets.
The purpose of this commentary is not to throw cold water on the crowdfunding movement, but to point out four potential danger areas that investors should be aware of.
Knowledge And Experience
Real estate is an extremely complex and challenging asset that requires extensive and deep experience in the areas of acquisition, development, finance, construction, management and marketing. Critical factors that go into assessing real estate investments include location, market status, ownership, condition of the property, operating expenses, occupancy rate, access to transportation and surrounding businesses and properties.
Analyzing these and other variables that affect a property’s value requires professionals with solid knowledge and experience in real estate.
Jorge Newbery, CEO of American Homeowner Preservation, which purchases pools of distressed mortgages from banks at discounts and then offers sustainable solutions for homeowners to stay in their homes, has expressed caution about the ease with which crowdfunding sites can be created. “The barrier to entry is low: A web developer, sometimes with attorneys and accountants, and connecting up some vendors, will spawn an operational real estate crowdfunding site in a few months. As a result, the proliferation is likely to continue unabated,” he wrote in a Huffington Post blog. “That said, the expertise and prudence to be selective with offerings is essential to delivering on advertised returns to investors. … An event like 2008’s meltdown would strain even the most sapient platform operators.”
The Relationships Of Key Participants
At the end of the day, real estate is a relationship business, and one has to wonder about the degree of relationships in a crowdfunding environment. TwinRock Partners, for example, either personally knows the investor in the deals in which the firm is involved, or the investor was referred to the firm by someone it knows. Such relationships are a critical factor in any real estate transaction, establishing a foundation of trust.
With almost every real estate investment deal, there is a respected and experienced managing partner who is responsible for the day-to-day operations of the entity and the buck stops with him or her. In most deals, participants typically know one another and probably have been involved in other deals together and have a working relationship. That means if there is a problem, it can usually be resolved without litigation. That may not be the case with crowdfunding, where few, if any, of the participating investors know one another.
One-Off Investments
Crowdfunding sponsors host investment deals, and their credibility rests on their ability to select good investment opportunities. But like broker-dealers, they have no risk except to their reputations if deals go sour. They do not guarantee returns and have no obligation to their investors to fund capital calls or step in to restructure a problem property. They simply provide a platform to connect investors with investment opportunities. “Sidecar” investments, where crowdfunding participants invest alongside well-known developers or fund managers, may help reduce the risk of a deal going bad, especially when the prominent partner has most of the equity in the investment.
To ensure a property is everything that it is promoted to be, it is necessary for investment professionals with deep experience in real estate to actually walk the property and surrounding areas or have someone they trust do it for them. Boots on the ground are absolutely essential to really understanding and analyzing a property and the environment and market in which it is located. When it comes to assessing the physical nature of a property or investment opportunity, Google Maps just doesn’t hack it.
The Risk Factor
Since real estate crowdfunding is relatively new, it’s too early to accurately gauge the risks of investing via these Internet entities and compare them with traditional sticks-and-bricks investment firms. A paramount concern revolves around legal responsibility. Who is legally responsible if a crowdfunding investment goes bust? What if fraud is evident? Is it the developer? The sponsor?
There is one bellwether crowdfunding case in the state of Washington, where the attorney general in 2014 filed what’s believed to be the nation’s first consumer-protection lawsuit involving crowdfunding against a Tennessee entertainment and artist management firm and its owner. The sponsoring entity was Kickstarter, which was not named as a defendant. The campaign, funded in October 2012, raised $25,126 from 810 backers to create a set of playing cards, with an estimated delivery the following December.
The lawsuit alleges that the project wasn’t completed as promised, none of the backers has received any rewards and the company has not communicated with backers since July 2013. “Consumers need to be aware that crowdfunding is not without risk,” the lawsuit states. “This lawsuit sends a clear message to people seeking the public’s money: Washington State will not tolerate crowd-funding theft.”
Richard Peiser, Ph.D., has been the Michael D. Spear Professor of Real Estate Development at the Harvard Graduate School of Design since 1998. He can be contacted at [email protected].
Alexander Philips is chief executive and investment officer of TwinRock Partners, a real estate investment company in Newport Beach, Calif. He can be contacted at [email protected].