Challenges, Pitfalls and Problems with Crowdfunding Real EstateBy Jordan Wirsz

06/14/2016

It seems only a few short years ago, the “holy grail” of raising capital for developers and private issuers opened up. The term “crowdfunding” saw headlines all over the United States, and the sense of optimism that capital raisers had was at an all-time high. We even saw people crowdfunding to start crowdfunding companies. Crowdfunding conferences emerged all around the country, and regulators looked on in horror as every Tom, Dick and Harry had some new gimmick to fund through crowdfunding.

But the reality of crowdfunding is very different than the outward appearance of a sleek, easy and quick way to get deals done. From the outside looking in, a capital raiser would see crowdfunding as an opportunity to put their project onto the investor’s equivalent of “eBay” where people just see the offering, click buy, and all of a sudden your offering is full. However, the realities are a stark contrast to what most people, especially real estate developers and issuers, perceive.

Real estate technology is evolving rapidly, and not the least of which is how developers and investors raise capital. Crowdfunding, the natural evolution of real estate capital sources, has seen an incredible number of platforms (aka websites) rise up, some more successful than others. Competition amongst them is high, and although their business models vary, the net result is a relatively common core group of users that see all of the same deals or at least types of deals.

There are two primary types of crowdfunding real estate investors:

The individual: There are individual investors who like to log-in to online platforms and make their own assessments and judgements of which deals they want to invest in. Unfortunately, these investors might often choose to invest in the best sales-pitch, not necessarily the best deals. From the issuer’s perspective, these investors carry a lot of risk. They are relatively low in experience, and the potential for litigation is high. Additionally, most of these individual investors believe in diversification as a fail-safe to one deal going bad… Which naturally sounds good, but ultimately proves to be a failing strategy when compared to just doing “good deals.” Unfortunately many investors who participate in real estate investments through crowdfunding are of modest means, and no matter how many disclosures they sign, the optimism outweighs the risk in their minds. This is why I have made it a point to only work with accredited investors who have the means and experience in accumulating wealth to understand the risks.

The institution: More and more, institutions are looking at “crowdfunding” type opportunities to diversify their holdings. When an emerging manager, or perhaps even a family office decides to diversify into real estate, they might consider crowdfunding as a means to enter the asset class. Institutions and institutional type investors like simplicity. Unlike the reality that all developers and true hands-on real estate investors understand, institutional folks don’t understand how “hands on” real estate really is. So, they seek a “hands off” approach by finding other people to do the hard work through crowdfunding, or alternatively through publically traded or even private REITs. Institutional types like the “push of a button” buy and sell process. Even to individual investors get romantic about the idea of sitting at a computer screen, clicking a mouse, and getting a good return on their investment. After all, real estate investing is a “sexy” concept.

Trust me, there is nothing “cheap” about raising capital from a crowdfunding platform.

Dealing with the two different investor types can be challenging. On one hand, the individual investors might buy into an investment with less due diligence than an institutional investor would, but the dollar amounts are usually small. On the other hand, institutional investors might bet bigger, but they’ll scrutinize every offering to a high standard, and I’ve found, they often ask the wrong questions and focus on the wrong things. Albeit, they have their own way of doing things.

The real challenge with crowdfunding real estate isn’t necessarily the investors, but more so, the issuers…i.e. the developers or real estate investors who are trying to raise money from outside sources that they don’t understand. Real estate capital raisers are more often than not, self-promoting real estate developers and investors. They are not in the securities business, and they often have little understanding of the implications of being in the securities business. As an issuer raising capital from other investors, there is a complex standard of doing business that not only protects the investors, but protects the capital raiser from extenuating and undue liability, both regulatory and litigation. Believe it or not, the most problems any capital raiser will have is not with the investor who invests $1 million, but the investor who invested $5,000. The lack of sophistication and understanding, in addition to the lack of experience in risk management and risk knowledge, is a dangerous combination.

The other side of the real estate business, when using outside capital, is the securities business, which most real estate investors/crowdfunding issuers don’t have any experience in at all. I liken that scenario to a baggage handler at a local airport, climbing into the co-pilot seat of a Boeing 737. Just because you work in real estate, with investors, does NOT mean that you have a good understanding of the rules and regulations around being a securities issuer, nor does it mean that you understand the risks of regulation.

In addition to the challenges and pitfalls discussed above, one very important problem with crowdfunding is the lack of commitment that any crowdfunding platform will give you to “fill the offering.” I have seen countless examples of investors and developers trying to raise money in crowdfunding sites, only to achieve a minimal percentage of what they actually need to do the deal. So you raise half your funds… Then what? You can’t do half of a real estate deal because you only have half the capital needed. And besides, UNDERfunding yourself is one of the biggest mistakes anyone can make. So, the choice becomes either find another source of money, or don’t do the deal. Frustrating, but no crowdfunding platform will guarantee that you will fill your offering.

Few investors/developers who consider crowdfunding realize how expensive crowdfunding can be, and as such, fail to pro forma the true costs and risks associated with even attempting to raise the funds. Many crowdfunding websites will charge subscribers to look at deals… But they will also charge the issuers who are trying to raise capital. And those fees aren’t always small… It can cost thousands, even tens of thousands, to list your deal on one or more platforms. Next, before you put your deal out to raise capital, you’ll need all the proper disclosure documents. Oh how many times I’ve heard, “Oh Jordan, don’t worry about that – I found a template online!” That is usually the second or third signal to “run” away from that deal. There are no online templates which are sufficient to use for disclosure documents and subscription documents to investors. A lawyer, and an experienced securities lawyer at that, should always be used in the creation of disclosure documents and offering documents. That cost can range from $5,000 to $50,000 very easily, depending on the size and complexity of any given deal.

The next area of cost, is usually a percentage that the platform charges to raise the capital. For example, if you want to raise $500,000, the platform might charge a fee of 5% to 10% of that amount. Not only does that dilute the investor (another disclosure by the way), but it also dilutes the return… And as such, the developer’s profit.

Trust me, there is nothing “cheap” about raising capital from a crowdfunding platform. By the time you figure in legal fees, platform fees, and a good split with the investors, crowdfunding often turns a “great deal” into a mediocre deal at best.

How Crowdfunding Has Permanently Changed Commercial Real Estate
By Nav Athwal
 

 
MAR 21, 2016