By Blake E. Robbins
“Perhaps the biggest disadvantage of crowdfunded real estate deals is that they aren’t liquid investments. They cannot be sold if you need the money. Additionally, the time horizon of most of these investment offerings are five to ten years to recapitalize. That is a very long time, with a lot of market assumptions along the way. Returns may take years to materialize.”
In this day and age we can press a button on our computer, or touch a piece of glass on a handheld screen to get anything we want. At the speed of light, these platforms will charge our bank accounts, arrange packing and delivery, and bring it to us wherever we desire. Furthermore, we can track our orders and get up to date geographical information to know where in the world our package is at.
This technology is remarkably convenient for many retail products (even groceries), however, it is paradoxical to most aspects of investing. For the day trader in the stock market, you can point and click your way into multiple investments and secure puts, calls, options, futures, forwards, and swaps, to hedge your derivative strategy, however, all of these tactics have an expiration date and require a lot of monitoring, studying, and attention. Crowdfunding suggests that investing can be a point and click sport; it is not.
In recent years, crowdfunding has become extremely popular within the real estate landscape – but primarily in only one sector of real estate. Although the basic concept of real estate crowdfunding might sound great, it does come with a few disadvantages, of which potential investors should be aware.
In February of 2019, I addressed the direction of the commercial property marketplace (according to me), and my thoughts questioning its long-term sustainability in The Commercial Calamity. It turns out, I wasn’t alone in my thought process. I believe it is highly probable that one of the culprits of the next financial catastrophe mirroring the great recession could be the within commercial crowdfunding arena.
“While the global financial crisis is fading into history, the roots of the next one might already be taking hold.” — New York Times
New legislation brings about new markets and verticals. President Obama signed the The Jumpstart Our Business Startups Act (JOBS Act) in 2012, and private equity and crowdfunding sponsors awaited the green light from government regulators. When the JOBS Act went into effect in May of 2016, it allowed, for the very first time, “non-accredited” investors to back private companies. Prior to that, investing in private companies was limited to “accredited” investors only — meaning they needed to have at least a $1 million net worth or have earned at least $200,000 for at least two years (if unmarried).
To me, the JOBS Act is a very good thing for businesses raising capital, and significant in giving consumers greater access to investments that are not limited to the public market alone. My company, Hillstone Capital has benefited from the Act by providing various structures that help us accomplish great things with our single-family and multi-family residential development funds. That being said, we do not host any crowdfunding platforms, and do not rely on those exemptions for our investment offerings.
The underlying intention of the JOBS Act was the bolstering of capital for start-up companies and further funding for existing companies by way of alternative financing unrelated to restrictive banking institutions. And, to substantially increase job opportunities within these firms.
Experience Not Required
In any new platform, there are opportunistic entrepreneurs who will exploit these structures to get their fees. Commercial real estate crowdfunding quickly adopted this as a strategy.
Here is why that’s not always a recipe for success. Many of the crowdfunding companies have not been founded by established, experienced real estate professionals, but rather by tech entrepreneurs with little to no real estate investing experience.
Consider underwriting. Large scale commercial projects are highly complex with many moving parts requiring weeks of review, appraisals, research, etc. However, the crowdfunding platform’s panel responsible for evaluating new opportunities may not be an experienced expert or qualified underwriter, but instead a panel could be assembled by a zero barrier of entry process. Sure these groups themselves are not the investment sponsor, and aren’t responsible for anything that happens within the investment. However, they are vetting the sponsors and investments they allow on their platform. From my perspective, the crowdfunding platform has a fiduciary responsibility — especially when the sponsors can elect to purchase specific promotion offerings.
Long Term Lockup
Perhaps the biggest disadvantage of crowdfunded real estate deals is that they aren’t liquid investments. They cannot be sold if you need the money. Additionally, the time horizon of most of these investment offerings are five to ten years to recapitalize. That is a very long time, with a lot of market assumptions along the way. Returns may take years to materialize (or may never accrue). In many cases, equity may not ever accrue to the investor; management may deviate from the business plan, or could become a preventative asset when trying to scale up the company. Over time, this may lead to capital deterioration rather than wealth creation. In such cases, there may be an opportunity cost attached to standard equity crowdfunding because it ties up capital that could be deployed into shorter-term investments or funds to generate returns.
If we learned anything from the previous recession of 2008, we know it doesn’t take long for something to grow exponentially out of control. It’s not a problem now; it’s only a problem when it is. The sudden growth of commercial real estate crowdfunding has generated rapidly growing tranches of debt, and fractionalized equity. Statistically, the growth rate of the crowdfunding sector (all crowdfunding) is astounding. In 2015, the total amount of money raised reached $34.5 Billion compared to $2.7 Billion back in 2012. In 2015, real estate crowdfunding reached $3.5 Billion. Experts predict that the whole crowdfunding sector will have expanded to $300 Billion by 2025.
Crowdfunding platforms and those operating in the Regulation A+ model face pressure to quickly deploy capital to show progress and begin generating income for investors (and platform fees). When this a high level of user activity has been attained, then the crowdfunding platform also generates ad revenue. However, a platforms popularity of website visits doesn’t mean that the investments are performing. That will take years to measure. Therefore, the urgency of gaining online attention is achieved by offering a tremendous volume of opportunities on their site, which calls to question the due diligence practice and underwriting these offerings. There is no experienced fund manager here.
The probability is, that these online hosts will invariably suggest overpriced assets that may not be worth as much as anticipated when they near the end of their five to ten year lifespan.
Think of the platform fees as ‘broker’ fees. Not only does the investment manager or development company charge fees on their offerings to cover overhead costs, but there are additional costs charged by the shopping platforms, which can vary greatly. These could include sign up fees, annual fees, maintenance fees, acquisition fees, asset management fees, disposition fees and others. Just like trading fees by stock brokers, fee articulation can be buried in the brokerage documents or kept purposely vague. Are the figures promoted returns net of fees? Not likely.
The reality is that fees diminish your total return.
Brag: Hillstone creates equal opportunities for capital partners to eliminate all annual fees with referrals. We are proud to provide our partners with many ways to wipe out fees, and create additional income.
Lack of Diversification
Some have asked why our firm has many different offerings and structures. It’s simple. We favor diversification first, and single-asset equity second. We created a system in which investors make their first move into one of our diversified funds, then have the opportunity to invest into Preferred Equity™ direct investments.
Some of our clients invest the minimum required into a fund ($50k), then further invest $500k+ into equity portions of multiple Preferred Equity™ projects. Others, invest 100% of their allocation into the fund and do not participate in direct investments. Both methods are correct.
Alternatively, crowdfunding is most often a single-asset commercial real estate project — like a skyscraper, a high-rise, or huge hotel or apartment project — that can be much riskier than other types of equity investments (like short-term residential). Most crowdfunded real estate deals are backed by a single asset, and there’s a fair amount of execution risk involved in most strategies.
Say a developer plans to renovate an apartment building and increase rents. An economic downturn or oversupply problem in the market could cause returns to drop. Whereas there are many alternative exit strategies within the residential landscape. For many of our assets, we secure three alternative methods to recapitalization. To be fair, not every market will support all three strategies. However, we do all we can to prepare in advance for what we cannot see. Luckily, residential real estate moves very quickly and is financeable by virtually any depository bank, or mortgage bank. The buying pool is vast.
The disposition of large commercial buildings is much more difficult, slower, and with a smaller buying pool limited to real estate focused venture capital firms, and institutional buyers.
I’ve said it before, and I’ll say it again, there are no guarantees in investing — ever. It doesn’t matter if you’re investing in stocks, bonds, or real estate.
There are always unexpected factors that can negatively affect the performance of an investment; market fluctuations and construction setbacks are two that are relevant in all aspects of real estate investing. Crowdfunding investments may not reach the projected returns, and could reduce the dividend return providing a lower-than-anticipated yield. Worst-case scenarios?
The investment might fail. The sponsor could file for bankruptcy. The asset might go through foreclosure. In many cases, the sponsor may not be required to return interest or principal. There’s no guarantee you’ll get the advertised return or even the return of your capital. Crowdfunding isn’t litigation proof, fraud proof, or recession proof.
Crowdfunded real estate deals have the potential for excellent returns, but there’s a lot you should know before considering them for your portfolio. You have to be comfortable with that before investing.