A major selling point real estate crowdfunding platforms tout is the “democratization” of real estate investing. The idea is crowdfunding breaks the barriers to invest in quality real estate transactions, which traditionally depended on “who you know” and “how much money you have.” And it’s working.
Since the passage of the JOBS Act in 2012, which established laws making crowdfunding possible, real estate crowdfunding has grown into a multi-billion-dollar industry.
Born in the upswing of a market cycle, real estate crowdfunding has benefitted from largely positive early results. However, we are nearing the top of the market cycle and much of the current inventory of commercial real estate is overpriced.
For some time now, we have witnessed deals posted on crowdfunding platforms that are overpriced or have questionable business plans. When the market inevitably starts to taper off, some of these deals will go bust and investors will be left hurting.
There are several reasons why a real estate crowdfunding platform would post a less than adequate deal on its website.
First, many early real estate crowdfunding companies were not built by experienced real estate professionals, but by technology experts. These companies lack the deep real estate experience necessary to analyze deals, let alone survive and perform in all market cycles.
Second, some methods of crowdfunding are more prone to settling for a weaker deal. For example, the Regulation A+ model allows a company to raise up to $50 million at a time before even acquiring a property. These companies raise funds based on nothing but a bare-bones investment strategy, while marketing targeted returns to investors. But in reality, it’s next to impossible to predict how a fund will perform if there are no underlying investments in the fund when raising money. Needing to deploy capital to produce investor returns, these companies may feel pressured to overpay for assets that exhibit poor market fundamentals.
Conversely, the 506(c) crowdfunding model—which we employ at ArborCrowd—allows companies to offer one transaction at a time, eliminating both the pressure to deploy dormant capital and the need to rely on vague investment strategies to attract investors. This creates the opportunity for companies to provide investors with detailed, deal-specific business plans that highlight the underwriting performed for each transaction. One of the primary reasons we like this model is that it enables us to close on our transactions prior to bringing them to the market, which we believe offers an added level of security for investors that would be hard to find in the Regulation A+ model.
Finally, some crowdfunding companies displaying flashy double-digit projected returns only perform perfunctory diligence on their investments. This may be due to a lack of proper underwriting experience or to a belief that the onus to perform diligence is on the deal sponsor (which is oftentimes not the real estate crowdfunding company).
Unfortunately, many investors are blindly rushing into overpriced deals with weak business plans and will be angry when their investments don’t pan out, scarring the entire industry.
To be clear, there are certainly good deals to be found in real estate crowdfunding. So how can investors ensure that they are making sound investments? They must get educated!
Beyond focusing on projected returns, investors need to understand the deal risks and how the sponsor intends to execute its business plan. They need to review a transaction’s pro forma and sponsor’s track record. People don’t buy houses without doing research and investing in commercial real estate shouldn’t be any different. Luckily, there are great resources to educate investors, such as ArborCrowd (to do a little self-promotion, if I may).
The early days of real estate crowdfunding have been kind to crowdfunding platforms and investors alike, but not every story will have a happy ending. By getting educated and picking a strong platform, the story can be a happy one.
Adam Kaufman is a co-Founder and managing director of ArborCrowd