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   ARTICLE   |   From Scotsman Guide Residential Edition   |   November 2015

Crowdfunding’s Potential Pitfall

Raising money online for real estate deals poses underwriting risks that must be addressed

Crowdfunding’s Potential Pitfall

The financial crisis of the 2000s drastically changed access to capital in the real estate industry. As banks were forced to reassess their risk exposure and tighten lending guidelines, many developers also were forced to get creative in their approach to securing funding. This created a need, and so a new spin on an old means of raising capital was born — and crowdfunding is now increasingly finding itself useful in closing the funding gap.

What effect will a new, tech-driven group of funding intermediaries have on the quality of underwriting and the rise of a new real estate market?

The process of raising capital from a group of investors via a private or public offering is not new. But the injection of technology and the Internet into the process has led to a new term being coined for those offerings: crowdfunding. More than 100 real estate crowdfunding  platforms currently operate in the United States to connect developers — from small, residential “flippers” to large, commercially focused entities — with investors looking for sound opportunities and real returns.

Crowdfunding research company Massolution estimates that real estate crowdfunding platforms alone will raise $2.57 billion in 2015. This is a 157 percent increase over the $1 billion generated in 2014. Real estate is one of the fastest-growing sectors in the crowdfunding space, which has helped to fund numerous deals that otherwise would have died on the vine.

This increase in activity related to online investing was spurred largely by the passage of the federal JOBS Act in 2012. If every big piece of legislation has to have a catchy acronym, this is no exception. JOBS stands for Jumpstart Our Business Startups, and it tells the story of the original intent of the law. This was a bill aimed at increasing funding for nascent companies. Many in real estate, however, have seen an opportunity to leverage the associated regulatory changes to drive capital into real estate development.

Due diligence

This push to leverage crowdfunding for real estate finance carries with it some important questions, specifically in relation to underwriting. Crowdfunding platforms have an explicit responsibility to ensure that their offerings are listed only after a robust vetting process has taken place to prevent the participation of bad actors and to ensure quality deal flow.

The health and viability of any market is directly proportional to the market’s ability to inspire trust. Leveraging the Internet to increase access to capital does nothing to change this. If anything, it makes underwriting more important, because the process of investing is taking place within the digital court of public opinion.

As you might imagine from an industry built around the idea of increased access to capital, listing a real estate deal for consideration on a crowdfunding platform is relatively easy. For this reason, responsible stewards of this nascent industry will likely find themselves turning away far more opportunities than they list. Some platforms in operation today may only list 10 percent of proposed deals or less.

As brokers and underwriters know, local expertise
is crucial to a viable underwriting process.

To understand underwriting risks in real estate crowdfunding, consider that crowdfunding platforms are essentially technology companies, which often seek to expand their market to achieve scale. This approach runs counter to the dynamics of the real estate market, where underwriting benefits strongly from local market expertise. Crowdfunding platform valuations are driven by metrics like the number of active investors, total deal flow and total revenue generated — the latter being either a percentage of the total amount raised or a flat fee charged per deal listed.

The implied incentive for crowdfunding platforms is to fund as many deals as they can in as little time as possible to achieve the type of scale that plays well in a pitch to investors. This raises some serious concerns about the underwriting process suffering as a result. With this in mind, investors and underwriters would be best served by going back to the basics to know what to look for in a crowdfunding platform.

Underwriting concerns

Investors should be wary of crowdfunding platforms listing deals at a national level. For platforms listing opportunities from across the country, ask whether they maintain local teams in each of the markets they serve that know the market’s trends. Do they have longstanding experience selling and vetting real estate deals in a given market? Are they positioned to be able to accurately predict future trends? Do they live in the market in which they’re claiming expertise?

In some markets, vacancy rates can swing by as much as 15 percent within one square mile. Those are the types of trends that are hard to account for from a central office hundreds of miles away. As brokers and underwriters know, local expertise is crucial to a viable underwriting process. Losing sight of this historical best practice in the age of the Internet can spell the difference between facilitating a greater flow of capital and opening a proverbial Pandora’s box.

Today’s real estate market is getting difficult even for the most seasoned participants. Rents are up, vacancies are historically low and values have rebounded from the lows of the late 2000s. In some markets, the term “rebound” may be a gross understatement. High-quality deal flow can be hard to come by.

The tendency can be to loosen underwriting criteria to keep deal throughput up. For those who want to see a healthy real estate crowdfunding market in the long term, this risk should be watched closely. All participants bear a responsibility to ensure that standards don’t slip in the name of scale, especially the platforms listing these deals.

Future issues

The eventual hope is to open these crowdfunding offerings to not only accredited investors, but all investors. Title III of the JOBS Act specifies this eventuality, although regulators have been slow to implement the exemptions necessary to make this a reality.

Platforms hoping to capitalize on the future involvement of unaccredited investors have some difficult challenges to overcome. Not only will these platforms have to keep a relatively unsophisticated investor base in mind when vetting deals, but there also will be an ethical responsibility to educate their investors on how the market works. 


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