The 5 Big Dangers of Online Real Estate Crowdfunding
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We have watched with excitement and awe as the online commercial and residential real estate crowdfunding market has grown from practically nothing five years ago to a multibillion dollar industry today.
As a whole, we view the real estate crowdfunding market as an exciting alternative asset for accredited investors, and we note that most platforms and offerings look great at first glance. However...
Buyer beware: those 13% IRR figures don't come without significant risks.
Below we note several risks that may or may not be obvious when it comes to online real estate crowdfunding.
As we note in our post Debt: A Dangerous Amplifier for Real Estate Investing, debt is a great tool of modern finance that is not without risk. Most real estate crowdfunding sites offer properties with Loan-To-Value (LTV) rates of 75% to 80%, though some of them are even more levered. In an investment with an LTV of 80%, the owners' equity portion is only 20% of deal value, while the debt accounts for the remaining 80%.
While this leverage can amplify your returns, it also amplifies the downside. An economic recession, poor site selection, poor management, increases in local competition, government regulations, or even just a negative cycle in commercial real estate can drive down the value of the property by 20% or more pretty easily. If the value is down just 20%, this means that the investors' portion of the deal is worth ZERO.
While often overlooked, the articles of organization and subscription documents can hold important information. Sometimes, the grizzliest of these limitations are buried in legalese that is hard to decipher. While most real estate industry terms are standard, look out for predatory terms or unfavorable treatment in the case of default.
Many of the well-known crowdfunding sites work with established multi-deal sponsors on their sites. However, that isn't always the case, as we have witnessed well-funded deals that relied upon sponsors that had little or no experience.
Even in the case of well-experienced deal sponsors, local real estate knowledge is important, and we have seen examples of seemingly well-intentioned sponsors putting together dangerous looking deals in unfamiliar territory.
Due Diligence Limitations
For an example of the above, we recently came across a hotel recap and remodel offering from one of the industry-leading crowdfunding sites in a southern state. The sponsor had experience in neighboring Texas, but none in the target state where they were (successfully) raising millions of dollars to do a heavily-levered hotel deal.
Unfortunately for the investors, and likely even the locally-inexperienced sponsors, there is a mostly-unannounced $100 million development being planned across the street that includes two hotels.
At the time of capital raise, it is possible that only local developers knew the massive development was going to break ground soon. While the investors' pitch on fixing up an old hotel looked great on paper, a flood of hotel room supply across the street may end up destroying a lot of value... all because the developer was speculating in a new market.
As multi-billion dollar commercial real estate lender Bank of the Ozarks said during its July 2018 conference call, competitors that are getting more aggressive with credit structures and pricing may "set off concerns across the banking industry."
It is no secret that commercial real estate is a very cyclical industry. In fact, it is not uncommon to see the real estate industry go through 10%, 20%, or greater corrections (see chart below).
Source: NCREIF, Bloomberg, Bankrate, NYU Stern School of Business, Federal Reserve Bank of St. Louis and AcreTrader calculations. All returns are estimates and assume reinvestment of dividends. This data reflects the period 12/31/1990 - 12/31/2018.
For this reason, as well as the reasons listed above, we remain optimistic but very cautious about most forms of real estate crowdfunding online.
Note: The information above is not intended as investment advice. Data referenced herein and in the chart above is through year end 2017 and is sourced from Bloomberg and NCREIF, with additional calculations and analysis performed by AcreTrader. Past performance is no guarantee of future results. For additional risk disclosures regarding farmland investing and the risks of investing on AcreTrader, please see individual farm offering pages as well as our terms and conditions
See how farmland differs from commercial real estate and the potential benefits of investing in different types of real estate.
Explore why debt has been associated with amplifying returns for real estate investors but how it can greatly increase the risks at the same...