The 5 Big Dangers of Online Real Estate Crowdfunding

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.

Leverage

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.

Deal Terms

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.

Unknown Sponsors

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.

Heavy Cyclicality

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.

Supplemental Information: 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.

The above content is not intended to be a comparison between products, but is intended for general, educational and informational purposes only. Any performance noted is historical and there is no guarantee any trends will continue. All investing involves risks, including the complete loss of principal. Diversification does not guarantee a profit or protect against loss in a declining market. It is important for each investor to review their investment objectives, risk tolerance, tax liability and liquidity needs before investing. Investment vehicles have differences in fee structure, risk factors and objectives. Investments are considered speculative, involve a high degree of risk and therefore are not suitable for all investors.

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