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Crowdfunding: Everyone Looks Like a Genius When the Market is Hot

According to Michael Hawthorne, a Washington D.C. based attorney specializing in start-ups, there are over 85 U.S. investment platforms offering crowdfunding-type access to real estate investments. Some of the more well-known firms include Fundrise, RealtyMogul and RealtyShares, and there are dozens of others.

The SEC’s new crowdfunding guidelines on Regulation A+, approved in April of this year, means even non-accredited investors can get in on the action, and they are. A recent crowdfunding industry report published by Massolution claims that crowdfunding is on pace to contribute more than $2 billion to the real estate market in 2015.

“It’s easy to understand the desire to find investment assets that will provide a higher yield in today’s low-rate environment,” Hawthorne said in a recent article on the firm’s website. “However, all of these online crowdfunding real estate opportunities are eerily similar to many of the bad ideas marketed for commercial real estate in the past and are ripe for potential abuse or outright fraud.”

Hawthorne points to the 7-1 write-off tax shelters of the 1980s and the tenant in common (TIC) investments of the ’90s, as examples of risky real estate investment ideas. Perhaps the biggest flaw with TIC deals was the non-existent exit strategy. To some observers, that’s also the biggest risk in crowdfunding. But, as Hawthorne notes, investors and crowdfunding platforms can mitigate their risk by carefully structuring deals and complying with relevant laws.

All of these online crowdfunding real estate opportunities are eerily similar to many of the bad ideas marketed for commercial real estate in the past and are ripe for potential abuse or outright fraud.

Jilliene Helman, the 29-year-old founder of Los Angeles-based RealtyMogul recently told Forbes, “There are no guarantees. It’s real money, and there’s potential for real losses.” But, as RealtyMogul’s website points out, a passive real estate investment allows tax-deferred cash returns. Unlike interest payments or stock dividends that can be taxed at your highest bracket, your share of the property’s depreciation expense works to offset your income.

The tax benefits, along with a low cost of entry and the possibility of high returns, is driving huge investor demand. Real estate crowdfunding companies are looking at a variety of strategies to stand out and attract clients.

San Francisco-based RealtyShares just announced that it is introducing new mezzanine financing products where the investors will be in a “preferred” position to the equity held by the project sponsor, although the investments remain subordinate to the 1st-position debt on the property.

“These products give investors the opportunity to potentially enjoy higher yields on their investments, even though the project generally still has a true ‘equity cushion’ that helps reduce the effect of asset value diminution risk,” said Nav Athwal, Founder and CEO of RealtyShares. “By their nature, of course, these mezzanine products are somewhat riskier than first-lien debt; on the other hand, investors are in a “preferred position” relative to sponsor equity in the project, and the products usually feature relatively brief investment periods.”

Usually these types of mezzanine products are only offered by large institutional investors. Annual return rates in this portion of the real estate ‘capital stack’ can often outpace those of the S&P 500 Index, so it’s no surprise that the product is generating a lot of interest. Athwal is projecting returns in the 14-20% range. Offering the possibility of double digit returns to small individual investors is either a fantastic marketing idea or one of the pitfalls that attorney Michael Hawthorne was warning us about.

“These products fill a market niche that has been left void since banks retrenched in the wake of the Great Recession,” insists Mr. Athwal. “The attractiveness of these products — whether debt or equity — is that both investors and sponsors benefit, in different ways, from reasserting themselves in this level of the traditional capital stack. Investors get potentially higher returns and a preferred position, while sponsors retain the remaining ‘upside’ potential, which they often prefer to do when they’re confident of the property’s prospects.”

Washington D.C.-based Fundrise, which has signed up more than 25,000 accredited investors, is going to great lengths to reassure potential investors. The company uses its own funds to underwrite deals before they offer them to investors.

“By using our own balance sheet, we can increase the speed of funding and, most importantly, create certainty of execution,” says Daniel Miller, 28, Fundrise’s president. Miller founded the company with his brother Benjamin, who serves as CEO.

Crowdfunding real estate is a tempting proposition with a lot of potential upside for small investors and cash-strapped developers. There are several credible companies who are proving the concept. But just like any other form of real estate investing, investors need to ignore the marketing hype and conduct their own due diligence.

“Everyone looks like a genius when the market is hot,” says Benjamin Miller. “It’s when things cool down that you see who was making smart decisions.”

Propmodo is a global multimedia effort to explore how emerging technologies affect our built environment.

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