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Crowdfunding for real estate - buyer beware

Dan Engle Michael de Leon Hawthorne September 1, 2015

Much has been made in the press lately about online crowdfunding websites that allow people to contribute money to fund business start-ups in exchange for rewards such as a copy of the finished work, a special invite to a movie premiere, etc. There are now crowdfunding websites claiming that they can raise capital (money for equity) via their websites. So it was only a matter of time before the commercial real estate industry jumped on board to use crowdfunding to solicit cash investments for real estate projects.

If you search the Internet for “crowdfunding real estate investments,” you will find numerous websites offering potential real estate investors the opportunity—typically after registering with the site (making sure you are an “accredited investor” as defined under U.S. securities laws)—to review properties available for investment. You can buy i) a piece of the debt secured by a property; ii) a slice of a membership interest in an LLC that has already acquired the property; iii) an ownership interest in a property that will be acquired if the necessary equity is raised; or iv) some other variation. Each of these items may include the sale and purchase of securities, a regulated and complex area of federal and state law. Whether or not these portals comply with U.S. securities laws is open to review and potential prosecution. Before offering or buying any such securities, it would be wise to consult with securities counsel.

Buyer Beware

It’s easy to understand the desire to find investment assets that will provide a higher yield in today’s low-rate environment and the desire to raise capital to fund real estate projects. 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. 

Remember the 7-1 write-off tax shelters of the 1980s, the “tenant in common” investments of the 1990s, and the development of the “time share” industry? Real estate promoters saw ample opportunity to pay themselves gratuitous commissions, disposition fees, due diligence charges, guaranty fees, property management fees, asset management fees, and more. For the investor, the experience was analogous to riding a roller coaster where you have no control and cannot exit until the ride ends at some indeterminate time. All that said, numerous legitimate and solid real estate projects were funded and completed using these tools. Obviously, structuring the deals correctly and complying with the laws are important. 

Crowdfunding via the Internet is one of the newest tools in the commercial real estate industry that has once again paved the way for a fee-paying parade—again to the potential detriment of investors who are searching for a higher return on their money and are not sophisticated enough to fully appreciate the risks involved with crowdfunding or how each commercial real estate opportunity is unique, location- and site-specific, and certainly not fungible. Passively investing in commercial real estate is more complicated than ever given today’s regulatory and environmental worlds. Proceed cautiously and carefully review all such investments with your professional advisors. 

Today there are more than 85 active U.S. real estate crowdfunding platforms online, with more on the way. Some are even structured for IRA investments as well as for providing advisory services for real estate crowdfunding investments. There are also websites that link angel investors directly to entrepreneurs looking for equity investment in their real estate projects. Again, buyer beware. 

What sparked this?

The Internet opened the door to large-scale crowdfunding. Congress enacted and the President signed into law the federal Jumpstart Our Business Startups Act (JOBS Act) in 2012, enacted by Congress in 2012, which increased interest in raising capital online. Under Rule 506(c) of the JOBS Act, a private placement of securities can be initiated through a general solicitation, i.e., a public offering for a private deal, via the Internet, the airwaves, print media or various other means. Not all of the rules under the JOBS Act are final, including the main crowdfunding rules. Nonetheless, some have used these proposed rules to raise monies. Such reliance on proposed rules is not recommended, and the issuer must be very careful to comply with all of the technical rules in order to make such offerings. 

How will it end? 

Whether crowdfunding for commercial real estate investment will stand the test of time remains to be seen. Will it gain acceptance like Real Estate Investment Trusts (REITs) as an alternative investment to stock and bonds? Or will it flame out like the once highly marketed "tenant in common” investments? Only time will tell. Either way, the use of the Internet to connect investors with potential real estate opportunities will continue to expand.