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Examining the First Crack in the Real Estate Crowdfunding Industry’s Fragile Foundation

RealtyShares’ collapse is evidence that change must occur to protect investors and ensure the industry’s viability.

The real estate crowdfunding industry is young, rife with opportunistic tech entrepreneurs and flush with venture capital. Combined with a strong U.S. economy and a growing desire among individuals for greater exposure to alternative investments, it’s easy to see why real estate crowdfunding has rapidly grown into a multi-billion-dollar industry since the passage of the Jumpstart Our Business Startups Act of 2012.

However, it’s fair to question if the industry’s impressive growth is built on a strong foundation. This is especially true in light of the recent news that RealtyShares, a well-known and heavily venture capital-backed real estate crowdfunding platform, is shutting down. This well-publicized development rattled many industry participants and revealed the risks investors must consider when placing their trust and capital with a real estate crowdfunding platform.

All nascent industries face challenges as they evolve and become more institutionalized. This inflection point has reached the real estate crowdfunding industry, and one of its primary challenges is a lack of focus on real estate among platforms operating in the space. Many existing real estate crowdfunding companies were not founded by established and successful real estate professionals, but were largely created by individuals in the tech sector, with little to no experience investing in real estate.

Why does this pose a danger to investors? Real estate is a highly complex and nuanced asset class. In addition to understanding economic fundamentals, local markets and the capital markets, becoming a successful real estate investor requires highly specialized underwriting, and asset and property management skills, among many others. While technology is important, it is merely the facilitator for real estate crowdfunding.

Considering this, and the fact that the entire real estate crowdfunding industry was created during—and continues to exist in—a market upcycle where attractive investment opportunities are overpriced, it should come as no surprise that some real estate crowdfunding platforms are struggling or have had to close shop. One could make the argument that the cracks in the industry’s fragile foundation will become even more pronounced as many crowdfunded investments near the end of their five- to seven-year lifecycles.

This does not mean that investors should avoid the industry. On the contrary, real estate has traditionally been viewed as one of the most resilient asset classes that can provide stable income and act as a hedge against inflation. Real estate crowdfunding has leveled the playing field, enabling individual investors to take advantage of these benefits, which were previously only available to institutional and ultra-high-net-worth investors.

What this does mean is that many real estate crowdfunding platforms must remember what their core product is—real estate. It is critical for individual platforms and the long-term viability of the industry as a whole that the people deploying capital have the expertise to make sound investments in all market environments. This may seem obvious; however, these credentials are often overlooked by less experienced investors eager to put their money into real estate.

Enacting change starts with discipline. Real estate crowdfunding platforms must refrain from hastily engaging in transactions that display unrealistic returns based on less-than-sound business plans and then presenting those deals to unwitting investors. Moreover, there must be a greater emphasis on transparency, so that investors know where and how their capital is being deployed.

The issue is that certain real estate crowdfunding models make it difficult for companies to invest and operate this way.

There are several regulatory models available to crowdfunding companies to offer their investments. One, known as Regulation A+, is commonly employed to offer REIT-like vehicles in which crowdfunding companies can raise up to $50 million in funds and then invest those funds in a transaction. Since investors provide the capital before the platform finds and invests in actual deals, how could those platforms provide investors with accurate information as to where their capital will be deployed and what returns they can expect?

The truth is, they cannot, and instead, their offering materials are often laden with generalizations, estimations and marketing fluff. Additionally, these offerings can be black holes of fees, with charges paid to affiliates either well disguised or withheld from investors. A lack of transparency leads to distrust, which can damage a young industry that is working to legitimize itself.

Other real estate crowdfunding platforms operate under the 506(c) model, in which they first identify a specific property to acquire and then offer the transaction to investors. This model provides for greater transparency, allowing platforms to present detailed information upfront about each investment—including fees—before investors choose to commit capital.

Importantly, a number of real estate crowdfunding platforms have raised large amounts of venture capital and are under immense pressure to show rapid growth and profitability to keep that capital flowing. The only way they can achieve this is by offering a tremendous volume of deals on their platforms, which does not provide them the “luxury” of dedicating the time necessary to properly vet transactions. Without proper underwriting, these platforms will find themselves in a precarious position when the market turns and their transactions don’t perform.

Real estate crowdfunding is an exciting industry with incredible potential, representing the future of real estate investing. But this does not mean that common sense should be thrown out the window. Those companies that operate in a disciplined and transparent manner, and that focus on the real estate, will succeed. Those that operate as if they are seeking to be the next unicorn in the venture capital-backed tech world will find themselves out of business.

Adam Kaufman is co-founder and managing director of ArborCrowd, a real estate crowdfunding firm. In this role, he oversees ArborCrowd’s corporate growth strategies, including business development, digital technology and marketing and sales initiatives.

TAGS: Real Estate
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