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 thirteen percent IRR figures do not come without significant risks.

Below are several risks that may or may not be obvious when it comes to online real estate crowdfunding.

Leverage

As explained in our post titled “Debt. A Dangerous Amplifier for Real Estate Investing”, debt is a powerful tool of modern finance that comes with meaningful risk. Many real estate crowdfunding sites offer properties with Loan to Value rates of seventy five percent to eighty percent, and some are even higher.

When an investment carries an eighty percent Loan to Value rate, the investor equity makes up only twenty percent of the deal while the debt represents the remaining eighty percent. This structure can amplify returns, but it also magnifies the downside. A recession, poor location choice, management issues, rising competition, changing government regulations, or even a general market slump can drive property values down by twenty percent with ease. If that happens, the investor equity can be completely wiped out.

Deal Terms

The articles of organization and subscription documents often contain important information, yet they are sometimes ignored. Some of the harshest limitations can be buried within complex legal language. Even though many industry terms are standard, it is important to watch for predatory conditions or unfavorable terms that activate during a default.

Unknown Sponsors

Some well known platforms do work with trusted multi deal sponsors. However, this is not always guaranteed. We have seen large successful raises built on sponsors who had little or no experience.

Even experienced sponsors may create risky offerings if they lack local knowledge. We have seen examples of seasoned sponsors attempting deals in unfamiliar regions, which can be dangerous for investors.

Due Diligence Limitations

As an example of this problem, we once reviewed a hotel recap and remodel project from a top crowdfunding platform. The sponsor had experience in Texas but none in the target state. Although they raised millions, they were entering a market they did not fully understand.

Investors were not made aware that a mostly unannounced one hundred million dollar development was planned across the street. The project included two new hotels. Local developers likely knew about this major development, but investors did not. While the pitch looked attractive on paper, the sudden increase in hotel supply could destroy much of the investment value. The sponsor was essentially speculating in a new market without proper knowledge.

Heavy Cyclicality

As commercial lender Bank of the Ozarks noted during its July 2018 conference call, competitors who push aggressive credit structures and pricing can create concerns across the entire industry.

Commercial real estate is known for its deep cycles. Corrections of ten percent, twenty percent, or more are common. Historical data supports these swings, and they can impact crowdfunded deals significantly.

Chart source mentioned in the original content

For these reasons and the points listed above, we remain cautiously optimistic about online real estate crowdfunding. It offers opportunity, but the risks are meaningful and must be understood clearly.

Supplemental Information

The data referenced above reflects year end 2017 and comes from Bloomberg and NCREIF, with additional analysis performed by AcreTrader. All returns are estimates and assume reinvestment of dividends.

This information is meant for general education and should not be taken as a comparison between products. Performance is historical, and there is no guarantee that trends will continue. All investing carries risks, including the possible loss of principal. Diversification does not ensure profit or protect against losses during a downturn.

Some links within this article lead to independent websites. Their services and information are not reviewed or endorsed by AcreTrader. Their policies and terms may differ from ours.