Warren Buffet famously said, “Only when the tide goes out do you discover who’s been swimming naked.”
In recent years, the U.S. real estate industry has enjoyed positive economic growth and market fundamentals (with the obvious exception of spring 2020). During this five- to 10-year expansion period, crowdfunding emerged as a democratized way for investors to access commercial real estate. This new form of fundraising has opened doors to opportunities historically only available to large investors.
However, crowdfunding comes with some big risks, and thanks to the dazzling veil of an upward trending market, many of these risks have gone unnoticed.
Many crowdfunding platforms that general partners (GPs) use to raise capital play up their selectivity and due diligence, but ultimately few of them have actual skin in the game. Most platforms are paid a success fee once deals fund, whether the investment is ultimately profitable or not. This makes for terrible alignment with limited partners (LPs), many of whom are not sophisticated enough to adequately underwrite a complex real estate transaction.
Most crowdfunding is structured and documented by GPs, making operating agreements very one-sided in terms of LP protections and governance. Investor protections, performance milestones, major decision-making rights and removal rights are often watered down to the extent they exist. Even when these critical provisions are part of an operating agreement, the large number of small investors with noncontrolling interests makes them difficult to enforce.
As an online platform, crowdfunding anonymizes the GP/LP relationship. This detached structure easily facilitates the communication of exaggerated and unrealistic returns. In the days of “old school” syndications, face-to-face interactions at the local country club or family events were informal guardrails for GPs hyping unlikely performance.
An important question to ask when considering crowdfunding is, why is the GP — who often has a high number of assets under management and established partnerships with big institutions — using crowdfunding to finance this deal? Chances are large single-check LPs are not willing to participate for a reason (unfavorable fees, structure, asset quality, etc.), driving the GP to look to less sophisticated investors (aka “dumb money”) for financing.
Unfortunately, the list of crowdfunding disasters is growing long. Here are a few examples:
Investors were left completely wiped out when the CEO of Prodigy Networks, a crowdfund that raised hundreds of millions of dollars to develop coworking projects and hotels suddenly died after aggressively leveraging its holdings. Prodigy failed to provide any LP protections or steps for taking control of its developments. Investors lost everything.
Investors in a syndicate sponsored by Henley USA, an arm of U.K. private equity firm Henley, lost 100 percent of their capital on a supposed value-add apartment deal in Queens, N.Y., when the investment became mired in too much leverage and a lawsuit with the property manager over misappropriation of funds. Apparently structured without LP major decision rights, investors were unable to remove the GP for nonperformance.
Cardone Capital, which bases much of its marketing on its founder Grant Cardone’s flashy lifestyle, is currently being sued for allegedly misleading thousands of unsophisticated investors across the country, falsely promising annual returns of at least 15 percent and other incentives that never materialized.
While blowups and lawsuits like these generate headlines, the more widespread problem we will likely see in the coming years when the market softens is “zombie investments,” where lofty return projections do not materialize thanks to overly aggressive underwriting. LPs will find themselves stuck in underperforming investments without the ability to remove the GP, clawback fees, force a sale, etc.
While democratization is a worthy goal, true empowerment for individual investors can only occur with a level playing field. Investors should take time to assess investment opportunities to ensure when things go wrong, or “the tide goes out,” they are not exposed to unforeseen risks. An alternative to crowdfunding risk is finding a hybrid investment platform that provides the investment discretion of syndications and the protection of blind pool funds.
Adam Deermount is managing principal of RanchHarbor, a real estate investment firm.