The Dangers of Real Estate Crowdfunding | Socotra Capital

Over the last few years, online real estate crowdfunding platforms have exploded in popularity.

For the uninitiated, crowdfunding—popularized by sites like Kickstarter, Indiegogo, and GoFundMe—typically involves motivating a large number of interested people to pay or donate a small amount of money to finance the production of tech gadgets and other products.

As crowdfunding quickly exploded in popularity, entrepreneurs seized upon the idea of applying the concept to real estate loans. Nowadays, sites like PeerStreet and LendingHome advertise opportunities for small scale micro-investors to invest a few thousand dollars per person. These funds are combined into more sizeable loans, which are offered to residential and commercial real estate flippers. Each investor then earns interest on their portion of the loan as it’s paid back.

Crowdfunding platforms tout these opportunities as being low-risk, due to the small amounts of capital involved and the short durations of the loans, which typically range from 6 months to a few years.

But, while we can understand the appeal of real estate crowdfunding—especially for investors who lack the capital necessary to invest with Socotra Capital and other real estate investment firms—our expertise has allowed us to identify a number of issues with crowdfunding platforms which indicate that they are simply not a safe or advisable means of engaging in real estate investment.

The first priority of crowdfunding platforms is the platform, not the security of investors’ funds.

We live in an age where a significant percentage of technology startups don’t have the goal of generating a long-term profit. Instead, these Silicon Valley startups aim to quickly attain the visibility necessary to become another lucky multi-billion dollar acquisition bought up by the likes of Google or Facebook, regardless of the actual profitability of the venture.

Without a doubt, this is the goal for the vast majority of crowdfunding platforms.

This presents a problem that should worry investors. In order to be an attractive acquisition, these crowdfunding platforms must have one goal above all else: build volume, no matter the risk involved.

This means that the goals of the platform do not align with the goals of their crowdfunders. More dangerous still, the platform owners will realize a profit regardless of whether or not crowdfunders profit as well. So, what is the impetus for them to protect their investors?

The necessity of building volume encourages crowdfunding platforms to neglect proper due diligence.

While there are only a few very popular real estate crowdfunding platforms out there, there are far more than most people realize. According to a Bloomberg article from May 2016 (nearly a year ago!), at that time there were more than 125 real estate crowdfunding sites. That’s a lot of competition.

Now, consider this: the Internet is not an environment that fosters competition. Once a given search engine, online retailer, or social media platform reaches the tipping point of popularity, market domination quickly ensues, driving competition into obscurity.

This means that crowdfunding sites are in a mad rush to dominate the real estate niche. As a consequence, they are doing everything they can to attract investors and borrowers en masse. This leaves little room for the due diligence that is necessary to ensure long-term investor security.

Defaults happen. But pulling your money out of a crowdfunded loan that’s gone bad will be nearly impossible.

While the vast majority of loans are paid off without issue, loans do go bad. Under normal circumstances, the process of recovering funds can be laborious, time consuming, and costly. But in a situation where dozens or hundreds of people are foreclosing on a single property, the recovery process becomes infinitely more complex, and the likelihood of a satisfactory resolution plummets. In this situation, who will handle the litigation? Will the platform cover the legal costs on the behalf of their investors?

Some platforms are actually attempting to avoid this complexity altogether by including contract terms which specify that if investor funds are not recovered within 3 years of a default, then those funds are forfeit altogether. They’re throwing their investors under the bus in order to maximize the platform’s profits.

Crowdfunded loans are almost certainly more likely to go into default than typical hard money loans.

As mentioned previously, crowdfunding platforms are motivated to minimize due diligence, in order to build up their customer base and portfolio. This need to build volume is resulting in loans that are even riskier and more ill-advised than the subprime loans which contributed to the economic recession a decade ago.

When the next market downturn occurs, high risk loans like those made by crowdfunding platforms will be the first to go into default.

If you value the security of your investments, stick with traditional hard money lenders like Socotra Capital.

Managing a successful real estate investment firm like Socotra Capital requires successfully managing risk. Our firm and our investors share the same North Star—if our investors don’t make money, we don’t make money. Our firm’s foremost goal is to protect our clients and the long-term success of our funds as a whole.

Before we make a loan, we meet the applicant face-to-face. We personally visit the properties in question. We conduct background research.

This isn’t the case with real estate crowdfunding. The interests of these platforms don’t coincide with the interests of their investors. That’s why we strongly recommend that would-be investors stick with established investment firms with the experience and local knowledge necessary to protect investor capital, and steer clear of crowdfunding-based real estate investment.