As a result of new regulations, a rebounding property market, and an interest in investing beyond traditional stocks and bonds, real estate crowdfunding has experienced phenomenal growth. Last year more than $2.5 billion was invested in real estate crowdfunding and new financial players continue to enter this market, eager to take advantage of fresh sources of capital.
Despite robust growth, the real estate crowdfunding industry is still in its infancy. Crowdfunding came about as a result of the JOBS Act of 2012, which was intended to encourage funding of small businesses. As an investment product, crowdfunding is less than four years old. Due to this short history and an unproven track record, investors should approach crowdfunding deals with caution. Crowdfunding has all the risks typically associated with real estate investing (lack of liquidity, cyclicality, sensitivity to interest rate changes, etc.) as well as additional risks that are specific to this product.
The two main types of crowdfunding are equity crowdfunding and debt crowdfunding. The principal challenge associated with equity crowdfunding is that returns can take years to materialize or never happen at all. Delays can occur for any number of reasons, including a change in the developer’s business plan, a setback in the local economy or a project that encounters unexpected hurdles. Even if the investment does eventually generate returns, there are opportunity costs associated with tying up capital for years. Because of the uncertain timing of returns, equity crowdfunding deals are best suited to risk-seeking investors.
The second type of crowdfunding is debt crowdfunding and these products are more likely to appeal to income-focused investors, Most of the investors who own mortgage pool funds are also Income-oriented. Mortgage pool funds provide hard money loans to real estate developers and fix-and-flip specialists. Some crowdfunding sites also focus on this market and are attracting developers and rehabbers unable to secure financing from conventional lenders. An emerging trend in real estate crowdfunding is portals offering investments in mezzanine financing, with loans typically ranging from $1 million to $2 million. These loans are likely to grow even larger as more crowdfunding portals compete for investor capital.
Like any investment product, there are advantages and disadvantages associated with real estate crowdfunding. Here are five areas where mortgage pool funds have advantages over crowdfunding:
- Transparency and track record: One of the major risks associated with debt crowdfunding is the unproven track record of the lenders. The best developers and rehabbers already have banking relationships and the ability to secure low-cost financing from hard money lenders. Developers and rehabbers seeking crowdfunded capital tend to be newcomers to the real estate industry or have had project failures that make it difficult to secure conventional loans. In addition, the types of projects that newly minted developers and rehabbers advertise on crowdfunding sites tend to be lower-quality investments with above-average risk and less income potential. Mortgage pool funds must comply with state and federal agencies and typically supply investors with an offering memorandum that discloses management’s backgrounds and the fund’s historic financial performance. Disclosure requirements for mortgage pools are much more rigorous than for crowdfunding and crowdfunding investors may have difficulty securing information about the project’s management team or the track record of the developer.
- Underwriting criteria: A quick search of the Web shows many crowdfunding deals have very aggressive underwriting criteria, such as loan-to-value ratios of 85% or higher on projects. Loan-to-value measures the size of the loan as a percentage of the property’s value. Very high ratios are considered risky since no cushion is left to protect investors if the loan defaults and the property is sold to pay the loan. Mortgage pool funds understand underwriting risk and typically limit loan-to-value ratios to a range of 65% to 75%.
- Capitalization: The capitalization of the deal sponsor is another factor that should be considered since poorly capitalized crowdfunding sites are not likely to survive in an increasingly competitive lending environment. At present, more than 120 Internet sites are marketing crowdfunding investments. Due to low barriers to entry, new crowdfunding sites emerge on the Web daily. Neither capital nor lending experience is required to set up a crowdfunding site. In contrast, a shakeout in the mortgage pool fund industry has already occurred. Many poorly capitalized funds folded during the housing crisis. The mortgage pool funds that exist today are often managed by large firms that have a long-standing presence in the non-bank lending market.
- Fees and pricing model: Due to the newness of the product and the variety of platforms, there is no standard pricing model for crowdfunding investments. Some sites get paid by underwriting each deal and taking a percentage of the returns. Other sites charge the sponsor a flat fee or collect fees from the deal’s investors. Unlike crowdfunding sites, almost all mortgage pool funds use the same pricing model and clearly spell out their fees and management compensation in the offering memorandum. Mortgage pool funds collect fees (loan origination, processing and other fees) from their borrowers, not from fund investors.
- Diversification: Since diversification reduces risk, a diversified portfolio should be the goal of every investor. Mortgage pool funds hold hundreds of loans and diversify their loan portfolio geographically, by loan size, property type and years to maturity. An example is the Socotra Fund, which has more than 170 loans in its portfolio, ranging in size from less than $12,000 to more than $1.0 million. No one loan represents more than 3% of the portfolio. In contrast, many crowdfunding sites offer just two or three investible opportunities at a time. The individual projects tend to be large, ranging from $1.0 million to more than $5.0 million. As a result, an investor must participate in many crowdfunding deals to diversify risk.
- Security of the website: The ability to reach large groups of investors makes online forums ideal for crowdfunding, but may also attract hackers interested in stealing information about subscribers or con artists wanting to fleece naïve investors. Mortgage pool funds don’t advertise and generally fly below the radar. As a result, the risk of attacks from hackers and online fraudsters is low.
As a new investment area, real estate crowdfunding may offer immense growth potential. Until the risks and uncertainties of this investment product become better known, however, income-oriented investors may prefer the safety and reliable income of a mortgage pool fund.