NEWPORT BEACH, CA—While crowdfunding is gaining ground in the real estate realm, it has some definite drawbacks, and not everyone agrees that it is a viable alternative to traditional financing. GlobeSt.com spoke with Alexander Philips, CEO and CIO of TwinRock Partners here, and Jeff Lerman, a partner with real estate law firm Lerman Law Partners LLP in San Rafael, CA, about some of the caveats to crowdfunding and why it may not have legs in the real estate industry. Stay tuned for a feature story on crowdfunding's progress in an upcoming issue of Real Estate Forum.

GlobeSt.com: Jeff, why do you feel the term crowdfunding is being misused?

Lerman: There's a lot of misinformation out there about crowdfunding, including the misuse of the term crowdfunding itself. Crowdfunding started in 2003, and it was reward based, where you have entrepreneurs or artists pre-selling some sort of product or service via Kickstarter or IndieGoGo, and investors would get a discount on the product. Then, fast-forward to 2012 and the JOBS Act. Basically, the idea was that through that act Congress directed through the SEC to expand this notion to crowdfunding to start letting small businesses partake in a way that was easier than it had been prior to 2012. They were trying to solve the problem of a stalled economy with a shortage of jobs. When the SEC did that, it passed 585 pages of new rules proposed in 2013 that have still not been finalized. Under this act, two new types of crowdfunding were introduced: equity based or loan based. States waited so long for these rules to be finalized that some of them passed their own intrastate crowdfunding rules, but this only applies if you do all of your business within that state.

When firms say they're doing crowdfunding, what they mean is that they are enabling people who need money to come to them and do one or two types of fundraising: Rule 506(b) or Rule 506(c) syndication. Under the new law, the old rule 506 split into these two laws. Rule 506(b) is like the old 506 rule where investors self-qualify as accredited; under 506(c), the Feds want a more rigorous qualification that includes getting a CPA or lawyer to sign a statement or the investor to provide bank records. Most accredited investors don't like to do that, so there aren't many crowdfunding firms offering 506(c). So, they're basically taking it to their pool of accredited investors via 506(b), which isn't really crowdfunding. The only way you can do that today legally is under rule 506(c), under future Title III crowdfunding or intrastate.

Globe: What is your view of crowdfunding as a viable alternative to get real estate deals funded?

Philips: Right now, with the large number of investment entities filling the Internet “airwaves” and many more certainly on the horizon, it reminds one of the heady and eventually disastrous days of the Internet startups that went bust in March 2000. The dot-com bubble was, according to Wikipedia, the result of a historic speculative timespan covering roughly 1997 to 2000 during which stock markets in industrialized nations saw their equity value rise rapidly from exuberant (some might say greedy) growth in the Internet sector and related fields, and then fall like a rock.

When and if enacted, Title III is expected to set standards that will allow for an unlimited number of non-accredited investors to invest in crowdfunding offerings without registration via an Internet-based platform. There would be certain limitations such as no more than $1 million could be raised by a single issuer over a rolling period of 12 months, as well as dollar limits on investor positions. As a long-time investor in all forms of real estate I believe that while crowdfunding may have its upsides, it definitely has its potential pitfalls, especially for investors who are not experienced in the complex and risky world of real estate assets. My purpose here is not to throw cold water on the crowdfunding movement, but to point out from my perspective what I consider could be danger areas for crowdfunding as it applies specifically to real estate.

Lerman: It's difficult to do any serious wealth building with only $1 million. Also, the costs and fees are high, and few people can afford those kinds of fees. If you do it yourself, the legal fees will be under $20,000. Through crowdfunding, you're looking at easily $150,000 to $200,000. And it's all or nothing: if you don't raise the entire amount, you can't sell anything. In addition, the time to market is longer than most real estate investors like—30 to 60 days. Crowdfunding is like putting a poster on a tree in a forest: how do you let people know about it?

Globe: So, Alex, what do you consider to be the danger areas of crowdfunding from a real estate perspective?

Philips: First, the site operators' level of knowledge and experience. Real estate is an extremely complex and challenging asset that requires extensive and deep experience in acquisition, development and/or improvement, management and marketing. Critical factors that must be considered include location, market status, current ownership, condition of the property, operating expenses, tenant mix if it's an income-producing property, access to transportation and surrounding businesses and/or competing properties. Analyzing these and other variables that affect a property's value and its potential upside requires someone or a group of professionals with solid knowledge and experience in real estate.

Then, there are one-off real estate investments. Searching several of the crowdfunding sites, it is apparent that many of the investment opportunities are single-smaller properties including single-family homes. One site has 24 different investment possibilities with annual returns ranging from 7% to 24%. I am sure these deals are researched to some extent and offered by honest brokers with every good intention of doing the right thing for investors. But one has to wonder just how extensive is the due diligence that goes into fully assessing the investment value of each property ranging from retail to student housing to office buildings to residential—all in one site. To ensure that a property is everything that it is promoted to be, I believe it is necessary for an investment professional with deep experience in real estate to actually walk the property and surrounding areas or have someone they trust do it for them. Boots on the ground are absolutely essential to really understand and analyze a property and the environment in which it is located.

Third is the relationship of key participants. At the end of the day, real estate is a relationship business, and one has to wonder about the degree of relationships in a crowdfunding environment. It has been my experience in every deal in which I or my team has been involved that we either personally know the investor—whether an individual or entity—or the investor came to us via a referral of someone we know. That relationship is a critical factor in any real estate transaction in that it establishes a level of trust between two or more participating parties. Relationships also play another important role, and that is creating a comfort level around who's in charge. Due to the structure of almost every real estate investment deal, there is a majority equity partner who has final say over financing and other decisions, and frequently a managing partner (who may or may not be the majority equity partner) who is responsible for the day-to-day operations. For the most part, in a traditional investment environment, these people know one another and probably have been involved in other deals together. Another advantage of a strong working relationship is, if there is a problem, it can most likely be resolved without litigation, which may not be the case with crowdfunding where few, if any, of the participating investors knows one another.

Fourth is the risk factor. Since real estate crowdfunding is relatively new, there has not been enough investment activity to create any reportable legal or meaningful regulatory action to date. According to the Wall Street Journal, the 50 existing real estate crowdfunding sites have raised $135 million, a drop in the bucket compared to the more-than-$700 billion in market value of publicly traded REITs. There is no way at this juncture in real estate crowdfunding's short lifespan to gauge if the risks of investing via these Internet entities is any greater—or less so—than dealing with a traditional sticks-and-bricks investment firm. Who is legally responsible if an investment goes bust? What if fraud is evident? Is if the issuer? The sponsoring site?

Lastly, what about a “bad actor”? When it comes to fraud and dirty dealing, the Internet is still the Wild, Wild West. It is for this reason that the Securities & Exchange Commission created a series of private-placement safe-harbor regulations under Rule 506 protecting investors from deceit and fraud, including what it terms “bad actors.” Under existing bad-actor rules, an individual who, for example, has been convicted of certain securities felonies or misdemeanors, or has been disciplined by the SEC, may not be involved in a securities issuance. If Title III is enacted, it could throw open the floodgates for all types and forms of investors including marginally shady, if not totally dishonest ones, who could turn the crowdfunding industry upside down. This regulatory vacuum leaves a large and uneasy legal void that could potentially be a new field of opportunity for less-than-honest crowdfunding sites and the entities they sponsor.

Many of these crowdfunding sites such as Kickstarter and IndieGoGo are on the up-and-up and can be trailblazers for the entire new industry. Nevertheless, with this evolving crowdfunding environment for real estate, the well-known consumer warning “caveat emptor”—buyer beware—may not be joined by a less-known but equally important warning, “cave investor”—investor beware.

GlobeSt.com: Jeff, what are your final thoughts and recommendations about crowdfunding in real estate, as both a real estate attorney and an investor?

Lerman: After extensive analysis, I believe crowdfunding is not a viable alternative to get deals funded. To quote Forbes magazine, “Despite the sound and fury, the crowdfunding exemption will do little to help small start-ups raise capital. That's because it will not be economically feasible for most companies to comply with the filing and disclosure requirements; take on the risk of legal liability; and undertake annual reporting obligations to raise a maximum of $1 million in a 12-month period…[I]t is difficult to imagine why a company would opt for crowdfunding instead of other, less burdensome, forms of private placements—for example, a Regulation D Rule 506 raise… Whether you're a company or an investor, don't try this without legal advice either. The myth of easy capital raising through crowdfunding has overtaken the social media start-up marketplace. Compliance with the crowdfunding rules is harder than it may look.” (Emphasis added.) The bottom line is: You can't do Title III Crowdfunding until the final rules are enacted. It's too expensive. It's too complicated. It takes too long to be useful. There's no certainty. And there's little to no issuer control.