NEWPORT BEACH, CA—While crowdfunding is gaining ground in the realestate realm, it has some definite drawbacks, and not everyoneagrees that it is a viable alternative to traditional financing.GlobeSt.com spoke with Alexander Philips, CEO andCIO of TwinRock Partners here, and JeffLerman, a partner with real estate law firm LermanLaw Partners LLP in San Rafael, CA, about some of thecaveats to crowdfunding and why it may not have legs in the realestate industry. Stay tuned for a feature story on crowdfunding'sprogress in an upcoming issue of Real EstateForum.

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

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Lerman: There's a lot ofmisinformation out there about crowdfunding, including the misuseof the term crowdfunding itself. Crowdfunding started in 2003, andit was reward based, where you have entrepreneurs or artistspre-selling some sort of product or service viaKickstarter or IndieGoGo, andinvestors would get a discount on the product. Then, fast-forwardto 2012 and the JOBS Act. Basically, the idea wasthat through that act Congress directed throughthe SEC to expand this notion to crowdfunding tostart letting small businesses partake in a way that was easierthan it had been prior to 2012. They were trying to solve theproblem of a stalled economy with a shortage of jobs. When the SECdid that, it passed 585 pages of new rules proposed in 2013 thathave still not been finalized. Under this act, two new types ofcrowdfunding were introduced: equity based or loan based. Stateswaited so long for these rules to be finalized that some of thempassed their own intrastate crowdfunding rules, but this onlyapplies if you do all of your business within that state.

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

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

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Philips: Right now, with the largenumber of investment entities filling the Internet “airwaves” andmany more certainly on the horizon, it reminds one of the heady andeventually disastrous days of the Internetstartups that went bust in March 2000. The dot-com bubble was,according to Wikipedia, the result of a historic speculativetimespan covering roughly 1997 to 2000 during which stock marketsin industrialized nations saw their equity value rise rapidly fromexuberant (some might say greedy) growth in the Internet sector andrelated fields, and then fall like a rock.

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When and if enacted, Title III is expected to set standards thatwill allow for an unlimited number of non-accredited investors toinvest in crowdfunding offerings without registration via anInternet-based platform. There would be certain limitations such asno more than $1 million could be raised by a single issuer over arolling period of 12 months, as well as dollar limits on investorpositions. As a long-time investor in all forms of real estate Ibelieve that while crowdfunding may have its upsides, it definitelyhas its potential pitfalls, especially for investors who are notexperienced in the complex and risky world of real estate assets.My purpose here is not to throw cold water on the crowdfundingmovement, but to point out from my perspective what I considercould be danger areas for crowdfunding as it applies specificallyto real estate.

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

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Globe: So, Alex, what do you consider to be thedanger areas of crowdfunding from a real estateperspective?

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Philips: First, the siteoperators' level of knowledge and experience. Real estate is anextremely complex and challenging asset that requires extensive anddeep experience in acquisition, development and/or improvement,management and marketing. Critical factors that must be consideredinclude location, market status, current ownership, condition ofthe property, operating expenses, tenant mix if it's anincome-producing property, access to transportation and surroundingbusinesses and/or competing properties. Analyzing these and othervariables that affect a property's value and its potential upsiderequires someone or a group of professionals with solid knowledgeand experience in real estate.

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Then, there are one-off real estate investments. Searchingseveral of the crowdfunding sites, it is apparent that many of theinvestment opportunities are single-smaller properties includingsingle-family homes. One site has24 different investment possibilities with annual returns rangingfrom 7% to 24%. I am sure these deals are researched to some extentand offered by honest brokers with every good intention of doingthe right thing for investors. But one has to wonder just howextensive is the due diligence that goes into fully assessing theinvestment value of each property ranging from retail to studenthousing to office buildings to residential—all in one site. Toensure that a property is everything that it is promoted to be, Ibelieve it is necessary for an investment professional with deepexperience in real estate to actually walk the property andsurrounding areas or have someone they trust do it for them. Bootson the ground are absolutely essential to really understand andanalyze a property and the environment in which it is located.

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Third is the relationship of key participants. At the end of theday, real estate is a relationship business, and one has to wonderabout the degree of relationships in a crowdfunding environment. Ithas been my experience in every deal in which I or my team has beeninvolved that we either personally know the investor—whether anindividual or entity—or the investor came to us via a referral ofsomeone we know. That relationship is a critical factor in any realestate transaction in that it establishes a level of trust betweentwo or more participating parties. Relationships also play anotherimportant role, and that is creating a comfort level around who'sin charge. Due to the structure of almost every real estateinvestment deal, there is a majority equity partner who has finalsay over financing and other decisions, and frequently a managingpartner (who may or may not be the majority equity partner) who isresponsible for the day-to-day operations. For the most part, in atraditional investment environment, these people know one anotherand probably have been involved in other deals together. Anotheradvantage of a strong working relationship is, if there is aproblem, it can most likely be resolved without litigation, whichmay not be the case with crowdfunding where few, if any, of theparticipating investors knows one another.

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Fourth is the risk factor. Since real estate crowdfunding isrelatively new, there has not been enough investment activity tocreate any reportable legal or meaningful regulatory action todate. According to the Wall Street Journal, the 50existing real estate crowdfunding sites have raised $135 million, adrop in the bucket compared to the more-than-$700 billion in marketvalue of publicly traded REITs. There is no way atthis juncture in real estate crowdfunding's short lifespan to gaugeif the risks of investing via these Internet entities is anygreater—or less so—than dealing with a traditionalsticks-and-bricks investment firm. Who is legally responsible if aninvestment goes bust? What if fraud is evident? Is if the issuer?The sponsoring site?

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Lastly, what about a “bad actor”? When it comes to fraud anddirty dealing, the Internet is still the Wild, Wild West. It is forthis reason that the Securities & Exchange Commission created aseries of private-placement safe-harbor regulations under Rule 506protecting 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 ormisdemeanors, or has been disciplined by the SEC, may not beinvolved in a securities issuance. If Title III is enacted, itcould throw open the floodgates for all types and forms ofinvestors including marginally shady, if not totally dishonestones, who could turn the crowdfunding industry upside down. Thisregulatory vacuum leaves a large and uneasy legal void that couldpotentially be a new field of opportunity for less-than-honestcrowdfunding sites and the entities they sponsor.

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

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

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Lerman: After extensive analysis, Ibelieve crowdfunding is not a viable alternative to get dealsfunded. To quote Forbes magazine, “Despite the sound andfury, the crowdfunding exemption will do little to help smallstart-ups raise capital. That's because it will not be economicallyfeasible for most companies to comply with the filing anddisclosure requirements; take on the risk of legal liability; andundertake annual reporting obligations to raise a maximum of $1million in a 12-month period…[I]t is difficult to imagine why acompany would opt for crowdfunding instead of other, lessburdensome, forms of private placements—for example, a Regulation DRule 506 raise… Whether you're a company or an investor, don't trythis without legal advice either. The myth of easy capital raisingthrough crowdfunding has overtaken the social media start-upmarketplace. Compliance with the crowdfunding rules is harder thanit may look.” (Emphasis added.) The bottom line is: You can't doTitle III Crowdfunding until the final rules are enacted. It's tooexpensive. It's too complicated. It takes too long to be useful.There's no certainty. And there's little to no issuer control.

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Carrie Rossenfeld

Carrie Rossenfeld is a reporter for the San Diego and Orange County markets on GlobeSt.com and a contributor to Real Estate Forum. She was a trade-magazine and newsletter editor in New York City before moving to Southern California to become a freelance writer and editor for magazines, books and websites. Rossenfeld has written extensively on topics including commercial real estate, running a medical practice, intellectual-property licensing and giftware. She has edited books about profiting from real estate and has ghostwritten a book about starting a home-based business.