Investors Need Be Aware of Crowdfunding Risks

LOS ANGELES—Although the crowdfunding space has grown phenomenally in the past year, and offers notable preferred returns, investors should still be aware of the potential risks, warns Paul S. Rutter, of counsel at Gilchrist & Rutter and a board member of the UCLA Ziman Center for Real Estate. Along with the Los Angeles County Bar Association, the UCLA Ziman Center is preparing to host the annual Crocker Symposium with the theme “Constructive Disruption: Adapting to Change in Evolving Real Estate Markets.” To find out how crowdfunding has disrupted commercial real estate, what investors should do to evolve and about the new and soon-to-be SEC regulations that affect this space, we sat down with Rutter for an exclusive interview. Here is what he told us:

GlobeSt.com: How has crowdfunding disrupted the commercial real estate space?

Paul Rutter: Crowdfunding in the commercial real estate space has made it simpler and easier for investors to participate in equity and debt deals. The internet-based platforms take advantage of technology to provide potential investors with access to information and deal flow that previously was distributed by brokers and often not easily accessible to the average retail investor.  As the crowdfunding option grows in acceptance, it may affect the role of brokers who previously raised capital for deals by making it easier for retail investors to participate in deals.

What should both investors and lenders do to adapt and remain competitive?

Rutter: From the investor perspective, they need to be aware of the risks associated with investing through these relatively new platforms, where there have not yet been failed deals requiring the exercise of remedies on behalf of the investors, and they need to look at the qualifications and experience of the key personnel at the crowdfunding company. From the perspective of lenders, the crowdfunding approach is likely only to affect the smaller private-money lenders who might have otherwise been making the kinds of loans currently offered through the platforms. Crowdfunding is unlikely to compete with larger commercial loans, at least anytime soon.  For developers and real estate operators, crowdfunding should at least be on their list of potential sources of capital as they consider their deals.  If their deal has cash flow, it may well attract investment capital that is less expensive and has fewer conditions and covenants than some alternative sources of capital.

GlobeSt.com: What are some of the potential dangers or risks of crowdfunding?

Rutter: The risks of making a crowdfunding investment depend on the type of investment and the sophistication of the platform. For investors making an investment in a loan, the risks are similar to those taken by any lender.  The borrower might default; there could be a loss of income from defaulted interest payments and a loss of principal from a failure of the borrower to repay the loan. These risks are mitigated by the pledged collateral, in the form of a mortgage or deed of trust on real estate, and by guaranties from the borrower or its principal, at least in many cases. If the borrower defaults, the investor is also taking the risk that the crowdfunding platform is ready, willing and able to exercise remedies to collect on the loan.  The costs of collection and exercise of remedies will diminish the recovery by investors unless the property and/or the guarantor provide sufficient sources of payment to cover the lost principal and the costs. Of course, the platform will also have its own costs to cover in exercising remedies on behalf of its retail investors.

In the context of an equity investment through crowdfunding, the risks are similar to any other syndicated equity deal. The limited partners/members who invest are at risk of dilution through the investment of additional capital, whether to meet cost overruns, to pay deductible losses on insurance claims, to satisfy third party claims, and to pay for ongoing capital expenditures and leasing expenses.  Most retail investors are not interested in an investment that would require any additional capital investment beyond their initial investment. Each deal is different, but in every equity deal the investor should thoroughly understand when additional capital may be required, what the sources of that capital will be, and what impact that capital will have on the returns and ownership interests of the original investors.  Likewise, if there is no source of additional capital for investment over time, then there will be risks that the property cannot compete and attract tenants, or be maintained properly, all of which would jeopardize the value of the investment.  As with the debt deals, the equity investors need to be protected by the crowdfunding platform if the operator of the property defaults or fails to comply with the business plan. Until the first deals go into default it will be unclear how effective the platforms will be in protecting their investors. Finally, there needs to be a clear understanding by the investor of the exit on the deal—when will the investment be mature and the asset sold? The investor needs to understand the investment is illiquid, there is probably no secondary market for the interest, and there may be no return of his/her money for many years. As with any equity investment, the returns to be paid to the investor should reflect the lack of liquidity and the risks of the investment.

GlobeSt.com: The SEC may open up to non-accredited investors. Do you have an opinion about whether or not non-accredited investors should operate in this space?

Rutter: I believe many of the platforms offering the crowdfunding real estate investments will be reluctant to open up the deals to non-accredited investors, even when the regulations under the JOBS Act are adopted that will permit this. For one thing, the platforms seem to have plenty of accredited investors for the deals they can produce. Secondly, if non-accredited investors are included, there will be a higher risk of claims by those investors that they did not understand the deal risks, and it is likely that the loss of the investment will have a disproportionately negative impact on those retail investors. The crowdfunding platforms require expensive systems and technology to function. This creates a barrier to entry by potential operators who might be willing to offer these deals to non-accredited investors with less of a concern for the associated risks. Crowdfunding platforms have to protect their reputations in order to continue to attract new investors and new deals from potential borrowers and equity partners, so they will likely stay away from non-accredited investors who could easily damage those reputations and create risks of claims.

GlobeSt.com: This is a new industry that has grown quickly. Where is it headed?

Rutter: As long as the deals continue to offer attractive returns compared to alternatives, and in light of the continued preferential tax attributes of real estate ownership compared to other investments, I believe direct investment in real estate through these crowdfunding platforms will continue to expand even if only for accredited investors. If the first crowdfunding deal or deals that fail are not handled and addressed properly by their platform so the investors are protected, this will cause a real concern for the industry and impair the growth. Many of the crowdfunding teams are not experienced real estate experts. They are technology and marketing folks and may not have the necessary experience to handle a defaulted deal. Time will tell if they retain the necessary experts to help them deal with bad deals. If they succeed in addressing the failed deals, then this will support continued growth and acceptance by retail investors.