This is article was originally published on Crowdfund Insider on September 10, 2015.
The investment crowdfunding space is on fire – growing by more than 1000% a year. Within real estate alone, total investment is projected to hit $2.5 billion by the end of December. Meanwhile, FinTech has become glorified as a revolution in finance ready to take down Wall Street.
It’s true – technology can and will cut costs, increase transparency, and deliver improved performance, especially compared to the fat margins of Wall Street.
But technology is an amplifier that drives efficiency, it will not and cannot replace the core fundamentals of disciplined investing and the importance of experienced real estate legal counsel.
Crowdfunding is a revolution in who can invest…it does not magically transform bad investments into good ones.
We are anxious as we watch some crowdfunders let venture-backed irrational exuberance get the better of them.
Let’s play find the pea (and the problem)
There is no substitute for rigorous vetting in how investments are sourced. And it is not easily mechanized, especially in real estate.
An underwriter, the analyst responsible for performing due diligence and ultimately structuring an investment, must approach each deal with skepticism. Everyone wants money for their project but few deserve it. Every deal has its flaws and an underwriter has to find them.
Fundraisers seeking to raise money for a real estate deal have a natural tendency to underestimate potential challenges and overestimate their own abilities. Exaggerated performance projections are the norm. The job of the underwriter is to eliminate hyperbole, discount growth projections, and stress assumptions.
Top 6 Crowdfunder Best Practices
Our recommendation is that the industry implement guidelines to protect the sector in its infancy. Our top 5 best practices for crowdfunders are:
- LexisNexis Background Checks: The number of real estate company sponsors who have criminal records is shocking. Everything from securities fraud to assault and battery. Just because someone has developed a couple of buildings, or even a dozen, doesn’t mean you won’t find trouble in their history. When in doubt, don’t risk it.
- “Bad Boy” Guarantees: A bad boy guarantee is like a personal guarantee, but only triggered by bad acts by management, most commonly fraud, gross negligence, malfeasance, and conversion (i.e., stealing). In other words, if a developer does something blatantly wrong they will be personally liable.
- Engage Counsel: No one is a fan of big legal bills, but using top-notch attorneys is worth it. Sometimes real estate companies complain about the cost or the speed, but a good law firm will save you from making the kind of mistakes that sink projects.
- Title Insurance: While title companies are some of the least technologically-savvy players in the industry, running title is an industry best practice. A title endorsement means that if someone down the line claims to have ownership rights or encumbrances, you are protected.
- Transparency in Underwriting: Do the underwriting and then share it. When in doubt, disclose it. Anything that might give you pause is better off in front of your investors before they invest. In many ways, we can and should be more transparent than institutional investors.
- Coordination with Existing Lien Holders: It’s common for sponsors to obtain capital from multiple parties. Responsible capital providers coordinate with all parties in the transaction to ensure that the rights of each party are respected when placing capital. Failure to coordinate with other interested parties can cloud the title to the property or cause technical defaults within the transaction. Often times, this default stems from failure to work with the senior lender in the transaction and/or to conduct proper legal due diligence.
This is just a short list. Real underwriting means sweating the details. Worrying about what can go wrong and not trusting anyone else’s assumptions. Real underwriting must include:
- Having multiple team members walk a property in person
- Detailed financial analysis with independent data and well researched assumptions
- Looking at downside scenarios and what happens when things go wrong
- Calling references and carefully reviewing the schedule of real estate owned (SREO)
- Engaging third party appraisers
- Co-investing with major banks
- Negotiating fierce legal documents
- Always using the lesser of Loan-to-Cost (LTC) or Loan-to-Value (LTV)
Our list of recommended due diligence is long.
Fraud, negligence, and malfeasance are all too real. Nothing is true until proven so. Failing to follow these strict standards makes losing investors’ money just a question of time.
The future is bright (for those that survive)
In an industry where startups are valued by the number of dollars originated, entrepreneurs have become addicted to increasing volume — scared of the venture capitalists funding them and lulled by positive media attention. A “grow at any cost” mentality has emerged.
In finance there is a very simple way to grow origination volume quickly: lower quality standards.
It is clear that either some platforms have not spent the time reviewing every number, budget, contract, and pro forma to present the risks to their investor base or are choosing to ignore them to grow volume. It appears some are unwilling to sacrifice deal flow quantity for deal closed quality.
A great investment crowdfunding platform should be like any top tier investment fund; they must screen thousands of opportunities, overturn every stone, perform ferocious underwriting, and negotiate tough deals — aligning the interest of the investors and real estate company appropriately.
Investment crowdfunding holds enormous promise. But poor underwriting standards will claim many would be unicorns before long.
What Amazon, Twitter, Kayak, and Uber did to the retail, newspaper, travel and taxi industries, respectively – investment crowdfunding will do to finance.
But only by staying grounded and diligent throughout will we deserve to win the trust of our investors and the begrudging respect of Wall Street.
Image Source: Michael Theis, Flickr