Being an active, rather than passive, real estate investor can be time consuming, labor intensive and fraught with pitfalls. So the rise in real estate crowdfunding comes as no surprise as busy people seek safety from, or at least an alternative to, the
stock market.

The equity crowdfunding movement is bound to swell when the SEC’s rules allowing interstate crowdfunding take effect, part of implementing Title III of the 2012 federal JOBS Act.
Title III of the Act, approved by the SEC in October 2015, opened the door for anyone to participate in equity crowdfunding – not just accredited investors with a net worth of $1 million or more, or annual income over $200,000.

Let’s face it – real estate crowdfunding seems to offer the best of both worlds: expanded investment opportunities along with strong potential returns and the sense of security that comes from having a stake in a tangible, hard asset – all
delivered with a couple clicks of a mouse. What could possibly go wrong?

There are two broad categories of inherent risks to be considered: business risk and property risk. But the undisputed convenience of crowdfunding tends to remove any sense of the need to do your own due diligence, even at the most fundamental

For example, management – who are you dealing with? Is their background in real estate or finance only? How many deals have they done?

While the government requires disclosures of things like managers’ identity and experience, company operating history, and a description of the offerings, according to the Texas State Securities Board, crowdfunding portals must inform investors
that the accuracy of the disclosures have not been confirmed by any federal or state regulator.

Does the company have a track record in real estate at all? Because crowdfunding is so new, it’s likely you’re dealing with a startup company.

As Chicago investment banker Charles Smith with Pegasus Intellectual Capital Solutions points out in his article “Crowdfunding: Boon or Mortgage Backed Disaster?”:
“The most dangerous of all investments is a privately held startup with complete control by the officers of the company…This is a situation that is ripe for self-dealing and myopic decision making by the management.”

Theoretically, crowdfunding cuts out costs associated with traditional borrowing so returns to investors should be higher. But management determines whether or not those savings are passed on to investors as promised returns.

Smith compares the highly fragmented ownership model of equity crowdfunding to the mortgage backed security debacle that caused the 2008 financial crisis where investors had no voice and servicers had no financial interest of their own in the
assets or in protecting them. There is no one to represent the many small outside investors in the event of a default.

Lack of liquidity and control is another consideration. See RealtyShares’ disclosure as one example.

What about the property – is it detailed in the offering or is it a “blind” offering, as yet unidentified or acquired by the sponsor? Is the price quoted above market, below market, at market or realistic at all? How do you know?

For those wanting to do some due diligence of their own, information may be hard to come by and harder to verify.

What recourse do investors have if promised returns don’t materialize, especially due to management misconduct? Limitations on liability, reduced regulatory requirements, and less oversight for fund sponsors increase investors’ risk.

Since the JOBS Act passed, states have seen financial fraud increase significantly and so are enacting their own rules on crowdfunding and are making efforts to educate investors on the risks. In its Information for Investors, the Texas State Securities Board notes that “Fraud investigations and prosecutions usually do not result in a recovery of investor funds, and there is no reason to think that will change if fraud
occurs in equity crowdfunding.”

No doubt equity crowdfunding presents exciting new opportunities, as well as convenience, to real estate investors. The challenge is ensuring some safeguards for your hard-earned capital.

Diane Velasco is a marketing communications professional and real estate investor in the Dallas area.

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