The Good, the Bad and the Ugly: An Open Letter to Crowdfunding Real Estate Investors

Article by Billy Procida, President of Procida Funding & Advisors      

In January of this year, the Obama administration passed the JOBS Act, which includes permission for private entities to solicit accredited investors. Prior to that legislation, it was illegal for a firm like ours (we run a private equity fund that makes real estate loans and investments of $2 million to $50 million), to advertise or solicit in any way. Ten months after its passing, numerous real estate crowdfunding platforms have sprouted up online like a garden in spring and accredited investors have flowed like a garden hose.

The Good

There are obvious benefits. Smaller, accredited investors are now able to see investment opportunities that prior to January 2014, they could not. Accredited investors are individuals with income exceeding $200,000 for two consecutive years, households with $300,000 of income for two years, or a net worth of $4.1 million (excluding their primary residence). Corporations and trusts with $5 million of net worth also qualify.

The JOBS Act also benefits small and mid-market companies who can now solicit investors directly. It’s amazing that something this simple, literally, required an act of congress. Increased access to capital for companies outside of big Wall Street firms is always good and, in theory, should create jobs which is what it was intended to do. When a good company with good morals and a good investment opportunity are connected with knowledgeable accredited investors it should be a win-win.

The Bad

Like anything, the devil is in the details and like most new frontiers, there are kinks to work out. The challenge of this space is that an individual investing $25,000 to $ 250,000 doesn't have the wherewithal or resources to perform the appropriate level of due diligence.

When my firm entertains making a loan, due diligence is our top priority. After the deal terms are set, our borrower or developer first writes us a check for $10,000 to $50,000 for third party reports to assist us in completing the process. Outside professionals from appraisers to environmental engineers to construction consultants to attorneys provide numerous reports including background checks, title reports and credit reports. This process verifies that everything told to us is true and accurate and, more importantly, whether or not there is something our borrower or developer didn't think of. We, like most competent fund managers, banks and institutions, do this to protect our shareholders and, frankly, to protect and inform our borrowers.

In the crowdfunding world, due diligence generally falls to the platform that is offering the investment. The platform typically makes their money by collecting fees of 2% to 5% of investor proceeds from the borrower/developer. Thus, if you invest $100,000, it turns into $95 or $98 of deployed capital and the due diligence conducted under these circumstances is questionable.

For example, we came across a crowdfunding opportunity that claimed the developer had 20 years experience, had built 1,000 homes and won awards. When we performed our own due diligence, we did find these accolades to be true. However, we also found that the developer had several defaults, judgments and lawsuits against him. We found that out with a press of a button, not on google, though that is sometimes a good resource, but on one of the several background search systems not available to most private investors that we spend thousands to subscribe to. In other cases, we’ve seen construction budgets and schedules that are impossible to achieve, and key points like the status of approvals and the developer’s equity to be fuzzy at best.

The fact is that there is really no due diligence of any significance being done and even if they put all the third party reports online, one needs years of experience to interpret this information. Basically, anyone investing currently is making a leap of faith that it's a good deal by good people.

The Ugly

Like any other new legislation, there are always gamers and fraudsters, not to mention incompetents, and the current crowdfunding paradigm, unfortunately, leaves the door wide open to them. There are a ton of questions to asked, like does the developer have key person insurance? What happens if they die or become incapacitated? Does a computer step in? The ugliest part of this space is that investors typically have no idea if these questions have been asked. There are no controls, monitors or asset managers to speak of. You are fully reliant on trust because the contracts have no teeth. Even if they have teeth, an investor who invested $100,000 will not likely spend $25,000 to $50,000 on a lawyer to collect their investment in the event of fraud, mismanagement or gross negligence, all of which is very common in commercial real estate.

Competent asset managers monitor projects on a monthly basis, review schedule, budget, construction, sales, marketing, insurance compliance, etc., etc… I've been doing this for 35 years as contractor, developer, fund manager and asset manager. I can tell you that you need eyes in the back of your head and a team of consultants behind you when investing in real estate. Basically, with crowdfunding, you’re counting on the person or company who now has your money to tell you everything's OK. If it is OK, great, but if it's not, what then? It’s also conceivable that a deal could perform, make a ton of money and no one gets paid back. We don't know yet because of the millions already invested though crowdfunding platforms, none of the projects have been complete.

The Solution

I'm strongly in favor of leveling the playing field for people like me to raise money. Wall Street, large institutions and public companies have dominated the real estate industry, and the country as a whole, for too long. I believe crowdfunding has great potential. To have people investing, however, with little information and monitoring is reckless. The first time a senator's grandfather gets ripped off, you could easily see this repealed. I'd rather get ahead of the problem with a solution. That solution, while not perfect because nothing is perfect, is for the platforms offering these investment opportunities to have an independent third party perform due diligence and to facilitate the same interaction between borrower, lender and investor that we strictly follow: term sheet, deposit, due diligence, independent legal representation with previty to the investor.

About the Author

William “Billy” Procida is president of William Procida Incorporated ("WPI"). He has been an independent entrepreneur since 1981. WPI was founded in 1995 and is based in Englewood Cliffs, New Jersey. The firm specializes in providing management and capital for both distressed and value added situations. WPI has completed over $2 billion dollars of transactions ranging from $1,000,000 to $50,000,000. The Firm utilizes its own capital as well as strategic capital partners. Procida Advisors provides due diligence and asset management services to financial institutions and private equity funds with a concentration on construction, bankruptcy, restructuring and marketing.