Real Estate crowdfunding provides exposure to an asset class that was previously out of reach for most investors. It also allows investors to participate in multiple deals and reduce risk through diversification. While it provides new investment opportunities, it also creates new challenges. Investing with unfamiliar sponsors on platforms with short operating histories increase counter-party risk. While the internet is full of success stories, there are few articles or blog posts that discuss investments that do not go according to plan. I wanted to share my experience of my first crowdfunded real estate investment.
I signed up for multiple crowdfunding platforms, reviewed multiple deals, sent emails to the platforms to see how quickly they responded to investor questions. After three months of reviewing deals, I found an investment that looked like a good opportunity.
The Deal
My first crowdfunding deal was a preferred equity investment in a value-add 48 unit apartment building in the DC metro area. The company was looking to raise $1.5 million in preferred equity to complete the purchase, renovation, and stabilization of the property. At that point, the sponsor would refinance the property to retire the construction loan and pay off the preferred equity investors. The company had a senior loan of $14.2 million and $2.3 million in sponsor equity. The funds would be used to purchase the building for approximately $9 million, $7.2 million construction and rest for closing costs and working capital.
Investors could purchase shares of preferred equity at $10,000/share. Shareholders would receive a 10% annual dividend distributed quarterly and 11% annual accrued interest at exit. The length of the deal is 2 years with a sponsor’s option for a 6 month extension.
For example, a $10,000 investment would get 8 quarterly distributions of $250 and $12,200 ($2,200 accrued dividend and $10,000 initial investment). The preferred equity was subordinate to the bank loan but senior to the sponsor equity.
Due Diligence
Deal
I initially broke my deal diligence into 3 parts; the local market, the financial projections, and the deal structure.
Things I liked about the local market include; a growing neighborhood, 90+% apartment occupancy rates and continued rent growth. My concerns regarding the local market were the incredibly low cap rates (4.5-4.75%) and regulatory restrictions. The property was required offer a fixed number of rent controlled units which would limit the ability to raise rents in the future.
Things I liked about the projected financials include; that purchase price and projected rents were in line with comparable properties in the area and the valuation of the stabilized building was calculated using a capitalization rate that was higher than the current cap rate. I was concerned by my inability to effectively analyze the construction cost estimates or if the construction schedule was actually feasible.
The deal structure itself was also something that I liked about the deal. Having a preferred position on the capitalization table to the sponsor meant that I would have to get paid off before the sponsor would receive any return on investment. Also, my projected exit opportunity was a refinance rather than a sale. Freddie Mac commercial loans require a minimum of 25% equity to refinance which was significantly lower than our projected 40% equity position after renovations. This provides about 15% cushion in the event the sponsor overestimated the valuation of the stabilized property. The sponsor had a $2.3 million equity position and long-term plans to hold the property, so they are incentivized to meet their NOI projections. My biggest risks based on deal structure would be inability to the sponsor to refinance out of the deal at the end our 2-year investment term or any major setbacks that would delay completion of the project.
The Sponsor
The sponsor had a professional looking website with multiple examples of current and past deals in the DC metro area. After looking at the website, I used LinkedIn and Google to learn about key personnel and looking for history of lawsuits or bankruptcy. I also used Google Maps to verify the physical location of the business address. After passing my internet screen, I called the company to verify that phone number listed was active. I also called again to ask about some of their "current" projects to make sure they were in fact active. My impression after my diligence was that sponsor seemed legitimate and had history of operating in the same market as my potential investment. My biggest concern at this point was that this deal was larger than their typical deal but I was reassured that they had made a $2.3 million bet on themselves. After performing my due diligence, I was comfortable investing with the sponsor.
The Platform
I initially came across the crowdfunding platform after a friend of mine told me he had participated in and successfully exited an investment on the platform within the past 12 months. After reviewing the platform website, I again used Google and LinkedIn to investigate key personnel. I also used Bigger Pockets investor forums to get more investor reviews on the platform. After finding no obvious red flags, I began reviewing individual investment opportunities. As part of diligence, I called, emailed, and chatted with platform investor support staff. If they couldn't answer one of my questions, they would reach out to the sponsor and get back to me in a timely manner. They also seemed to have steady deal flow with 1-2 new investments being posted on the website each week. My biggest concern at this point was their short operating history of 2 years. However, my overall impression was that platform seemed legitimate and I felt that my exposure to their ongoing operation risk was limited by short investment term and minimal responsibilities once the deal closed. After performing my diligence, I was comfortable making an investment on the platform.
The Investment Decision
After performing my diligence, I felt like I had a good grasp of the deal specific risks and thought there was sufficient upside to put my money at risk. However, I was still not comfortable writing a large check to an online investment platform with less than a 2-year operating history. After discussing the deal with a friend of mine, we decided to split a share, and each contribute half of the investment capital. That way we'd have some experience with the platform and would hopefully be more comfortable making future investments.
After Writing the Check
The deal closed as expected and we received our first quarterly distribution as expected. However, shortly after our first distribution, things began to slowly unravel for both the crowdfunding platform and the sponsor. We stopped getting timely updates regarding the project. When we reached out to platform, we were told that it was taking longer to obtain permits than expected, but the sponsor was going to go ahead and start the demolition work, so they could stay on track. The platform also stopped posting new deals on the website. The explanation that we received was that the platform needed to get a Broker/Dealer license to continue operations. However, they planned to resume operations once they were back in compliance. We sent regular emails to the platform trying to maintain a line of communication since they quit updating the website.
Approximately 6 months after our deal closed, we received an email that the founder of our sponsor was murdered while confronting a man who was loitering near one of his other properties.
Two months later, we received another email that the platform was going to cease operations. At this point, we faced the LLC declaring bankruptcy or finding a new manager for the project. Luckily, one of the larger investors was willing to take over management responsibilities for a 1% management fee. We had two weeks to review the new operating agreement then vote whether to hire a new management team or take our chances in the bankruptcy process. After conferring with my co-investor, we decided to vote to hire the new management company. Most shareholders voted in a similar fashion and we hired a new management company to oversee the investment.
Where We Currently Stand (as of 12/1/2017)
The company that took over the management role is trying to get the deal back on track. The failed platform had 18 months of interest in escrow, so we are still current on our quarterly distributions to date and should remain current through April 2018. After depleting the escrow account, we will have had 15% of our initial investment returned. We are also getting monthly investment update emails. They have also reestablished communication with the sponsor. The sponsor is having liquidity and legal issues resulting from the death of the founder. Fortunately for us, the sponsor is a family business, so they are motivated to keep the business operating. They are currently selling off assets to get their business back on track. Our project is still listed as a current project on their website and they are still doing demolition work as of our last update.
At this point, I am hoping for a return of my invested capital. I am glad that I decided to co-invest with a partner because I reduced my potential loss by 50%. Also, because of high preferred dividend, there was sufficient margin to hire a new management company to try and salvage the deal. While I had no way to predict the death of a sponsor and the crowdfunding platform did not disclose their dire financial situation, this experience has improved due diligence process.
I have revised my platform diligence process that I have applied to my subsequent crowdfunding investments. Now when I make crowdfunding investments, I try to make sure that the platform is sufficiently capitalized to operate throughout the duration of my future investments and that they have a plan to close out existing investments if the platforms fails. I also plan to invest to across multiple crowdfunding platforms to reduce my platform specific risk through diversification.
Please use comments to share experiences with other real estate crowdfunding platforms or any lessons you have learned from making crowdfunding investments.