By Stacy Stack-Rudolph
The importance of understanding the borrower is one of the five pillars of commercial real estate underwriting. Underwriting the borrower is about knowing where to look and sniffing out the stinkers. This particularly the case in crowdfunding, which is the latest form of syndication.
Crowdfunding syndicators aggregate capital investments from individual investors and contributes this larger investment as equity within an individual asset. At first glance, this seemingly innocuous nondescript LLC blends into the entities within the organizational chart, with a managing member and a distinct warm-bodied principal leading the charge of management of the asset. However, digging slightly beneath the surface can reveal the real time-bombs. It is crucial for the lender to understand the major risks.
RETURN is the goal of the crowdfunding entity. The crowdfunding entity has a designated time horizon that may fit with the stated and preferred time horizon of the real estate business plan and the initial duration of the loan. Anything else and the interests of the lender and sponsor may be at odds with the crowdfunding entity. It’s important to do the following:
- Confirm whether the term of the loan matches the term of the crowdfunding vehicle. A mismatch can lead to a forced asset sale and/or a drain of any managing member liquidity in the case of a forced asset sale and/or equity position purchase.
- Understand the return timing of the fund and the promote structure. At a minimum, the goal of the crowdfunding entity is to achieve the return promised over the life of the fund, not maintain the asset to retain tenants or facilitate an easy takeout.
CONTROL is the key to the plan of the crowdfunding entity. The managing member may be the face, but the crowdfunding entity has their finger on the trigger. The operating agreement has triggers built into the areas of risk that shift control from the lender and sponsor to the crowdfunding vehicle. It’s important to remember two things.
- Minor decisions can harm in a major way – Budgets are approved annually by the crowdfunding entity. Remember the goals above? A budget is no longer about the property, but instead about the achievement of returns.
- Disagreements lead to disarray – When harmony is not heard, fists start flying. Forced sale provisions, force position purchase and general disarray of focus on everything but property performance.
DILUTION is a don’t where the crowdfunding entity is concerned. Emphasizing the goal misalignment of the crowdfunding entity and the lender/sponsor, the operating agreement rarely allows the sponsor the ability to contribute and recapture additional equity infusions. It’s important to remember this:
- Crowdfunding can be a platform for anyone, with pay to play for as little as $5,000. Often these investors are not real estate savvy and not accredited investors. This can vary by platform and fund raising within the platform.
- Assuming the property stumbles, the Sponsor has no financial incentive to infuse rescue capital into the asset. If infused the funds move to the end of the line with regards to preference of returns, certainly without interest or promote, if received at all.
The entity is a nondescript LLC on an org chart that has slipped thru lender controls. A compilation of small investors, each less than 10-20%, fall below the KYC requirement. Thorough diligence, awareness and proper structuring within the operating agreement and structure of the loan is crucial. With these protection in place these vehicles can be good equity contributors. It is crucial for the lender to understand and mitigate against the risks as it is the devil in the details that may destroy the deal.