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McNellis: Marching Into Madness?

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John McNellis Partners Palo Alto Bay Area RealtyMogul.com crowdfunding commercial real estate prediction market analysis San Francisco
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By John McNellis

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“Cocaine’s for horses, it ain’t for men
They say it’ll kill you, but they won’t say when” Cocaine Blues
When it comes to business cycles, predicting when is the great temptation, one that pundits—for fear of being spun off the publicity carousel—seldom resist. But let’s withstand that impulse and also ignore national politics and the stock market’s all-time high. Let’s pretend instead we’re meteorologists searching the skies for cirrus clouds—what the Brits call mares’ tails—the wispy clouds that presage a gathering storm.

While financial mares’ tails come in fifty shades of greed, they often involve the promises of ever higher yields from carnival barkers trying to get the last suckers into the tent. Rather than scan the whole sky, let’s focus on a tiny but rapidly growing segment of commercial real estate, Crowd Funded Real Estate (CFRE), a grouping that could well prove a bellwether for the entire industry.

The still awkward progeny of tech and real estate finance, CFRE is quickly coming of age. When we examined this nascent field several years ago, it was in its infancy. Different CFRE start-ups were taking varying approaches to the business, some—the more enlightened perhaps—charging a small fee to act as platforms connecting money and deals. This version of CFRE likes to think of itself as a mere conduit, sponsoring neither the real estate deal nor its promoters (aside from the implicit yet inescapable endorsement of listing the deal on its platform). We thought this pipeline approach the more sustainable in the long run (reference earlier articles). Swinging for the longer ball, other CFRE’s chose to act as deal sponsors, aggregating their numerous clients’ small investments into a controlling interest in deals the CFRE’s themselves co-sponsored. Thus, the classic money partner, these CFRE’s are in bed with their promoters and, like other professionals in that horizontal position, charging large fees for the effort.

Two years ago, we questioned whether combining inexperienced underwriters (youthful CFRE staffs), naïve investors and real estate promoters in need of new sources of capital (i.e. they either lack the qualifications to raise money traditionally or have burned those traditional sources) might prove problematic. Whether such a combination might not be an ideal breeding ground—the financial equivalent of standing water in June—for that most ancient of real estate’s woes: fraud. The question remains. Before you ponder it yourself, recall that the most notorious swindler of our time—Bernie Madoff—scammed his billions by promising investors a relatively paltry 12 percent annual return.

At least a smattering of CFRE is turning Bernie into a piker. A Jacksonville Florida company recently sent out an on-line offering with this headline: “IHT Realty Crowdfunding Offers Record High 28 Percent Yield Investment Opportunity.” When an internet company offers you more than a passbook savings rate, you should remember those wealthy Nigerian princes somehow in need of a short-term loan. IHT may be an honest company and its 28 percent offering may be gilt-edged. Leaving that for others to decide, l will simply point out that financial promises tend to become increasingly outlandish as we near 2 a.m. Madoff’s penthouse of cards collapsed at the outset of the Great Recession, the moment his investors’ panicked desperation for safety finally offset their greed.

Other CFRE companies are promising less staggering yields but doing their best to mine the last dollar from inexperienced investors of modest means, the people who invariably jump on the money train at its penultimate stop. In a recent press release, RealtyMogul.com, a CFRE of the financial partner model, touted a couple of its loans yielding 10 and 10.5 percent. To an unsophisticated investor, this may sound like the best deal since night baseball. Anyone who knows her way around real estate finance will have a different opinion—she will know you get what you pay for, that highly secure real estate loans yield less than half as much and that a 10 percent interest rate can only mean one thing, the underlying security for these loans—whether the real estate or its promoters—is likely to be distinctly second-tier.

To sell these investments, RealtyMogul.com is now accepting investments of as little as $1,000 for its on-line real estate investment trusts. It is taking money from people who should no more be entrusted with analyzing real estate investments than your canary. This, by the way, is one you can’t blame on Trump. The Obama administration, in a soft-brained effort to democratize investing in real estate—that is, granting nearly everyone the opportunity to pour money into highly illiquid and complex investments—had the SEC loosen the investor minimum net worth and income standards.

RealtyMogul.com may be a swell company. Hell, it may be the most reputable company in America, but its underlying premise—that $1,000 investors (or $100,000 investors for that matter) can successfully underwrite complicated real estate deals by reviewing materials on the internet—is not only wrong, but bound to have unpleasant consequences.

The old saw about John D. Rockefeller selling his entire stock portfolio when he overheard a shoe shine boy giving stock tips is probably apocryphal, but like most fables, it has a point. When its doors are flung wide open, the party’s over.

John E. McNellis is a Principal at McNellis Partners in Palo Alto, Calif.

Articles published in our Contributor section do not necessarily represent the views of The Registry or Mighty Dot Media, Inc. They represent a selection of topics chosen for the value of their editorial perspective. We welcome feedback and alternative positions on topics, and we will consider publishing those, as well.

mcnellis-book-coverTo read more from McNellis, please consider his book Making It in Real Estate: Starting Out as a Developer.