Saturday, February 2, 2013

“Crowdfunding” -- A New Name for an Old and Abused Concept

I’m normally a fan of Bloomberg BusinesWeek, but I found myself baffled by last week’s article, “Crowdfunding for Skyscrapers”, particularly with the idea that this is a revolutionary concept in real estate funding.  Was the writer too young to remember the “syndications” of the 1970s and 1980s, which made general partners richer and limited partners poorer?  Did the writer not notice the TIC (tenants-in-common) scams of last decade and the recent bankruptcies of SCI and DBSI, two of the largest TIC sponsors? ( He even implies that real estate crowdfunding is a concept that originated in – sit down for this one – Colombia, a nation that has given the world so many good ideas.

This concept often changes its name with each new decade as it repeats itself, with the sponsors selling their own properties or unwanted properties to investors, or buying first and then charging a hefty mark-up, all the while charging investors for selling commissions, wholesaling fees, placement fees, reimbursement of offering costs, underwriting fees, and reimbursement of offering and organization expenses. The sponsor is always the winner while investors are usually losers when it comes to "crowdfunding".
It's not the concept of crowdfunding that is the problem, though, so much as the people and the marginal quality of real estate that it attracts.  There is nothing wrong with organizing investors to fund great deals, but crowdfunding, or whatever else you want to call it, often attracts the unscrupulous seeking to exploit the unsophisticated, even if it is just to get rid of their own properties.

The crowdfunding sponsor featured in the BW article, Rodrigo Nino, started his Prodigy Network to sell troubled condo projects, such as Trump SoHo in New York and Sole’in Sunny Isles Beach, Florida.  To his credit, Mr. Nino didn’t cause the problems at these projects, he just solved the problem of selling the condos, something he does very well.  He sells them to foreign investors. And he is an immigrant from Colombia, which makes me suspect that BusinessWeek just let him write his own article.

What's in it for investors in these ventures?  Let’s get some investors to buy condos that Trump can’t sell!” is an investment proposition that does not inspire confidence. It is instead a casting call for suckers.

What was most alarming about this article, though, was the observation that the new JOBS Act “will open new deals to Americans”, as if the Obama Administration is doing our nation a favor in removing SEC (Securities and Exchange Commission) barriers between naïve small investors and fast-talking condo salesmen. 

SEC scrutiny of crowdfunding promotions can already be avoided by making “Private Placements” to “Accredited Investors” of 35 or fewer. An accredited investor self-certifies that he or she has at least $1 million in net worth or an annual income of at least $200,000 ($300,000 for couples). The concept of “accredited investor” has been greatly weakened by time and inflation, though, as in the early 1980s, when these thresholds were established, an accredited investor was meant to be in the top 1% of Americans in terms of wealth and presumed sophistication. Today, this category covers about the top 7%, and many accredited investors are ordinary professionals, widows or heirs who are not financially sophisticated. To counteract this weakening of the definition of "accredited investor", the SEC has now eliminated home equity in the computation of net worth.  Nevertheless, this whole system relies upon investors certifying that they meet the definition of an accredited investor and understanding the change in the definition.

As a Certified Fraud Examiner, I have been approached before by groups of aggrieved “accredited investors” who lost most of their money to TIC promoters.  All who I met were senior citizens, and these were people who were counting on a secure retirement after an honest life’s work as, for example, a geologist, a radio engineer, and even a handyman. The DBSI and SCI bankruptcies alone (after the sponsors had received ill-gotten gains) wreaked financial havoc on 22,000 such investors, and the media has ignored the massive predation of the real estate investment industry on unsophisticated senior citizens. 

My neighbor, for instance, invested in the SCI Mezzanine Fund, in which investors paid for the privilege to lend SCI money, unsecured, rather than the usual protocol of the borrower (SCI) paying fees to borrow money from lenders.  His $87,000 investment has disappeared now in the SCI bankruptcy.  We watched the well-tailored SCI co-founder Marc Paul squirm in the bankruptcy court hot seat as he explained how he lost his home as the result of the bankruptcy.  He currently lives in a 4000 square foot Beverly Hills mansion (9661 Wendover Drive) that he deeded, not really "lost", to his children. What suffering he must be going through. Meanwhile, the SCI trustees are now suing my neighbor and his fellow investors for "performance fees" that are somehow owed to these TIC sponsors.

Thanks to the JOBS Act, though, the real estate investment industry will be able to find even more suckers with the new ability to use general advertising and general solicitation to attract accredited investors. Final SEC rules have not been issued yet.
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