The Definitive Guide to Real Estate Crowdfunding

Can crowdfunding transform the real estate industry?

Source: http://therealnovator.com/definitive-gide-real-estate-crowdfunding-part-1-2/

I’ve been meaning to cover real estate crowdfunding for a while now as it’s one of the trends in real estate/tech which piques my interest the most.

Setting aside the potential of broader crowdfunding (a global game changer) for now, some believe that crowdfud investing in real estate can revolutionize the real estate capital markets, and become its own separate asset class. Others think it’s just a novelty, or at the very least will be relegated to only smaller projects. I personally think it will eventually be transformative to the industry, along the lines of REITs — which themselves took decades to evolve to a game changer themselves.

What is Crowdfunding?

Crowdfunding is the collection of finance to sustain an initiative from a large pool of backers—the “crowd”—usually made online by means of a web platform. Either for a nonprofit, political, philanthropic, commercial or financing campaign. [Wikipedia].

Using mostly social networks and the viral nature of web-based communication, individuals and companies have raised billions of dollars in debt, equity, and donations for projects over the past five years.

The Business Models

The two main categories of crowdfunding are donation crowdfunding, raising non-equity capital rather than the sale of securities, sometimes in exchange for early access to a product or service, and crowdfund investing which is raising capital by selling financial instruments related to the company’s assets and/or financial performance. In both cases many investors make relatively small investments, filling the funding gap prior to mainstream financing (angel, VC, PE).

Crowdfunding as we’ve seen it used in real estate primarily comprises financing campaigns, or crowdfund investing (debt & equity), sometimes having an additional reward or community impact layer atop.

Breaking Down The Types of Crowds

Where Does Legislation Stand?

Donation based crowdfunding which is using the likes of Indiegogo, Kickstarter, Rockethub, GoFundMe, etc. to raise non-equity capital for projects or pledges started in 2009.

Crowdfund investing was kick started by the Jumpstart Our Business Startups Act (the “JOBS Act”), which is a law intended to encourage funding of US small business by easing various securities regulations, and was signed into law on April 5, 2012.

Title II of The JOBS Act, one of two of the most important pieces to much of crowdfund investing, went into effect on September 23, 2013. It lifted the General Solicitation Ban, allowing entrepreneurs to advertise their fundraising initiatives across almost every medium — though limited to accredited investors. This is one particular rule I always thought was very grey and counterintuitive since my days working in investment banking. It stated you could not raise money from anyone with whom you did not have a substantial pre-existing relationship.

Under Title III of the JOBS Act, so-called defined unaccredited investors (the other “99%”) will be able to invest in private companies as well.

But…

The SEC has blown through numerous deadlines and has yet to publish the final rules; hence unaccredited investors cannot yet participate today.

We do know that the average Joe investor will be able to invest up to a certain amount based on net income or worth thresholds. What’s not clear yet, and why some are saying Title III will not fully work for most formats is that the SEC is trying to achieve a balancing act in which a balance may just not be completely possible. The SEC has been tasked to create a crowdfunding rule book that accomplishes the following three things:

1) Provides an easy, low-cost way for startups to raise money online

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2) Protects investors from new forms of fraud

• This can probably be accomplished by having the proper systems and controls in place at the portal level, which would further build trust into the portals and companies listed on them. Paul Nieder shared a great list of ideas here
• The question is, can these systems be implemented and operated in a cost effective manner?

3) Creates incentives for financial firms to run crowdfunding websites and for businesses to raise money on them

• This I think is the big stickler. The very likely possibility that Title III crowdfunding will be cost-prohibitive for portals and companies
• The relatively small offerings that could take place on a Title III crowdfunding site are unlikely to generate enough fees to make it worthwhile to operate a public portal, especially against the potential fixed regulatory cost associated with each offering
• The proposed SEC rules consider crowdfunding portals “issuers,” and that means that the portals are held liable for the entrepreneurs raising money on their sites. The combined regulatory and liability risks are far too great under current proposed regulations to expect a vibrant funding portal marketplace. At the same time, portals are not allowed to give “investment advice”, which translates to: “portals can’t curate offerings by means of selections/rejections or rankings”
• Additionally, under the SEC’s proposed rules for Title III, companies must disclose a myriad of financial, tax and employee information that most startups would prefer to keep under wraps at a very early and delicate stage; deterring many companies who may not want to pursue crowdfund investing in fear of compromising trade secrets and business strategy

So as far as Title III goes, we’re in a “catch-22”. In order to achieve the appropriate balance of creating a usable crowdfunding model for small businesses while providing adequate protections for investors, the SEC may place significant liabilities on the funding portals — and without portals there is now crowdfunding.

If the law does prove unworkable, that doesn’t mean the end to crowdfund investing though. Instead, we may come to the realization that the crowdfunding revolution is already here.

There are also US states and other countries considering or passing their own crowdfunding legislation to beat the Fed to the punch.

Why real estate has a leg up on other crowdfund investment classes at the moment

• High net worth investors have had direct real estate investments in their portfolios since real estate’s been around. Conversely, only about 3% of the top 1% of America invests in startups or early stage ventures.
• Real estate is a tangible asset that doesn’t require a particular academic degree or industry experience to grasp. The key is getting those same investors in real estate comfortable with these online formats.
• Direct real estate investments, though possessing their own set of risks, don’t experience nearly the amount of risks that your average tech startup does. In fact, real estate operating startups trump every other industry in survival rate statistics:

So even if Title III were to falter, Title II gives niche real estate portals who are operating today plenty of runway.

Evolution of Commercial Real Estate Finance Leading to Crowdfunding

• 1970’s — The Start of the Modern Commercial Real Estate Market
• New class of entrepreneurs with access to private capital emerged The first publicly owned funds dedicated to real estate came into being Real estate syndicators increasingly began developing sophisticated vehicles for financing
• 1980’s — ERTA, S&Ls and Real Estate Limited Partnerships
• Recessions & rate spikes led to formation of Economic Recovery Tax Act of 1981 (ERTA) Real estate limited partnerships, taking advantage of ERTA provisions, increased rapidly in size and number More and more, real estate activity moved from the hands of individual entrepreneurs and onto the books of institutional investors S&L industry swelled, underwriting standards loosened, and uncertainty about the underlying value of real estate assets permeated (ring a bell?) Congress enacted The Tax Reform Act of 1986 which among other things, repealed tax benefits of ERTA and stopped real estate syndicators in their tracks Hundreds of S&L and other thrifts along with local banks shuttered leading to the creation of a government-run entity known as the Resolution Trust Corporation (RTC) to take control of assets from failed institutions, asset manage and eventually sell off all these loans and properties back to the private sector
• 1990’s — Institutionalization of Real Estate Investments
• Massive amounts of capital was pooled by large financial companies to acquire asset pools being sold by RTC REITs took off, with more than 150 being launched between 1992 and 1997 Securitized debt found a new market through the creation of commercial mortgage-backed securities (CMBS)
• 2000’s — What Goes up Must Come Down
• Optimism and renewed confidence spread like wild fire Real estate prices seemed fixed and to be “only going up”. Some acknowledged the excessive growth, but put it down to “overpricing” rather than “overbuilding.” By 2006, the CMBS market had grown to nearly $550 billion, REITs had a combined market cap of over $430 billion, and private investors and closed-end private equity funds had $161 billion under management Financial crisis, Great Recession, etc.
• 2010’s — The Age of the Crowd
• Following the advent of popular and successful information crowdsourcing concepts like Wikipedia and Reddit in the early to mid-2000’s, and donation based crowdfunding concepts in the late 2000’s, The JOBS Act clears the way for crowdfund investing Right around enactment of The JOBS Act, real estate crowdfunding platforms begin to emerge, dedicated to aggregating capital from accredited investors for individual real estate projects. Present

Where Does Crowdfunding Fit In Real Estate?

Just as crowdfund investing in startups is filling a funding gap in a company’s life cycle:

Crowdfund investing in real estate is filling a funding gap in a project’s capital stack

It should be noted that while crowdfund investing is truly filling a liquidity gap in the startup financing market, crowdfund investing in real estate seems to be more of a supplemental financing to in-place sponsor/operator equity at the moment. Whether it will become a truly alternative form of equity capital OR remain supplemental with its intended use more as leverage is yet to be seen.

Also, when it comes to the Title III based unaccredited crowd, unless the $1 million limit is increased (perhaps specifically for real estate which possesses less risk and is generally more capital intensive than a startup), unaccredited investor crowdfunding may remain limited to smaller scale projects like single family residential fix-and-flips rather than large scale commercial projects.

Some companies have pursued more complex and expensive routes to tap unaccredited investor capital through IPOs, examples being the owners of the Empire State Building and recently ETRE Financial.

Then there’s Fundrise, who’s taking advantage of the little used Regulation A, which lets you do public offerings under $5 million — meaning they’re already tapping both the accredited and unaccredited crowd. Using Reg A some crowdfunders may also be able to get around funding size limits by tranching their deals; breaking rounds into equity and mezzanine pieces.

Existing Capital Aggregation Vehicles vs. Crowdfunding

• REITs: Though investing in a publicly traded REIT will give you exposure to real estate, REITs are more akin to stocks and are subject to the same conditions that can cause stock prices to gain and lose value. Whilst REITs have a lower entry cost, higher liquidity and require no active management of the underlying real estate, they offer less control and tax and leverage advantages than direct real estate investment.
• Private Equity Fund Vehicles: An investment in a private fund vehicle, much like a REIT, provides the investor with no control in the investment decisions made by the managers of the vehicle. Fundraising is collected on a “blind pool” basis and on the merits of the manager’s brand, track record, strategy, credentials, and investment objectives, rather than the actual underlying investment.
• Syndications: Syndications, like private fund vehicles, are instances wherein a sponsor/operator takes passive investment commitments from investors, but rather than towards a “blind pool”, commitments are directed at a particular project. This form of capital aggregation and allocation most closely resembles today’s online real estate crowdfund investment schemes. Crowdfunding portals have just optimized the process by use of technology, and have harnessed the power of the “crowd” to overcome one of syndication’s main limitation: time to action.

Obstacles On The Horizon

The real estate crowdfunding industry right now is very fragile because it is so new. Portals must make it a priority to properly vet all projects and sponsors, as one deal gone bad can be detrimental to the entire industry. On the project side this involves having seasoned investment professionals examining leases, title, finances, operations, etc., and running background and reference checks on sponsors/operators.

As mentioned in Part 1 of this post, Title III of The JOBS Act in its current form would place hefty financial reporting and accounting burden on crowdfunding portals. The proposed financial auditing regulations could cost between $20,000 and $30,000 according to Jilliene Helman. So until the SEC concludes its rulings on Title III, we won’t know what the prospects of crowdfund investing in real estate for the unaccredited crowd will look like.

How Big is the Market?

In terms of the market size, real estate is clearly a huge sector, worth an estimated $11 trillion in commercial real estate alone. $400 billion change hands every year. According to stats collected by Realty Mogul, over the four-year period from 2009 to 2012, aggregate capital raised for real estate private placements accounted for $63 billion, excluding capital raised under private-equity and hedge-fund indicators. During the same time period, there were 5,617 separate Reg D offerings for real estate, 1,900 separate offerings in 2012 alone, and the median offering size for real estate offerings was $2.3 million, while the average was $15 million.

So can crowdfunding for real estate become a billion dollar industry? Certainly. After 5 years of operation Lending Club is already doing $1 billion in loan originations a year, and Propser is close behind. Real estate is obviously a much larger asset class than consumer loans, though not as fragmented. To say the least, there’s huge potential here.

Today’s Real Estate Crowdfunding Arena

http://therealnovator.com/definitive-guide-real-estate-crowdfunding-part-2-2/

Who Will Come Out On Top?

Intense competition between the portals is underway for a finite amount of investors’ dollars and best of breed sponsors/operators. While many crowdfunding portals have popped up and are riding this recent wave of popularity, only the best will survive — in fact some have already shuttered after operating for several months.

I believe trends in real estate crowdfunding will track similar to the peer-to-peer industry (and most online marketplaces for that matter) where a few key players emerge to dominate the broad market, as LendingClub and Propser did. Others may succeed by focusing on verticalized and niche opportunities (geographies? property types? etc.).

Venture capitalists have also already begun to make their bets. In this article, Hrach Simonian, a principal at Canaan Partners states that beyond proven track record, he believes strongly in a model of a full service and highly curated solution as opposed to companies that are just creating online portals on a “white-label” basis for a technology licensing fee, allowing sponsors and operators to pick up the technology and run with it to fund their own deals. I wonder how scalable a full service model is though.

Other factors I think will dictate success include strong & scalable technology (managing investments and distributions for 1000’s of investors is no easy task), industry experienced management (in underwriting, property management, fund/capital administration, compliance, etc. — startup portals like AngeList Syndicates and Syndicate Room operate on this same concept of industry professional run portals in the startup world), strong branding and customer engagement, and perhaps even ancillary profit centers that can buoy the portals during a down market.