Crowdfunding in Real Estate: Disruption or Evolution?
Featuring commentary by Bonnie Burgett
By Brian Vargo, M.Des Real Estate and Built Environment ‘15
Crowdfunding is a buzzword. The term coins an innovative method of financing, but also the basis of popularizing a product at its conceptual stage to enable its delivery. For the first time, the idea is relevant to urban development. Crowdfunded real estate has finally come to legitimacy, and it can now be studied for what it delivers rather than what it promises. Is this the beginning of a disruptive mechanism that will ‘democratize’ the built environment?
1876 saw the greatest feat of civic ‘crowdfunding’ to date. A gift from France to celebrate the United States’ centennial year, the Statue of Liberty lacked an essential element: a base on which to rest. The politician Joseph Pulitzer (of Pulitzer Prize fame) embarked on a visionary campaign using news media to raise funds publicly. The owner of a newspaper, The New York World, Pulitzer used his widespread circulation to solicit funds. Within a five month campaign, Pulitzer raised the $100,000 necessary to complete the base (over $2,000,000 today when adjusted for inflation). The campaign was funded by 160,000 donations, of which 75% were less than a dollar. Crowdfunding was born with an icon of a democratized built environment.
Now, “crowdfunding” is a buzzword widely credited for its innovative value, despite its historic roots. While the central principles of Pulitzer’s crowdfunding — raising money through a public network — still resonate, the term’s impact has grown exponentially in recent years. Rough estimates project that from 2009 to 2014, the worldwide funding volume of crowdfunding platforms grew from $500 million to $10 billion. The crowdfunding mantra spreads from one industry to the next, spanning from donation-based endeavors (e.g. Kickstarter) to peer-to-peer lending mediums (e.g. Lending Club) and other investment platforms.
As it typically does, the real estate industry lags behind others in adopting this new technology. By March of 2014, Kickstarter alone had reached the $1 billion threshold with over 57,000 projects funded. By comparison, the sum of online crowdfunding for real estate hovered near the $100 million mark. The reason for crowdfunded real estate’s slow growth is sometimes understated. As Kickstarter and other “reward-based” platforms solicit donations, a physical or financial return is not guaranteed. Those platforms offer a “reward,” which often translates to a physical product made possible by the funding raised from the campaign. However, even if the project is fully funded, there is no guarantee of delivery. Either way, the platform takes a fee (roughly 5%) of the funds raised. Raising funds for an equity or debt position in a project is much more difficult because it is tantamount to the public sale of a security. Crowdfunding investment involves a smattering of securities laws, requiring a lengthy and prohibitively costly registration process with the Securities and Exchange Commission (SEC).
The 2012 Jumpstart Our Business Startups (JOBS) Act aimed to remedy the inefficiencies of that process by legitimizing equity-based, investment-grade crowdfunding. A landmark piece of legislation, the JOBS Act promised to create new avenues for raising funds that balanced the needs for speed and efficiency in crowdfunding with the SEC’s chief responsibility of protecting consumers from fraud.
For real estate, many thought that the JOBS Act would offer increased access to investment opportunities, ultimately widening the base of capital available to fund real estate transactions. The traditionally labyrinthine process of real estate syndication could be superseded by reaching directly to a boundless pool of investors through the internet. For investors and sponsors alike, crowdfunding meant no longer relying on a middleman to idiosyncratically fund a real estate transaction. Rather than remaining subject to a handful of institutions or wealthy tycoons, the built environment could take shape with the input of hundreds or thousands of investors per project, each contributing a small share. Many hailed crowdfunding’s democratizing impact on real estate development. Upon signing the JOBS Act among bipartisan support in April of 2012, President Obama summarized this hopeful outlook:
“Right now, you can only turn to a limited group of investors — including banks and wealthy individuals — to get funding… Because of this bill, start-ups and small business will now have access to a big, new pool of potential investors — namely, the American people. For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in.”
With those lofty aspirations, crowdfunding for equity in real estate transactions was born. Since then, the industry has established a short track record. Crowdfunding for real estate can now be judged on what it is rather than what it promised. Is crowdfunding the innovative mechanism of financing real estate as imagined? Has it democratized the built environment?
A Legal Primer
By far the greatest obstacle to crowdfunding for real estate is the SEC. While the JOBS Act promised swift change, only three elements of its seven point agenda are actually implemented after three years of its passing. Although the democratically elected congress created the JOBS Acts, the appointed leadership of the SEC actually translates the legislation into law. The process of translating political language to legal mechanisms is typically fraught with lengthy periods of internal development, public comments, and an arduous finalization process. The JOBS Act is particularly slow. While the final rules were first due from the SEC in December 2012, it took until September of 2013 to finalize only the first major component (Title II). Key components have been delayed several times, and the finalization of rules for the more significant Title III and Title IV are now expected in late 2015.
This exceptionally lengthy process is not without merit. The SEC’s chief goal is to protect investors in the public domain from fraud. At issue is an existential rift between that mission and the implications of crowdfunding. For crowdfunding to succeed, the process requires public advertisement, a fast pace, and a wide reach. In its battle against fraudulent brokers, the SEC takes an opposite approach, generally banning public advertisement, subjecting offerings to a lengthy registration process, and deferring to state laws in addition to its own requirements.
In the eyes of the SEC, crowdfunding real estate translates to the public sale of securities — a potentially hazardous practice necessitating myriad protective measures. Omnipotent among these measures is the Securities Act of 1933. Now eight decades old, the act still governs the process of issuing new securities to protect buyers from fraud. The Securities Act first requires that issuers register public offerings with the SEC, a process that involves a thorough analysis of the company’s financial records and the disclosure of detailed information regarding the company’s management. Public registration takes several months (if not years) and can be drastically cost-prohibitive for small and medium scale capital formation.
The Securities Act also specifically bars the practice of advertising a specific security to the public. Bear in mind that the Act was penned in the 1930’s, when hawkish brokers first garnered a reputation for swindling the unwary public out of their savings over the telephone, promising unreasonable returns on junk assets while still collecting a brokerage fee on the transaction. In response, the SEC explicitly bans public offerings from general solicitation, meaning that an investor must first have an established relationship with the issuer of a security before the issuer can make any mention of the security itself.
The SEC also defers to state laws (termed “Blue Sky Laws”) governing the sale of securities in that state. Even offerings that may be exempt under federal law may still be subject to registration at the state level. As the conditions for registration vary from state to state, selling securities on a national level can translate to fifty more regulators beyond the SEC. This presents a costly barrier to implementing the high volume and frequency of offerings envisioned by crowdfunding platforms.
Given the concerns of the SEC and their lethargic implementation of the bulk of the JOBS Act, how has crowdfunding already emerged as a legitimate means of raising capital? By one year after the passage of Title II, 150 sponsors raised over $110 million spread over 190 offerings, despite the fact that the main ‘crowdfunding’ components of the JOBS Act (Title III & IV) have yet to be ratified by the SEC. How then can crowdfunding firms navigate the SEC’s requirements with tenable business models?
Fundrise
In 2010, brothers Ben and Dan Miller sought to answer that very question. The operators of their own real estate development company, the two focused on urban infill projects in the Washington, D.C. area. Their proclivity for creative projects in emerging neighborhoods was at odds with conservative investors and institutions that prioritized conventional applications of capital. In Dan Miller’s words, they came to the idea of crowdfunding circuitously:
“Institutional money is driven by factors relating to their own business model more than the actual deal. So we thought that instead of dealing with institutions, why don’t we go to people locally and invite them to invest with us? You don’t have to explain as much to someone who lives a few blocks away, and their inside knowledge can lead to a higher quality development, better tenancy, better architecture, etc. which ultimately translates to a better practice of real estate.”
With those aspirations, Fundrise targeted a derelict property on the H Street Corridor of D.C., an area ripe for urban revitalization. They envisioned that the 5,000 square foot warehouse could become a vibrant marketplace for local vendors, anchored by two neighborhood eateries. Specifically, they imagined that locals would also see the potential of co-investing in the project’s development through the company’s website. At the time, their idea was completely untried and at direct odds with the prevailing SEC ideology. However, while the Securities Act generally forbids the direct solicitation of an unregistered offering to the public, there are a few finely tuned exemptions. Although not designed for crowdfunded real estate, Fundrise pioneered the use of one of those exemptions, Regulation A, to implement their vision.
Regulation A of the Securities Act exempts particular offerings from fully registering with the SEC from their onset, subject to additional criteria. The SEC limits the offering size to $5 million for any 12-month period, and does not preempt state securities law, effectively requiring that the issuer register an offering in each state in which it wishes to sell that security. Also known as a “mini public offering,” the exemption permits a “test the waters” route to determine whether the market interest is sufficient to warrant the expense and time commitment of registration with the SEC. However, under current rules, any “test the waters” activity must cease while the issuer is undergoing the Regulation A qualification process, and the issuer cannot accept subscriptions for its securities until the SEC and each of the states has declared the offering “qualified.” Following such qualification, the issuer may conduct the offering through general solicitation in those states.
It took 18 months of legal work and meetings with the SEC to satisfy those requirements. By 2012, Fundrise officially raised $325,000 online to facilitate their first offering. The platform offered 3,250 shares with a minimum investment of $100, and the average investment hovered near $2,000. The offering advertised an expected 8.4% return to investors and the property is currently making distributions. From the point of its launch, 1351 H Street proved that the crowdfunding model held water.
“People from all around the country started reaching out to us, asking to be able to use the software. That is when we switched from being our own real estate development company to a platform that brings capital to other sponsors.” (Dan Miller)
Fundrise soon shifted from a technology-powered real estate company to a company specializing in the technology itself. The public profile of crowdfunding offered a greater insight into the built environment. The Millers argued that this would fundamentally shift the way the built environment takes shape.
“To improve the asset, you have to change the source of capital and how the building process works. Crowdfunding is not just about an x% yield, it’s about providing more outlets to invest and having that capital change things. Crowdfunding will change what gets built: better architecture, better streetscape design, local tenancy or more public uses, etc.” (Dan Miller)
Perhaps Fundrise marks the incarnation of the idea that crowdfunding would “democratize” real estate, but its beginnings lead to broader questions regarding the feasibility of crowdfunding at a large scale. The legal fees alone for H Street amounted to $800,000. The lengthy review process for SEC “pre-registration” required by Regulation A is a deterrent for sponsors and investors alike. Real estate acquisitions are undoubtedly dependent on speed and the ready availability of capital, making the time-consuming SEC review process far too costly when compared to traditional means of financing. Moreover, investors should rightfully expect interest bearing on their principle investment from the time of their promised contribution, not many months after the fact when the sponsor is first able to use the funds.
Fundrise now pre-funds qualified deals to alleviate that problem. If the crowd does not fully fund the offering, the firm maintains its own equity in the deal, and in any case, sponsors have immediate access to funds from the beginning. This is also advantageous for investors, who earn interest on applicable offerings when their investment is “bought” from Fundrise, regardless of the project’s individual timeline. Investors do not transact on the actual real estate asset, but instead purchase a “Project Payment Dependent Note,” a document that verifies distributions from Fundrise contingent on the performance of the offering.
Since 2012, Fundrise has acted as a service provider to like-minded real estate development companies. It offers a range of capital structures, including common equity, preferred equity, mezzanine debt, and senior secured debt, under the principle that crowdfunding can flexibly adapt to meet a sponsor’s demand:
“This is a curated, vetted network of real estate companies from around the country that comes onto the platform to build projects, build a brand, raise capital, and connect with investors. We will help guide them on the rules for capital, the different financial structures, and the opportunities offered by crowdfunding for real estate.” (Dan Miller)
Since the iconic H Street redevelopment, Fundrise has expanded its domain to either compete directly with and/or complement conventional capital. Fundrise recently announced an offering in 3 World Trade Center for $2,000,000 in partnership with Silverstein Properties. The platform’s laudable $100 minimum investments are now rare, and the typical minimum investment is $5,000. While formed with the intention of democratizing the investment process, Fundrise opened up more far-reaching opportunities for what crowdfunding could do in the process of raising capital. The firm’s evolution highlights an important transition in the space for crowdfunding from ideological to practical, garnering both widespread attention and alternative models to the same end.
RealtyShares
Though RealtyShares is comparable to Fundrise in scale, the platform’s structure entails a unique approach to crowdfunding or marketplace investing. While Fundrise began with the perspective of a development company reaching towards investors, RealtyShares had the vision of a comprehensive investment medium better enabling investors without backgrounds in real estate to access and invest in real estate offerings. Based in San Francisco and founded in mid-2013, RealtyShares positions itself as a financial technology company comparable to other platforms for alternatives investment like Lending Club or Prosper.
“Our investors are not always sophisticated real estate investors. They are trying to find a way to diversify their portfolio and put their money to work to earn a return that is comparable to other investments. As a marketplace, we provide them with access to investments and the data and tools to invest.” (Nav Athwal)
To facilitate that vision, RealtyShares approaches SEC regulations with a concise, scalable strategy to make investing in real estate directly comparable to other modes of online investment. The platform organizes offerings around Regulation D, Rule 506(b), commonly known as the private placement exemption. A component of the 1933 Securities Act and a long-trusted ally of the investment industry, Regulation D Rule 506(b) can exempt an offering from full registration with the SEC, but disallows public advertisement of the security and stipulates extra conditions for its investor base. An investor in a Regulation D offering must be “accredited”, a definition requiring a single income in excess of $200,000, a joint spousal income over $300,000, or the ownership of over $1,000,000 in property (single or spousal), not including a primary residence. This limits Regulation D offerings to roughly 3% of the US population.
However, Regulation D 506(b) offers significant benefits that improve the transactional efficiency of crowdfunded deals. While the offering’s issuer files basic paperwork with the SEC, the Regulation D process is minimally invasive and takes a matter of hours rather than months. Offering sizes are also unlimited under Regulation D, and it allows for exemption from filing separately in accordance with state laws (as in Regulation A). Therefore, while the income requirements for “accredited investors” may be restrictive, the minimal transactional barriers and unlimited investment ceiling make offerings made under Regulation D easy to scale into a mainstream platform. In the eyes of RealtyShares CEO Nav Athwal, that efficiency is essential to facilitating the crowdfunding vision:
“One benefit of crowdfunding is expanded access to compelling real estate offerings, but the second is streamlined investing — something that you can do quickly and more efficiently with an online platform.”
RealtyShares facilitates the streamlined vision with a simple investment product. Rather than encourage a large variety in the type of real estate assets that populate the platform, RealtyShares follows what Athwal describes as a “thesis of simplicity” to meet investor demand. To date, approximately 80% of the platform’s offerings have been residential, single-family homes, although the number of multifamily and industrial projects is also growing as the investor base broadens.
“We follow a thesis of simplicity. As such, we are a residential focused platform. By offering a consistent and easy to understand product, we are able to provide our investors with a simpler investment experience. The more complex your asset gets, the longer you have to spend looking at the underwriting, making sure you understand it. We want investors to make decisions within minutes or hours rather than days or weeks. As our platform matures, there will be plenty of opportunity for expanded product offerings.” (Nav Athwal)
From there, RealtyShares uses its online marketplace to scale and operate across a wide spread of locations and sponsors. The platform targets regions with strong macroeconomic trends (such as rising home prices or high rates of employment or job growth) in selecting the right kind of offerings to pursue. The overlap between keeping a transaction simple and the benefit of easily understood macroeconomic factors resonate with an investor far removed from the physical context or market in which the asset is located. Details of the physical asset, while important to the transaction, are less likely to convince generic investors of an offering’s worth when held against those prevalent factors. Offerings become investment products more than idiosyncratic decisions to partake in the ownership of property.
Offerings made by the platform appeal to passive investors who are interested in the underlying diversification of their investments rather than yields on the outer edge of the risk-spectrum or special interest in boutique real estate development. The platform typically structures offerings as preferred equity, mezzanine equity, or collateralized debt, a strategy that limits the downside of an offering while providing monthly or quarterly distributions to quell investors skeptical of the crowdfunding space. Most of the offerings made have short (6–18 month) to mid-term (2–5 year) maturities to avoid liquidity concerns. When investors partake in an offering, they buy into shares of an individual LLC that in turn holds an equity or debt position in a property. Under this structure, the investor benefits from limited financial exposure while avoiding taxes and other liabilities at the entity level, but also has less control of the actual asset or management of a property.
The RealtyShares approach is comparable to peer-to-peer lending mediums like Lending Club and Prosper. The platform vets the deals and sets the pricing, and investors buy as much into the RealtyShares brand’s worth as they do in the specific deal. Crowdfunding in this sense is about tapping into a breadth of investment opportunities that would otherwise be unattainable without modern technology. Moreover, it connects small to medium scale sponsors with another source of capital. The platform is the direct intermediary or marketplace between the two, curating the process and organizing optimal connections.
RealCrowd
The intermediary role of a crowdfunding platform can take more than one shape. While RealtyShares takes the role of hosting the transaction between parties, RealCrowd lets sponsors and investors connect directly. Begun in 2013 and based in Palo Alto, California, RealCrowd operates as a technology platform that lets real estate companies and investors freely interact:
“We provide a base layer of technology that every real estate company in the country can use to leverage how they raise capital. This is the technology platform that will enable and empower investors. From there, each will adapt. That is how crowdfunding can change this industry.” (Adam Hooper)
RealCrowd CEO Adam Hooper compares the RealCrowd approach to the difference between eBay and opening an online pawnshop. In this analogy, opening a crowdfunding real estate company that operates as an investment manager would be like opening an online pawnshop. It may have a variety of goods and increase its business by incorporating an online function, but the value proposition of that enhanced technology is limited. It is still a traditional operating company with the same limitations of staff, volume, and various operating expenses, so it labors under the same conventional set of rules. Meanwhile, eBay offers a systemic change because it enables buyers and sellers to connect on its platform without taking on the burdens of operating each individual company. Infinite sellers can build their own store in eBay to reach the ideal audience of worldwide buyers. That is only possible through the internet, and it fundamentally changed how commerce works. In Hooper’s eyes, if crowdfunding is to have a similarly disruptive effect on the market for capital, it must employ a comparable approach.
Hooper sees the opportunity of crowdfunding for real estate in both its improved technology and the ability of that system to access entire new pools of offerings that other means of raising capital cannot reach due to their inefficiency. He states:
“We noticed two things time and time again in the profession of real estate investment: First was the incredible inefficiency with which the traditional process of raising capital happens. Everything happens with a one-on-one, analog, brute force approach. Nothing has been done from the technology side to really innovate how that whole process works. Second was the lack of capital in sub-institutional sized properties. Institutions are not going to get involved unless they can put a minimum $10–15 million to work, preferably $25 million or more. We kept seeing high quality real estate deals from institutional quality sponsors requiring $8–10 million in capital that we couldn’t find institutional capital for. This lack of institutional capital relegates those deals to the basic bread and butter syndication model (i.e. friends and family, the country club, road shows, etc…), which is the most inefficient way to raise capital possible.”
Offerings made on the platform range a broad spectrum running from office, retail, industrial, and multifamily assets, but also including mortgage funds, blind-pool funds, and semi-blind-pool funds. In Hooper’s words, the firm follows the simple mandate of “finding the best real estate operating companies and giving them the tools to do their job better.”
The RealCrowd approach is to be as minimally invasive as possible to reduce the transactional costs per offering and maximize the base of offerings facilitated by the platform. For example, rather than orchestrate a separate LLC or coordinate payment notes, RealCrowd offerings are direct ownership stakes in the asset itself, as directed by the sponsor. When investors have questions regarding offerings, they communicate through the platform with a direct connection to the sponsor, rather than RealCrowd acting as a middleman. RealCrowd takes no equity stake in the deals it lists, prioritizing a streamlined, efficient process. The RealCrowd approach is to be the leanest possible mechanism, which makes its role a broadcasting medium for sponsors to reach an expanded investor base. As such, RealCrowd directly advertises its offerings openly to the public. That is only possible given the ratification of Title II of the JOBS Act in September of 2013, which created a new exemption entitled Regulation D Rule 506c. The law has virtually identical requirements to the long-standing 506b exemption, but lifts the ban on general solicitation. For the first time, offerings could be marketed broadly without first establishing a relationship with investors. This is critical for what Hooper considers the most efficient mechanism for crowdfunding real estate transactions. For RealCrowd, that is where the value of “crowdfunding” lies.
The Wildcard?
Many still hope that the pending finalization of the JOBS Act will provide a more direct legal route to crowdfunding. To date, the significance of the JOBS Act is ironic. While it may have sparked the industry into life, the pending implementation of Title III and Title IV still leaves the actual ‘crowdfunding’ element of the Act on the sidelines. Although originally planned for implementation in 2014, the SEC recently further delayed their internal deadline for rulemaking to late 2015. Nevertheless, what sort of impact will the Act’s eventual implementation imply?
Title III of the JOBS Act amends the original 1933 Securities Act to include an actual ‘crowdfunding’ exemption from public registration. Most significantly, Title III loosens the requirement of ‘Accredited Investors’ prerequisite to Regulation D offerings and opens two new avenues for potential investor qualification. For those with an annual income or net worth less than $100,000, the greater of $2,000 or 5% of annual income can be invested every year. For investors with an income or net worth over $100,000, that limit is set to 10% of annual income. A lower threshold for investor participation may be pertinent to expanding the base of potential users of crowdfunding mediums, but Title III also involves more rigorous reporting requirements that limit the efficiency of crowdfunded transactions.
Title III officially interposes a legal intermediary between the investor and security issuer, an element already loosely adopted in practice by existing crowdfunding platforms. However, this would also include a legal definition of a ‘funding portal’ along with far more stringent guidelines for auditing transactions and other considerations. This includes strict limitations on how the platform collects fees:
“A funding portal is defined as a crowdfunding intermediary that does not: (i) offer investment advice or recommendations; (ii) solicit purchases, sales, or offers to buy securities offered or displayed on its website or portal; (iii) compensate employees, agents, or others persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal; (iv) hold, manage, possess, or otherwise handle investor funds or securities; or (v) engage in such other activities as the SEC, by rule, determines appropriate.”
Those requirements are fundamentally restrictive and would make the Title III exemption far more difficult to use than the existing Regulation A and Regulation D exemptions. Title III also imposes a $1,000,000 limit on any offering and installs three tiers of auditing requirements based on the scale of the raise. In addition, investors must wait 30 days after registering with an intermediary to actually invest. Those factors make the process time and cost intensive, regardless of the expanded investor base.
“In their current form, the proposed rules in Title III are unworkable for this industry. Real estate is a capital intensive, quick-to-move asset class, so if you have to wait 30 days before you can actually close on an investor and you can only raise $1,000,000, you are quite limited in what you can do.” (Nav Athwal)
Title IV of the JOBS Act, entitled “Small Company Formation,” is more promising. Nicknamed ‘Regulation A+,’ the title would amend the text of Regulation A to include another rule. This rule would raise the limit for a Regulation A+ offering to $50,000,000 (rather than $5,000,000) and, most significantly, would include a preemption for state registration. Rather than limiting an offering to investors at the state level, Title IV would mean that any SEC qualified offering would be available nationwide. Lastly, Regulation A+ would ‘streamline’ reporting requirements. Any promise to reform the arduously complex preregistration process of Regulation A would be welcome news to the industry, but the vague outline proposed by the SEC has yet to be fully detailed. Title IV would also require ongoing reporting requirements on behalf of the offering, a factor that would complicate the transactional efficiency of those platforms using the new regulation.
While it is unlikely that Title III of the JOBS Act will make a significant impact in crowdfunding real estate, Title IV could still offer benefits. In the meantime, platforms are not counting on the JOBS Act making their jobs much easier:
“I think the ultimate implementation and execution of Title III and Title IV might be a bit cumbersome for real estate. Right now we are pretty content playing in the space provided by the existing regulations.” (Adam Hooper)
The State of Crowdfunding
Given the labyrinthine legal considerations and complexity of building a new market for capital, there is no optimal definition of crowdfunding for real estate. Nor is there any one approach to defining what crowdfunding means for the industry. Nonetheless, for each of the platforms profiled here, growth is ongoing and exponential. Each separately projects at least $100,000,000 in net volume of funds raised in the coming year. Given their current pace, those goals are realistic. These three platforms lead an industry that is swelling rapidly. Rough estimates place the current net volume of investment through crowdfunding platforms to date near $300,000,000, although given their pace, the industry has likely far exceeded that figure by the publication of this issue.
The underlying structure of crowdfunding platforms signifies that three components govern its future growth. The first is the size of the investor base, which is contingent upon both legal and marketplace considerations. Only a small percentage of the populace can currently partake in a crowdfunded offering given SEC policy. Regulation A is logistically burdensome, and only offers investment to those who reside in the state in which the offering is made. Regulation D restricts potential investors to the wealthiest echelon of Americans. Regardless of pending changes made by the JOBS Act, interest in crowdfunding platforms is also contingent on how real estate compares to other mediums of investment that the ‘ordinary investor’ may consider. Moreover, as in any real estate investment, only time will tell if returns broadcast from the onset of an offering come to fruition. In the meantime, a fluctuation in the general performance of real estate may dampen investor demand for crowdfunding services.
Also critical is the growth of sponsor demand for crowdfunded capital. Platforms garner value in how they connect sponsors with a new investor base. Most also argue that their networked efficiency reduces the cost of raising capital when compared to other mediums — particularly for small to medium scale transactions. Nevertheless, demand will also inevitably follow macroeconomic cycles. In the first year of mainstream crowdfunded real estate from 2013–2014, general construction spending grew 7.2% across the US. When the market inevitably contracts, it will test which platforms whether the storm. Moreover, the scale of funds raised via crowdfunding restricts sponsor interest. The median amount raised by most platforms is in the neighborhood of $1 million but rising. Lifting the ceiling for capital powered by crowdfunding will surely attract more sponsors to the space.
Thirdly, lowering the transactional costs associated with each offering is critical to scaling the industry indefinitely. The crowdfunding process still requires legal gymnastics both with the SEC and at the level of the actual asset’s ownership. This is particularly problematic when you consider that crowdfunding implies a high number of investors per offering. Coordinating investors is logistically complex. For true ‘crowdfunding’ to succeed, there must be a net benefit to managing many small investors over a few large ones.
“This platform and this industry will only exist if someone can build the technology that makes it more efficient to manage a bigger pool of smaller investors than what people are currently doing today offline. If you can solve that problem to the point where it is no more work for an operating company to manage 50–75 investors online vs. the 4–5 you manage today offline, this industry will flourish.” (Adam Hooper)
If the investor base expands, sponsor demand grows, and transactional costs fall, crowdfunding will maintain its momentum. Dr. Richard Swart heads the Crowdfunding Research Program at UC Berkley, and contends that the ceiling for crowdfunded real estate still leaves plenty of room for the modern state of the industry. He argues:
“Modern technology can decrease transactional information cost, so in theory crowdfunding platforms can be more efficient at working at a large scale. As people build trust in platforms over time, there will be an explosion of capital. If the industry can both build trust and create efficient mechanisms to attract larger pools of capital, this can be a trillion dollar global industry. We are still very early on. This will start making sense five years from now.”
Disruption or Evolution?
The ongoing growth of crowdfunded real estate is real. Another question entirely is whether crowdfunding delivers what many promised to real estate investment. In the 18 months since September 2013, when the first major component of the JOBS Act passed, it is now time to question whether the ‘innovative’ value of crowdfunding signifies a substantive change for the industry. Are these trends evident of a fundamental disruption in the market for real estate capital or simply the ongoing evolution of long-standing paradigms?
The typical crowdfunding process is essentially a hyper-efficient mode of traditional syndication. Online crowdfunding does not replace the viability of other sources of capital, but it does compete at certain scales. Better technology enables a greater reach for sponsors and investors alike. An online medium makes the practice vastly more time-efficient. In that sense, the crowdfunding process is simply an evolutionary step that builds from improvements in technology.
While some envisioned that crowdfunding could offer a change to the design of buildings, those perpetuated on most platforms are typically commonplace. RealCrowd and RealtyShares, for example, value reliable assets with consistent, predictable trends. Fundrise may be an outlier in that regard, although the vast majority of offerings made by the platform are also conventional assets. Almost no platforms operating in the space will sponsor ground up development given its elevated risk profile. If crowdfunding real estate was meant to invite more discussion to the crafting of the built environment, it has yet to follow through on that promise.
When held against the promise of ‘democratizing’ real estate investment, crowdfunding comes up short. Regardless of regulatory structure, the average minimum investment per platform still hovers at $5,000. The reality of the business model is simple — platforms have little incentive to go any lower. It costs money to increase the number of investors given the increased resources spent relaying information, attracting more participation, and coordinating each transaction. The simplest way to increase the volume of transactions while limiting cost is still to maintain investors with high net worth. While crowdfunding opens real estate investment to the public, not everyone can participate.
Nonetheless, crowdfunding for real estate is real, and its leaders are by every sense of the word innovators. Although the industry is yet undefined by any comprehensive regulatory body, platforms continue to grow. While crowdfunded real estate may not be exactly what was promised in 2012, it is already showing it could be something more.
Commentary by Bonnie Burgett
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Bonnie Burgett is the Co-founder of Collective Capital, a tech-enabled real estate private equity firm recently founded to raise capital via the Internet for deals that have been analyzed and vetted by the company’s proprietary algorithms. She has over 10 years of commercial real estate experience ranging from luxury-branded resort and mixed-use development to the disposition of non-performing CMBS mortgages and foreclosed commercial properties. Her knowledge of the real estate industry, crowdfunding, and technology allows her to seamlessly integrate all components of the business. Bonnie co-authored, “Democratizing Commercial Real Estate Investing: The Impact of the JOBS Act and Crowdfunding on the Commercial Real Estate Market,” which was completed in August 2013, and she has continued to monitor and study the nascent real estate crowdfunding industry. Bonnie holds a BS in Finance from Boston College and a MS in Real Estate Development from MIT.
As Vargo points out, crowdfunding has historically played an important role in the United States, a place where democratization and crowd participation have been an important part of building. From the Statue of Liberty to the Bunker Hill Monument and The Salvation Army’s Red Bucket Campaign at Christmas, myriad examples exist of the power of crowdfunding. In fact, the concept of raising funds in small increments from a large number of people is the fundamental basis for many financial platforms around the world — think about the basic idea of an IPO. But why is there a revitalization of the concept now? The Internet, social media, and the wake of a financial crisis have all given rise to change. Crowdfunding takes advantage of this change and has turned to the Internet to expand its reach. However, as this article points out, the current state of real estate crowdfunding is not “true” crowdfunding, and as a result is more evolutionary than disruptive or democratizing, but there are aspects of the industry that it will change for the better.
“Slow” and “arduous” can be used describe the two-sided investment market for real estate between those looking for capital and those seeking appropriate investment opportunities. Raising capital today for commercial real estate is essentially done in the same manner it was fifty years ago due to securities regulation and industry reliance on relationships. While crowdfunding for real estate is unable in its current version to extend the investment opportunity to everyone, it does expand the search ability for both sides. Vargo aptly summarizes this shift: “Crowdfunding in this sense is about tapping into a breadth of investment opportunities that would otherwise be unattainable without modern technology.”
Although the article does not delve into how onerous the securities laws are or the complexity that prevents the true power of crowdfunding from taking place, it correctly supposes that although “crowdfunded real estate may not be exactly what was promised in 2013, it is already showing it could be something more.” Interestingly, the advocates and authors of the JOBS Act, self-admittedly, did not consider real estate as a beneficiary of this law. The focus was on startups, yet real estate is the most likely to benefit from the JOBS Act and has already seen a tremendous amount of demand and growth. Only three of the more than seventy-five real estate crowdfunding firms are reviewed; however the explosive growth supposes the promise that so many see in this method of raising capital, in addition to the low barriers to entry.
However, pure crowdfunding is not actually taking place, but rather online advertising and execution of private placements utilizing the Regulation D 506(c) exemption. In other words, this is just taking the private equity world to the Internet. Yet, this shift will change the commercial real estate industry. Real estate is time-consuming and slow, and to some degree inefficient, but the online ability to raise capital, despite the restriction to Accredited Investors, gives way to changing this process.
The Lending Club IPO success and huge growth in peer-to-peer (P2P) lending and crowdfunding provides proof of demand from retail investors for alterative investing options as well as the ability to play a role in the development of young businesses and personal success via lending. The story and social mission components of P2P lending and crowdfunding has historically played a crucial role; however, it’s arguable that those aspects are secondary or not even a consideration in the investment realm.
Vargo finds that “[i]f crowdfunding real estate was meant to invite more discussion to the crafting of the built environment, it has yet to follow through on that promise.” Most crowdfunding projects have a social component or mission to them that sparks engagement by the crowd, but securities just do not have the same appeal. Conversely, although yet to be proven in real estate, evidence suggests that the crowd plays a self-policing role in finding fraud or issues with an offering. In fact, I would argue that inability to fund a real estate project is evidence of a poor investment, which leads into discussing the investment products and sponsors themselves.
Vargo surmises, “Lifting the ceiling for capital powered by crowdfunding will surely attract more sponsors to the space.” In fact, the crowdfunding and P2P space is slowly garnering interest from more sponsors and more “institutional” groups from both a capital-raising perspective and as an investment opportunity. Prosper, a P2P lending site, now attracts more hedge funds than peer lenders. As real estate crowdfunding in its current state becomes more commonplace, more well-known sponsors will offer their private placements on a portal, whether their own or another, and it won’t be called “crowdfunding.” Essentially, today’s version of crowdfunding is just using online efficiencies to transact what has been done offline for decades.
Vargo asks, “It is time to question whether the ‘innovative’ value of crowdfunding is a marketing gimmick or a real change. Are the industry’s trends evident of a fundamental disruption in the market for real estate capital or simply the ongoing evolution of long-standing paradigms?” I would argue that crowdfunding itself in this current state is NOT disruptive but purely an evolution. However, there are ripple effects such as data aggregation, efficiency, transparency, and speed of transactions that will ultimately change the industry even if not in an abruptly disruptive manner.
For example, there will be issues with the track records of sponsors and platforms having “skin in the game,” or control of assets, and all this information will be in plain sight on the Internet for all investors to see. Similar to the stock markets, knowledge about sponsors and investments will become more readily available, and some predict a secondary trading market for these currently illiquid securities.
While the evolution of the industry is unsure, what is a given is the failure of an investment within the next three to five years that has been offered on one of these platforms. Retail investors don’t necessarily understand the risk associated with these offerings. For example, “a “Project Payment Dependent Note,” a document that verifies distributions from Fundrise contingent on the performance of the offering,” is not the same as a first mortgage, and there is an underlying default risk that may not be fully comprehended by investors.
Unlike in peer-to-peer lending and Kickstarter projects, people investing via real estate crowdfunding platforms are making a sizable (although lower minimums than traditional private equity opportunities) and important investment, especially in a world where so few people have enough funds for retirement. As retirement plans shift to define contribution models, individuals have increasing responsibility to control their retirement accounts and thus expect a return.
However, as Vargo argues, we have yet to see crowdfunding in real estate or the democratization of securities investing extend to non-accredited investors. “To date, the significance of the JOBS Act is ironic. While it may have sparked the industry into life, the pending implementation of Title III and Title IV still leaves the actual ‘crowdfunding’ element of the act on the sidelines.” And, unfortunately, the SEC may have just missed the opportunity to ride the concept’s wave of popularity over the last few years. Its inability to pass rules and regulations for Titles III and IV has likely caused many to lose out on opportunity.
I’m not sure that there will ever be securities crowdfunding to the same extent that it has occurred via Kickstarter or Indiegogo in the reward/donation space. But I do believe that Regulation A+ could be something powerful. Even two years ago, with a vast unknown as to how the SEC would implement the law, it was evident that if done correctly this could create a middle tier opportunity to raise capital. Title IV is something to watch in 2015. Whether or not real estate crowdfunding proves to be disruptive, one thing is certain: using the Internet to raise funds for real estate is not going away.
