Viewpoints

Curious about Real Estate Crowdfunding, but too Nervous to Invest?

Posted on November 11, 2014 in Viewpoints by admin

By Bobby Speir
NAREIM Fellow, UNC Kenan-Flagler MBA ’15

Twice a year, NAREIM invites graduate students from the top real estate programs across the country to attend our Executive Officers’ Meetings as Fellows. After attending the September EO Meeting, Bobby Speir, a 2015 MBA student at UNC Kenan-Flagler concentrating in Real Estate and Corporate Finance further sifted out the possible merits to crowdfunding. His article considers how these young, innovative companies may impact the field of real estate investment management. 

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Inherently a capital-intensive industry, direct real estate investment has not historically been accessible to the individual investor. Instead, only institutional and high net worth investors have enjoyed the lucrative returns and tangible nature of real estate assets. All other investors desiring real estate exposure have been limited to REITs, blindly investing into a pool of assets hoping diversification provides sufficient risk-adjusted returns. There is now an alternative: crowdfunding allows an individual investor to hold an equity stake in a specific real estate asset.

Crowdfunding, born out of reward-based platforms such as Kickstarter in 2009, is now estimated to be a $10 billion global business. In 2013, three million people from 214 countries pledged $480 million and fully funded 19,911 projects on Kickstarter alone. If Kickstarter can generate this much velocity in projects simply by providing consumers the opportunity to pre-purchase a consumer good, how big is the opportunity to provide equity ownership in existing real estate deals? To date, only $135 million has been invested through crowdfunding in real estate debt and equity. A majority of that investment has occurred since the flood gates opened on April 5, 2012 when Congress passed the JOBS Act. The JOBS Act loosened the reins on a company’s ability to advertise private securities to accredited investors and has paved the way for the use of registered “funding portals”, which had been strictly regulated. If the highly anticipated Title III of the JOBS Act is passed, even unaccredited investors will have a shot at crowdfunding.

Undoubtedly, questions and concerns fill any investor’s mind when introduced to a new investment platform. The idea of transferring $10,000 from an online bank account to an internet startup that will invest the money in real estate and provide a double-digit return probably may seem a little farfetched. Real estate is complex enough without an online middleman to collect the money and distribute it to an unfamiliar sponsor. Surely the business model is to collect fees while the investor assumes all of the risk. While the inherent risks of investing in real estate remain in real estate crowdfunding, and always will, the crowdfunding process actually creates a more transparent and efficient method to invest in specific real estate assets than any alternative.

Pioneers of the industry, such as Fundrise and Realty Mogul, have designed platforms that essentially provide “online syndication,” allocating individual investors a portion of the project equity that the crowdfunding company has already acquired with their own balance sheet. This structure differentiates real estate crowdfunding from the reward-based crowdfunding platforms that simply serve as an online portal for interested parties to interact. Since real estate crowdfunding platforms have skin in the game by funding the initial equity takedown, they follow a disciplined screening and due diligence process, similar to any sophisticated equity investor. Fundrise, for example, only pursues five percent of the deals that are submitted by qualified sponsors. By filtering out deals that are inconsistent with Fundrise investment parameters and do not meet the due diligence hurdles in categories such as investment thesis, market analysis, management, and financial feasibility, Fundrise only pursues deals that are worthy of risking their own capital. This rigorous evaluation process provides non-professional real estate investors access to quality deals that have been vetted by a team of experienced real estate investment professionals.

Not only do individual investors see high quality deal flow and benefit from diligent underwriting, each investor has the ability to self-select the specific property in which to invest. The benefit is two-fold. First, the investor can choose a deal based on the risk return profile that is most appropriate for his investment goals. Even high net worth investors are not afforded this luxury if they invest through private equity funds because the fund manager has full discretion over the investments. Secondly, individuals have an opportunity to invest in local projects, thereby maintaining a sense of ownership in their community, which has historically been reserved for large investment firms from other cities.

By allowing direct access into a specific real estate project, real estate crowdfunding platforms have also reduced the net expense for an individual to make this type of investment. Traditionally, private real estate exposure was achieved through a pension fund investing on behalf of its individual beneficiaries. However, that process involved enormous fees including investment broker fees, pension advisory fees, private equity fund fees, and real estate brokerage fees. The diluted return that made it back to the actual investor was not typically commensurate with the level of risk assumed for that investment. Instead, crowdfunding platforms typically charge a 2-3% origination fee for coordinating the capital raise and do not use any other intermediaries that charge a fee.

The individual real estate investor further benefits from crowdfunding through the use of special purpose entities and the position within the capital stack that the platform is typically able to achieve. Compared to the traditional REIT investment, investors realize a significant tax advantage by investing through a limited liability corporation or partnership. The proceeds from a REIT, categorized as dividends, are taxed at ordinary income rates and considered portfolio income, which cannot be sheltered from the losses of other passive investment activities. Alternatively, proceeds received through an LLC or LP (pass-through entities) are passed through to the members of the investment vehicle. This structure allows realized gains on crowdfunding projects to be taxed at the capital gains rate. Pass-through entities also provide the benefit of depreciation, interest expense, and other deductions to the investor. If the sum of these deductions is greater than the income gains generated by the investor, the investor can be used to offset other passive gains in his portfolio.

In addition to the tax benefits, individual investors benefit from the aggregate of invested capital and the negotiating power of the crowdfunding platform to enter the capital stack as mezzanine debt or preferred equity.   Although this position is subordinate to senior debt on the project, it will always have a superior claim to the cash flow and collateral relative to common equity. The combined benefits of debt and equity make this investment very attractive, especially for an unassociated investor. It is very unlikely that a sponsor would allow an individual or small group of individuals to claim this position within the capital stack.

Given the benefits of crowdfunding, when does this investment strategy make the most sense? The sweet spot for crowdfunding seems to be the connection between a sponsor who desires a tranche of debt or equity relatively quickly which can be raised from individual investors who do not have the deal flow pipeline of a traditional private equity fund or institutional investor. For example, a two-person development shop in Charleston, SC needs equity within 60 days for a $10M boutique for sale residential project in a transitional neighborhood. This project profile does not fit an institutional equity partner due to its relatively small size and tertiary market. At the same time, the capacity of the development shop does not allow for fundraising because it is focused purely on execution. The solution: tap into the growing universe of crowdfunding investors. The sponsor’s goal of funding the project as quickly as possible is met while providing individual investors with the ability to select a specific asset and earn double digit returns, which are difficult to replicate in other asset classes. While this is the typical crowdfunding scenario today, the composition of the crowdfunding investor network is evolving as more qualified sponsors are seeking larger equity contributions, thereby attracting more sophisticated equity providers.

Crowdfunding is revolutionizing the way people make private investments in real estate. But is it just a fad? Will it continue to attract savvy real estate investors? To answer these questions, it is important to understand who is transacting on the crowdfunding websites. But more importantly, who is investing in the platform itself, suggesting there is long term potential? Fundrise, for example, recently received $31 million of venture capital from a group of investors including the owner and developer of the World Trade Center, three other notable real estate developers, and the former chief of Loopnet, a successful online commercial real estate listing service. As sophisticated industry experts continue to buy into the viability of crowdfunding platforms, the investing public can rest assured that transparency and efficiency will continue to increase, mitigating any perceived risk within the platform. So is there a limit to real estate crowdfunding – will the industry be able transition from niche to mainstream, and accommodate every variety of real estate investor? Only time will tell.