Funding from the crowd comes at an opportune time for real estate developers, who have suffered as banks and other institutional investors have pulled back on construction and property loans after the 2008 subprime housing mortgage meltdown.
Crowdfunding platforms are allowing individual investors to own parts of properties as members of an informed group, and in ways that were not easily possible earlier. In addition, online services are enabling individual investors to buy pre-vetted single-family homes in neighborhoods with stable rental demand, earning them monthly returns in addition to long-term capital gains. Proponents of crowdfunding note that the practice also gives communities a stronger voice in supporting or rejecting development projects in their neighborhoods.
So far, just a handful of online portals are active in providing platforms for real estate crowdfunding, including Realty Mogul of Los Angeles, Calif., Fundrise of Washington, D.C., and New York-based Prodigy Network. Between last November and May, Realty Mogul has raised nearly $22 million from investors to fund 69 properties, and distributed more than $2.6 million in returns. It accepts investments upwards of $5,000, and focuses on equity investments with existing cash flow, such as apartment and office buildings, retail shopping centers and self-storage facilities. Prodigy Network is targeted to investors willing to write checks upward of $50,000. So far, it has offered two projects in New York City to U.S. investors (an extended-stay hotel and a luxury apartment building) and three in Bogota, Columbia, to non-U.S. investors.
Fundrise was founded by Daniel Miller and his brother, Benjamin, in 2010. Real estate is familiar territory for them: Western Development Corp., a real estate development firm in Washington, D.C., founded by their father Herbert Miller in 1967, has so far built about 20 million square feet of properties. Fundrise last week received $31 million from a group of investors, including top executives from Silverstein Properties, the developer of the World Trade Center. The company has so far helped raise $15 million for 16 deals through crowdfunding. Its average investment from accredited investors is about $25,000, and $1,000 from non-accredited individual investors.
“You need a mix of government safeguards, legal and enforceable contracts and some of the value that a crowd can bring into a situation.” –Ethan Mollick
HomeUnion, a start-up based in Irvine, Calif., has a business model that allows individuals to buy single-family homes that would bring monthly rental income and long-term capital appreciation. “We are bringing to investors a very large asset class in a very structured manner where they can diversify from the stock market,” says Don Ganguly, founder and CEO of HomeUnion.
HomeUnion operates as a one-stop shop: After prospective investors choose from a list of properties on its portal, the company helps them secure mortgage financing, structure and close the deal, rent and manage the property, and sell the property if the investor chooses to do so. Through HomeUnion’s website, investors can store pertinent documents in personal “vaults,” and get periodic updates on the rental income, expenses and current valuation of their properties.
U.S. laws currently allow only “accredited investors” to make equity investments through crowdfunding sites. The Securities and Exchange Commission (SEC) defines accredited investors as those with an annual income of $200,000 or a net worth of $1 million. Companies or entrepreneurs who want to solicit equity investments from other, non-accredited individual investors must secure project-specific permissions from state-level regulators. Crowdfunding of real estate could get a boost from easier regulatory requirements in the coming year as the SEC finalizes the participation thresholds for issuers and individual investors.
Crowdfunding of real estate projects via the Internet is a relatively new phenomenon, but the basic concept has been around for a while, says Wharton management professor Ethan Mollick. He recalls that when the American Committee for the Statue of Liberty ran out of funds for the statue’s pedestal in 1884, newspaper baron Joseph Pulitzer urged the American public to donate to the cause. His appeal raised more than $100,000 in six months, with most donations at a dollar or less — enough to finance the pedestal’s completion.
According to Mollick, real estate is a natural fit for crowdfunding. As with real estate investment trusts (REITs), “the idea that you can raise a decent amount of money from lots of people who want to participate [in a particular project] is one aspect that is useful in crowdfunding,” he says. What also makes real estate attractive for crowdfunding is the fact that “people care a lot about their communities,” and may be drawn to the chance to support a project being built in their neighborhood, he adds.
The romantic appeal in owning real estate is another plus for crowdfunding as a financing route, notes Mollick. “Real estate has always been the idea that you own a real thing. [The prospect of] owning a strip of land or a building has for generations or centuries brought people to real estate.” He offers an example: Scotch single malt whisky maker Laphroaig offers its patrons a lifetime lease of one square foot of land at its Isle of Islay distillery in the U.K. The so-called “Friends of Laphroaig” community now has more than 607,000 members, and each is entitled to annual “rent” of one dram of Laphroaig whisky.
Investment Process and Returns
Daniel Miller says the process of raising and tracking investments through online platforms has the benefit of transparency. At Fundrise, a property developer looking for funding would submit the project’s profile on the company’s website, where it would also list information about the development company. Next, the developer would submit his or her project proposal to Fundrise, which would then conduct due diligence on the investment worthiness of the project, help structure the deal and arrange for the documentation to make it ready for investors to make transactions. After the deal closes, Fundrise manages the back-end technology for tax documents, electronic distribution, investor updates and other administrative functions. Only some 3% of all the project proposals submitted to Fundrise qualify as investment worthy, which means that the company’s due diligence process has determined that the projects are commercially viable, says Miller.
A Fundrise-affiliated real estate firm charges $2,500 to vet each deal, while Fundrise charges a fee of between 2% and 3% of the capital raised by project developers. The site does not currently levy fees on investors. Fundrise offers three investment avenues. One is senior, secured debt; the second is unsecured mezzanine debt and the third is equity through units in a limited liability corporation. Gross returns for investors range between 10% and 16% annualized. Debt holders get quarterly interest payments, while equity investors receive annual dividends, in addition to capital gains each time they sell a property for a profit. Each investment is transferable after a sign-off from the property manager of a project.
The company encourages developers that raise money through its site to distribute equity dividends even before their projects begin earning revenues, just to instill confidence among investors. In the event that a project fails, Fundrise has the ability to step in on behalf of investors, take possession of the property in question and liquidate it to distribute the proceeds, Miller adds.
“Paying regular dividends is the best way to make investors understand that the project is performing and get some cash flowing.” –Daniel Miller
According to Ganguly, individual investors who use HomeUnion’s services could earn net returns of between 6% and 9% annually from the rental incomes of the homes they buy. This is after adjusting for expenses on the upkeep of the properties, asset management fees and provisions for vacancies.
The returns on investment could be larger if people choose to sell their properties at some point, depending on the rate of capital appreciation. Investors that avail of subsidized mortgage financing stand to earn bigger returns from the arbitrage opportunity in prevailing interest rates, says Ganguly. For example, an individual with $100,000 available for investment could buy four properties by making down payments of $25,000 on each and borrowing the remainder at interest rates of 4.5% or thereabouts, he notes. HomeUnion earns revenues from asset management and fees for arranging mortgage finance and property sales.
Finding Market Gaps
Both Fundrise and HomeUnion were responses to perceived gaps in meeting investor demand. At HomeUnion, Ganguly discovered a market made up of individuals chastened by the 2008 subprime mortgage finance crisis — people who felt insecure about their jobs and places of work, and who were unfamiliar with residential real estate markets beyond their immediate neighborhoods. Many of them also had the added burden of student loans and were hesitant to take on home mortgages.
Ganguly figured he could entice such individuals if he offered pre-vetted investment-worthy properties in stable neighborhoods filtered out by attributes like median income, employer diversity, crime rates and school district quality. HomeUnion currently offers properties it has vetted in 13 markets that it calls “cash flow zones,” or markets that the company feels will provide stable returns on investments. These include specific neighborhoods in Chicago, Atlanta, Memphis, Dallas and Houston. Over time, the company plans to expand to more markets across the country.
At Fundrise, retail properties, such as a bar or restaurant that members of the local community are familiar with or already patronize, are popular among investors, says Miller. Other opportunities arise in segments that banks and other institutional lenders have vacated. He adds that most institutional lenders these days are risk averse and are willing to finance only stabilized properties or those with limited downside risk.
“We found that banks and other lending institutions, and private equity firms, have left gaps in the market,” says Miller about Fundrise’s opportunities. The two biggest gaps are where the equity component is $20 million or lower and where the loan size is under $500,000. Private equity firms find it unprofitable to make equity investments of less than $20 million because of the costs and processes involved in upfront due diligence, project monitoring and management, he notes. Similarly, he adds that banks find it “just too inefficient” to make loans of under $500,000.
Neighborhood Catalyst
The third opportunity for Fundrise and other crowdfunding platforms is the neighborhood center. Miller says the revitalization of neighborhoods, such as Bedford-Stuyvesant in Brooklyn, “is not fully understood by traditional investors,” but such resurgences attract a lot of community involvement that could lead to investments by its members. Fundrise recently received a grant from the Kresge Foundation in Detroit to explore ways to use crowdfunding “to support the rebirth” of the former auto capital, which has seen many of its neighborhoods fall victim to urban decay in recent decades.
Mollick, too, sees crowdfunding of real estate as “a powerful tool for communities” that want a say in ensuring that certain projects come to fruition. “It helps communities pool their own resources and take control of their own environment, in addition to providing returns on investment.” He cites a recent example of a skate park project in Philadelphia that was built through the help of crowdfunding.
Three dynamics are at work in crowdfunding of projects, Mollick says. One is the “herd instinct,” where projects that attract more backers tend to be more successful than others. He explains that such herd behavior also indicates that that the projects they back are investment worthy. “The herd instinct hopefully gets balanced out when you have a whole bunch of people participating,” Mollick notes. “You have many voices that are telling you about different issues and aggregating useful information about a project.”
“We are bringing to investors a very large asset class in a very structured manner where they can diversify from the stock market.” –Don Ganguly
The second dynamic is “the bystander effect.” That occurs in situations where some potential investors will wait until something is successful before joining in, says Mollick. The third aspect he sees at work is “periphery versus core,” where information from multiple investors helps in due diligence. Here, the “core” is a group of a few active investors who are big boosters of a project, while the “periphery” includes many other investors with some experience or awareness that might be useful.
“There is a good chance that if there is a problem with a project, one among a thousand investors may have that information,” says Mollick. That could be news about an increase in a neighborhood’s crime rate, or information about something going on in a particular area that may impact a project’s chances of success, he adds. “It means you have many more eyes on a problem, and there is a better chance of detecting issues.”
Uneasy Questions
As with all investment opportunities, the new real estate investment avenues raise questions about the risks involved and regulatory protection against downsides. “Real estate crowdfunding is very promising, but we are in the early days on how it will look,” Mollick says. He points to the need for regulatory clarity, including finalization of the SEC’s proposed crowdfunding rules under the 2012 Jumpstart Our Business Startups Act (JOBS Act).
Adds Miller: “The most difficult aspect now is regulations around offering [opportunities] to small-dollar investors.” With the revised rules, he expects having to complete less paperwork with the SEC and state regulators and a faster track for approvals. Fundrise has so far secured approvals from regulatory authorities to tap non-accredited investors for three specific offerings in Washington, D.C., Maryland and Virginia.
The JOBS Act seeks to create a supportive legal environment for equity crowdfunding. For example, it proposes a waiver of registration requirements if, in a 12-month period, issuers limit their equity offerings to under $1 million. It also proposes a waiver if individuals limit their investments in such offerings to $2,000, or between 5% and 10% of their annual income or net worth, depending on whether those measures are less than or greater than $100,000.
HomeUnion, too, wants to offer crowdfunding opportunities to individual investors sometime in the next four to six months. Ganguly sees a market niche where individuals could pick up shares in pools of properties that HomeUnion would put together and manage. Initially, he plans to offer that avenue to accredited investors, and later to non-accredited investors as clarity emerges on that front under the JOBS Act.
Not everybody thinks the relaxed rules for crowdfunding are desirable. “Under the proposed rules, investors could end up with next to nothing even if they invested in the next big thing,” states a New York Times editorial that analyzes the SEC’s proposed crowdfunding measures. “[The SEC] should instead require that shares issued through crowdfunding incorporate the terms that sophisticated investors routinely demand.” The new rules are likely to be finalized in about a year.
Critics of crowdfunding for real estate projects say the prospect of fraud is a major worry. “There will be fraud, but it won’t be disproportionate compared to other areas of financing,” Douglas Ellenoff, a securities lawyer at the New York City-based law firm of Ellenoff Grossman & Schole, told Real Estate Weekly magazine.
Mollick says he studied trends on the popular crowdfunding platform Kickstarter and found that instances where project creators stopped answering emails from backers or ran away with the money amounted to less than one half of 1% of all the money invested through the site in the technology, design and video gaming categories. Such failed projects also made up less than 4% of the overall number of projects funded on Kickstarter.
Still, crowds can bring the power of “aggregate information” to the table, Mollick notes. “[Studies show that] the crowd acts pretty rationally in identifying project quality.” For example, investors might flag that a particular building location has a swamp, or that a given developer has a bad reputation.
All the same, he adds, safeguards are essential. “You need a mix of government safeguards, legal and enforceable contracts, and some of the value that a crowd can bring into a situation.”
