Real Estate Crowdfunding
Real Estate Crowdfunding
Is it a Snazzy New Type of Syndication or Something More?
By Jan Brzeski
Managing Director and Chief Investment Officer, Arixa Capital
Introduction
I learned the real estate investment business from the author of a book called Principles of Real Estate Syndication, which informed and inspired many successful syndicators – particularly in California, from the 1960s onward. Today, real estate crowdfunding companies seem to be popping up monthly. Having had the opportunity to study syndication business models in detail, and their application in today’s real estate investment environment, with this article I aim to cover three topics:
Why is real estate crowdfunding attracting so much interest right now?
Where can crowdfunding sites provide real value to real estate investment sponsors and to investors?
What are the limitations of the crowdfunding model as relates to real estate investment today?
Why is Real Estate Crowdfunding Attracting So Much Interest Now?
A confluence of factors explains the flurry of activity in real estate crowdfunding in the past year:
Deregulation
The JOBS Act, which was intended to stimulate the economy after the Great Recession, included a provision to make “general solicitation” of certain securities offerings legal for the first time in decades. In the past, advertising private securities for sale — also known as raising capital for a particular investment from individuals, or syndication — would have resulted in harsh fines or even criminal liability for real estate developers aiming to raise capital. Syndicators had to have a personal relationship with investors, and had to establish their qualifications as an “Accredited Investor” before mentioning any specifics about the offering. Today, general solicitations are legal, so long as syndicators register appropriately with the SEC and follow other SEC guidelines.
Search for Yield
Investors are desperate for investment options that provide income. The Fed’s low interest rate policy has robbed investors of the income they need for retirement – as the yield on bonds and other income investments has dropped in step with the Federal Funds rate. Once seen as a haven for yield-hungry investors, public REITs now offer a miniscule yield. For example, as of early May 2014, office REIT Boston Properties (BXP) offers a 2.2% yield while apartment REIT Equity Residential (EQR) yields 3.4%. Even as real estate prices have risen, thereby compressing capitalization rates on income properties, such opportunities still offer a higher yield than many other investment alternatives. Real estate investment can also provide inflation protection and specific tax advantages.
Internet Innovation
Just as Amazon changed the market for consumer goods, today’s crowdfunding sites hope to shake up the world formerly known as “country club money” – where developers and sponsors raise money for investments. Companies such as LendingClub and Prosper have pioneered peer-to-peer lending with generally good results to date. Bringing the same approach to real estate investment and finance is seen as the next logical step by many entrepreneurs and their venture capital backers.
crowdfunding websites Figure 2 – Examples of recently-formed real estate crowdfunding companies are shown below.
Where Can Real Estate Crowdfunding Deliver the Greatest Impact and Success?
Let’s take a look at the areas where crowdfunding and real estate investment overlap most naturally and together promise to add the most value for everyone involved.
Opening Up Access/Democratizing Private Real Estate Investing
Public REITs have become popular in part because they allow ordinary people to invest in income properties that were once owned exclusively by ultra-wealthy families, pension funds and other institutional investors. In a similar way, real estate crowdfunding sites can make it much easier for investors with no connections in the real estate industry to participate in real estate investments — particularly smaller non-institutional properties which are usually outside the purview of public REITs. These same properties, often “Class B” rather than “Class A” properties, and possibly in secondary rather than primary markets, can provide attractive yields relative to other investment alternatives.
Potential for Lower Costs/Load vs. Private REITs
Smaller investors wanting access to real estate equity investments have flocked to private REITs in recent years. These REITs promise to offer steady income but they often come with quite substantial upfront costs to compensate the broker or dealers who gather assets for the private REITs. Given that 10-15 cents of every dollar raised for private REITs is getting paid in commissions, rather than being invested into property, well-run real estate crowdfunding sites have the potential to provide a more attractive deal to investors. However, to do so they need to keep their own costs down and remain vigilant about not offering investments where the sponsors or developers charge excessive upfront fees.
Transparency & Disclosure
The Internet naturally permits strong real estate operators to provide appropriate disclosure and transparency to investors. For example, my company has built an asset management portal that allows investors in our funds to see every individual underlying investment in each fund. In addition, the portal provides access to photos, budgets, loan documents and proof of title and hazard insurance. The internet allows for “self-service” 24 hours a day — which is perfect for investors wanting to conduct their own due diligence without having to travel to the operator’s office in person. This process would have been necessary in the past for many of these due diligence steps to take place.
Continuous Improvement
We can expect to see the winners among the current crop of real estate crowdfunding startups continually improve their websites and platforms over time. It is hard to predict exactly how, but Internet companies’ rapid product upgrade tempo will ensure that these sites become more valuable to the user over time – probably offering a wider range of investment types and more flexibility in terms of how investors can fund and monitor their investments.
Honest Broker of Information
While there are thousands of books and blogs about investing in real estate, on the whole the quality of this information is mediocre. There is surprisingly little clearly-written information about the opportunities, challenges, risks, mitigation techniques and mechanics of various types of real estate investments. Crowdfunding sites have an opportunity to de-mystify real estate investing and to provide insight into how the pros approach each type of investment, what they look for, and perhaps more importantly, what they have learned to avoid. In my experience, the great majority of material about real estate investing is either breezy generalizations or technical information. Often lacking is a systematic explanation of the techniques used by investors who have demonstrated a consistent track record of good performance. Sites that fill this niche will build something of real value, just as securities brokerage firms that provide truly insightful research can more effectively attract and retain clients.
Limitations of Crowdfunding in Real Estate
While the central insight of matching real estate investment opportunities to investors using the Internet may be highly logical, in practice there are a number of challenges. In this section we look at the two types of real estate investments offered on crowdfunding sites: (1) equity investments, where the investor is actually participating in the ownership of real estate; and (2) debt investments, where the investor is participating in a loan secured by real estate.
Challenges for Equity Investments
Equity investors participate in the purchase of a property. They face a number of risk and challenges, including the risk of fraud or overcharging for services by the manager of a syndication; mismanagement and dereliction of duty; sloppy underwriting and/or overpayment for the asset by the sponsor of the investment; and market risk. The fundamental challenge for crowdfunding sites in real estate is that by offering equity investments on their site, they are effectively endorsing the sponsors of investments they offer. Presumably they are careful to select sponsors who are honest, but honesty is not enough to generate good returns—experience, acumen and strong operational capabilities are also needed.
The most established and successful sponsors may prefer not to use a crowdfunding site to source investors. They have presumably made money for a long list of investors in the past. Often, the problem for the most successful investors is not finding capital, but finding projects that really make financial sense. In other words, there may be an “adverse selection” problem for crowdfunding websites in the near term. The most established sponsors may not need to pay a crowdfunding site to attract investors, since they probably have plenty of willing investors already.
Challenges for Debt Investments
Some crowdfunding sites are focused on providing loans to real estate investors and developers. This happens to be the focus of my business, Arixa Capital Advisors, and of most of the funds we manage. Making short-term real estate loans is an excellent strategy to earn income without taking too much risk of losing principal. While real estate investors need to focus on finding properties and meeting the needs of sellers, real estate lenders like us need to focus on finding and meeting the needs of borrowers with projects that make sense. This is a very different undertaking.
Borrowers prize private lenders who:
(1) bother to get to know them personally, understand their business, and treat them like important clients – rather than squeezing them for every last dollar they can on each transaction; (2) are quick to underwrite and commit to making loans; and (3) who give them certainty of funding (since the borrower is usually counting on the lender to fund by a certain date, and the borrower will likely lose a lucrative deal if the lender is delayed in any way). It is difficult for a website to provide all of the above “warm and fuzzy” characteristics that borrowers crave.
Additionally, real estate crowdfunding sites still face the risk of endorsing an investment that is listed on their site. They need to be able to provide expert underwriting and risk mitigation to make sure that investors do not become the victims of mortgage fraud; suffer losses due to title complications that come up; or lose money because it turns out the foundation of the property is cracked and the cost to repair it is so high that the borrower walks away from the project. This leaves the investors to deal with the mess.
Is Real Estate Crowdfunding Ready for “Prime Time”?
Internet companies like Google, eBay and Amazon were able to immediately offer a compelling value proposition to their customers. In contrast, crowdfunding sites have not yet come up with a formula that would compel either sophisticated investors or operators/developers to do more than investigate and keep abreast of this developing niche within the investment universe.
At its core, there are many things that can go wrong with an investment and the consequences of an unforced error can be dire. Consider the difference between making a $100,000 investment with a dishonest operator vs. the consequences of getting bad results from a search engine, or a bad experience when ordering a paperback book online.
Because of the high stakes in the investment world, reputation will continue to be of paramount importance in attracting both investors and operators who are seeking investors. Technology and the Internet can help facilitate this process, but it is unlikely to change the fundamental dynamics through which individuals and companies form their reputations. It can take years to be considered a valuable gatekeeper or intermediary.
To some extent, Lending Club and Prosper have facilitated a whole new type of investment — small balance loans to individuals. These loans were predominantly the domain of credit card companies who charged extremely high interest rates. Credit card companies may be ripe to be disintermediated to the extent that they charge annual interest rates in the high teens or even 20%+ range to relatively creditworthy borrowers. However, real estate investment is relatively mature and already served by a wide variety of financing sources, partly because it is such a popular and easy to understand investment type for individuals. To some extent, they have already “bid down” the returns to the point that there is less arbitrage for new entrants to take advantage of.
Conclusion
Real estate crowdfunding websites promise new opportunities and options for both developers seeking equity and debt for their projects, and for investors aiming to generate attractive returns without taking on excessive risk. Crowdfunding will undoubtedly establish its place alongside the traditional mechanisms of bringing together the operators who need money and the investors who need a place to put their savings. However, it is likely to be some time before a substantial portion of either investors or operators/developers look to crowdsourcing as their primary vehicle for finding each other. This process will start with the least sophisticated parties and both sides of the equation, and will gradually grow to include more experienced counterparties.
References:
Real Estate Crowdfunding Conference: http://www.coastalshows.com/the-cfge-real-estate-summit-austin-texas/
For more information on how crowdfunding has begun to infiltrate the real estate market, visit: http://www.forbes.com/sites/groupthink/2013/04/19/crowdfundings-latest-invasion-real-estate/.
If you’re thinking of engaging in crowdfunding to help you build your real estate portfolio, and are looking for additional insights into the various risks and rewards that are inherent to this method, visit: http://www.marketwatch.com/story/how-to-use-crowdfunding-to-invest-in-real-estate-2014-02-07.
For more insight into the new regulations and rules regarding crowdfunding and the real estate market, visit: http://www.cnbc.com/id/101054808.
The Top Three crowdfunding sites provide savvy investors with another means to diversify portfolios and gain entry into markets that may have otherwise been off limits. Read about these three sites here: http://www.biggerpockets.com/renewsblog/2013/11/20/3-things-need-know-crowdfunding-real-estate-investments/.
While crowdfunding in real estate may feel like a completely fresh concept, some liken it to “passing the sermon plate” at the end of a religious service. Whatever your take, read here for more information on how the contemporary crowdfunding process differs from the original method: http://www.inman.com/2013/11/25/real-estate-crowdfunding-why-its-a-big-deal/#.U3BT6jpOUeE