Publications

- October 1, 2021: Vol. 8, Number 9

Beware the madness of crowds: Real estate crowdfunding has offered great promise, but also cautionary tales

by Benjamin Cole

For better or worse, the age of the mass retail consumer and investor has burst into full blossom, under the fertile conditions of the internet and the on-lining of the multitudes.

The masses can be seen on Wall Street, where “meme stocks” have a day in the sun, or in the rise of no-commission trading, or in the ubiquitous Amazon.com delivery vans careening at the beck-and-call of tablet-punching shoppers.

Armed with billions of smartphones globally, investors and shoppers are increasingly independent from the advice of brokers and experts — instead they rely on online reviews of products and services, or take cues from message boards or social influencers. The middleman and professional adviser are often dispensed with entirely, like the travel agents of yore, who booked summer passages and arranged grand hotels for a nice markup.

Verily, the crowdfunding world offers greater ease, transparency and lower transaction costs than legacy systems. But for all the modern bells and whistles, the brave new world of crowdfunded property investing and syndication has antecedents that stretch back into earliest recorded history, and some aspects of property investing and promoting are likely to never change.

PROPERTY INVESTING

Anyone who ever directly purchased a property in the United States knows the sector remains a stronghold of skeptical loan officers, brokered transactions and legally mandated expert services, as well as reams of paperwork, inked signatures by the dozens, and even declarations made in person to public notaries. “Clunky” comes to mind to describe a process laden with wallet-sapping fees. Although many retail investors do buy and sell houses, the process is withering, and even a single house is a large swallow for many.

To be sure, even property investing has accommodated mass retail investors somewhat in recent decades, through publicly traded real estate companies, or REITs, and the property-oriented exchange traded funds (ETFs). The modern-era retail investor can indeed buy property through these vehicles with the click of a mouse, and for scant or no commissions, and with instant and permanent liquidity. All good.

But, it is turning out, the ease of investing in real estate through the legacy systems on the internet may be simply the first inning of the online property investing game.

CROWDFUNDING PROPERTY

Today, hundreds of online property crowdfunding platforms are operating in the United States and globally, into which investors can invest sums large and small to own — or lend money on — a piece of property or an entire real estate portfolio.

Because the property crowdfunding market is in some ways unregulated and still fairly new, estimates as to market size are iffy and range widely from source to source. By one account, about $120 billion of property transactions had been crowdsourced globally by 2019, and the total figure was growing by about one-third every year.

Adam Gower, founder of Beverly Hills-based GowerCrowd, gauges the amount of property crowdfunding doubled in dollar terms in 2020 from 2019.

“Though it is unlikely to continue doubling year-on-year, within the next three to four years it is likely that crowdfunding will be the dominant source of capital in subinstitutional, private-equity real estate markets,” says Gower.

Crowdfunding exploded in the United States after the passage of the Jumpstart Our Business Startups Act (the JOBS Act) in 2012, a law intended to encourage funding of small businesses by easing certain securities industry rules. The short story is the JOBS Act paved the way for business operators and property syndicators to legally solicit both large and small investors broadly, even through channels such as Facebook, Instagram and mass emails.

Under the 2012 act, real estate crowdfunders can beckon accredited or unaccredited investors, the latter being those with a net worth of less than $1 million, or income less than $200,000. In other words, nearly every adult in the United States. The biggest names of the industry mined the new stream of profits over the next 10 years, including AcreTrader, Fundrise, CrowdStreet, GroundFloor, Peer Street, Realty Mogul Co., Equity Multiple, DiversyFund and YieldStreet.

The scale of some property crowdfunders is impressive; for example, Fundrise claims to have paid out $100 million in distributions to its 150,000 clients. Another titan, CrowdStreet, has raised more than $2 billion from investors, at an average of $134,000 per client, to place them in property deals.

Certainly, crowdfunding real estate has been a bonanza for sponsors and syndicators, who evidently operate in one of the fastest-proliferating investment niches anywhere. Indeed, crowdfunding will be the future for many types of property capital raises, asserts Gower. “As familiarity with property crowdfunding on the part of both sponsors and investors continues to grow, it is inevitable that the old ways of raising capital will eventually go the same way as the travel agent and the stockbroker,” he advises.

But is this really something new under the sun?

POOLING MONEY

Syndicating real estate has been a practice for ages. Even before the telegraph, some property transactions were funded by subscription, and solicited investors through advertisements that ran in London newspapers and elsewhere. Indeed, by one account, properties were syndicated in the Mesopotamian city of Ur in 1800 B.C., with cuneiform-tablet records of investors tossing gold bracelets and other valuables into an urn to participate.

The more modern era saw a real estate–syndication boom in postwar United States, and by 1961, the New York State Attorney General’s Bureau of Securities and Public Financing had indicted five property syndicators for “grand larceny and similar crimes,” and declared intentions to keep the industry under close watch.

Technologies may change, but basics do not. As noted in “Real Estate Syndication: Property Promotion and the Need for Protection,” from the April 1960 Yale Law Journal, “The promoter has many sources of profit in a typical syndication. He may receive a brokerage fee from the seller of the property; a profit on the transfer of the property or assignment of the executory sales contract to the syndicate; and promotional underwriting discounts and commissions. Should he be an attorney, his office may receive legal fees for handling the transaction, as well as an annual retainer. Promoters generally share in the property's revenues, either as the operating tenant or as the owner of a participating interest in the syndicate. Realtor promoters may undertake management of the property, thereby earning a management fee. Finally, the promoter usually reserves the right to a disproportionate share of any gains from a resale or refinancing of syndicate property.”

The age-old usual cautions regarding investing in private-property equity syndications never change: Who is the syndicator, what is its verifiable track record, and what charges — disclosed, embedded or otherwise — are levied on retail investors? How heavily are properties leveraged? Are “guaranteed returns” merely returns of one’s own capital? Are ownership stakes liquid? How transparent are the transactions and syndicators?

COMFORT ZONE

The larger crowdfunders, with longer track records, generally file disclosure forms or other documents with the Securities and Exchange Commission, providing some measure of comfort for investors. The Regulation A and D filings are similar to IPO documents.

Reading through SEC and other disclosures does indicate, however, that not all crowdfunded offerings are hits for investors, even in one of the hottest property markets in history.

An investor who plunked down $10,000 in May 2017 for Fundrise’s eFund, which largely buys single-family detached housing or apartments in Los Angeles, would have had a stake worth $11,528 at the end of August 2021, according to Fundrise’s website, or a gain of 11.5 percent after more than four years. But according to Zillow, the average price of home in Los Angeles rose by nearly 40 percent during that same time frame. And in the seven months ended June 30, 2021, eFund’s net asset value per share hardly budged, according to Fundrise’s disclosure statement with the SEC.

The Fundrise eFund has acquired 87 properties, and rental income is rising slowly, but revenues are roughly offset by expenses, according to eFund’s filing with the SEC and online statements.

Compare those numbers with the Vanguard Real Estate Index Fund ETF’s, which rose 33.5 percent from May 2017 to August 2021, and paid a 2.3 percent dividend along the way.

Still, Fundrise’s website contends most of its 150,000 clients do far better, and indicates four years from initial investment, the average client had a 38.1 percent return on money invested with the crowdfunder. Indeed, $10,000 invested in October 2016 in Fundrise’s East Coast eREIT fund was worth $17,018 at the end of August 2021, according to the company’s website.

Fundrise certainly has some attractive features for retail investors. Investors can actually invest as little as $10, though a $1,000 minimum seems the norm. In general, Fundrise will buy back shares, though there was a period of illiquidity in the Fundrise eFund. Fundrise claims it charges only a 1 percent annual fee on client accounts, which is certainly slight, although other fees may apply.

For long-term investors, even a 1 percent fee is worth some consideration. Today, online brokerage Robinhood Markets offers no-fee trading, and the Vanguard S&P 500 ETF has a near-invisible expense ratio of 0.03 percent. To state the obvious, a 1 percent fee after 20 years is 20 percent of a portfolio’s value.

CAUTIONARY FLAGS

Some crowdfunders, however, have driven into the financial ditch, even in a rising property market.

The Prodigy Network crowdfund operation, for example, raised a reported $690 million from investors, but declared Chapter 7 bankruptcy in February 2021 and claimed $102 million in assets, against $6.4 million in liabilities.

And in April of this year, the SEC entered a final judgment against the CEO and co-founder of Innovational Funding, on charges of misappropriating for personal use more than $1 million of investor funds.

Other times the sins are minor — but worrying, nonetheless. Growth spurts and the rapid acquisition of thousands of clients can strain a popular crowdfunder, for example. An industry stalwart, CrowdStreet won plaudits for years for ease of use by retail investors. CrowdStreet sources and vets deals offered by third-party sponsors, which also pay a fee to be placed on the company’s website. Because the fees are levied on the sponsors, there are generally no visible fees on investors, who must be accredited and have $25,000 or more to plunk down.

Since launching in 2014, CrowdStreet has closed 524 commercial property offerings, raising $2.25 billion of capital, according to its website. To date, 54 of those offerings have been fully realized, and a solid 17.1 percent internal rate of return is claimed.

It is possible, though, that 524 deals were too many? CrowdStreet investors began complaining in 2020 about unanswered phone calls and emails, or that certain unexpected heavy expenses were incurred in the filing of arcane tax forms known as K-1s. Noting the chorus of investor complaints, Ian Ippolito of the The Real-Estate Crowdfunding Review put CrowdStreet on “probation” in August 2020 and reiterated the downgrade in February 2021.

And then we come to due diligence.

Like any investors in the crowdfunding world, those patronizing CrowdStreet must also carefully read about the offered deals to understand sponsor fees, how projected returns are divvied up and what are likely NAVs. Perhaps optimism is required for any investment, and certainly that is true for CrowdStreet deals, as well.

A recent deal on the company’s website offers investors equity stakes in a 404-unit Houston apartment building that will be purchased for $91.3 million and into which $14.6 million of improvements will be sunk. A loan for $75.7 million will be assumed. At the end of a five-year period, the complex will be sold for $133.5 million, a tidy 46.2 percent above the purchase price — if all goes according to plan.

The outlook assumes average rents in the building will rise by 35.7 percent over the five-year period, which will allow equity investors to collect distributions for five years and then, when the apartment complex is sold, get back $170,300 for every $100,000 invested. The investment plan also assumes the property’s net operating income will double in the five-year holding period.

The Houston apartment project makes confident projections, which is the way of any capital raise; however, it may difficult even for Houston real estate denizens to hazard a guess whether the deal can meet its goals. And investors will be locked in for the five-year period.

CONCLUSION

Property crowdfunding is riding the wave of retail investors willing to strike deals off Wall Street. The timing is propitious but also unsettling: Property values in the United States have been on a general uptrend since before the birth of the industry in 2012, and housing values and rents have spiked in the past year. It remains to be seen what will happen if property fortunes reverse.

“That’s the biggest threat to the crowdfunding industry, that when the tide goes out, a lot of people will lose their investments and realize only then that they have no recourse,” observes Gower.

Much more than investing in publicly traded REITs or property ETFs, figuring out a solid property crowdfunding bet takes a large investment of time, including burrowing through SEC filings and online disclosures intently. Determining the likelihood of five-year projections may take divine assistance.

In the end, there is a reason “caveat emptor” is a cliche. But hackneyed or not, some cliches are worth repeating.

 

Benjamin Cole (7continents7@gmail.com) is a freelance writer based in Thailand.

 

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