The potential for crowdfunding real estate investments

I am excited by the potential of crowdfunding real estate investments. Crowdfunding is the process of raising capital from a large number of investors who each make a relatively small financial investment in a particular venture. Despite the fact that in April 2012, the Jumpstart our Business Startups Act (the “JOBS Act”) was signed into law legalizing crowdfunding, the Securities and Exchange Commission (“SEC”) is still finalizing the rules for how crowdfunding will work and therefore crowdfunding remains prohibited. In the meantime, individuals have been taking part in a more restrictive versions of crowdfunding which are either restricted to “accredited investors” (those who meet certain high net worth / income requirements set forth by SEC) or applicable in limited circumstances (i.e. Regulation A, state blue sky laws). Proponents of crowdfunding argue that its legalization will increase the number of businesses able to obtain outside investments (only a small amount of startups are successful in raising equity) and ultimately increase job growth. Many view crowdfunding as the democratization of capital since it removes restrictions which prevented entrepreneurs from raising capital and investors from investing how they choose. It is also reflects the modernization of the securities laws (which were written as part of the New Deal in 1933) to allow for the collaborative nature and scalability made possible by the internet. I believe that real estate investment is particularly well suited for crowdfunding for the following reasons:

Real estate investment and valuation is well established.

Investing in early stage companies is not an easy endeavor. Professional funds with dedicated investment professionals (many of whom have successfully founded companies themselves) have difficulty making profitable investments. That is, valuing new and novel business models, emerging technology and ventures without historic cash flows is a difficult task even for dedicated professionals. Although real estate investment is by no means simple, it is a traditional business. In the majority of real estate investment opportunities there is historical financial operating information to review, data from comparable properties to analyze and assumptions to test and modify. Moreover, third party appraisals of value are widely used in real estate investments which will offer crowd investors additional insight into the investment opportunity. Finally, in a typical real estate transaction, there will be a single round of equity raised and the amount funded is meant to provide all the equity required for the investment period (which results in less likelihood of capital calls and a reduced risk of dilution).

The involvement of a first mortgage lender provides an additional layer of vetting and accountability for real estate investments.

The majority of real estate investments will involve a first mortgage lender who will make a loan to the venture secured by the property. In order to obtain first mortgage financing, the lender underwrites the asset, obtains and reviews numerous third party reports on various aspects of the property (i.e. environmental, property conditions, zoning) and scrutinizes the operator’s plans, track record and expertise. Only after the lender is satisfied with its diligence will it issue a commitment for financing and ultimately fund a loan. Consequently obtaining financing from a reputable lender is telling. In addition, lenders typically require the sponsor of the project to personally guaranty that they will not make or allow certain “bad acts” to be made while the loan is outstanding. The personal liability of the sponsor further reduces the likelihood that the project will be a victim of fraud or missteps by the sponsor. Involvement of the first mortgage lender provides additional oversight and protections even after the investment has been made. Typically, lenders hold real estate tax and insurance escrows (and ensures that they are paid), monitors construction work to ensure that construction is being done to standards within budget and schedule, reviews operating history on a quarterly basis and makes periodic inspections of the property. Although the first mortgage lender is senior in priority and therefore would be paid back prior to any equity being returned to investors in a liquidation, a lender’s interests is largely aligned with the interests of the crowd investor and the crowd investor will likely benefit from their involvement.

The crowd has a comfort level and a predisposition for real estate investing.

I believe that people have a preference for investing in what they are familiar with and understand. Real estate is an asset class that many individuals typically have a level of familiarity and comfort with based on their personal experiences. Members of the crowd are more likely to have an opinion on how much residential rents can be raised or whether a certain location is a good prospect for building a retail center, then the absorption of a new technology. Consequently, the crowd will have knowledge and insight to challenge and validate a sponsor’s assumptions and potentially can add value to the investment process by providing their insight. In addition, since home ownership is the single largest investment of the crowd results in the crowd having firsthand experience in real estate investment to draw from. Many of the concepts of residential home ownership (such as mortgage payments, property insurance, real estate taxes) are also applicable to commercial real estate investment. As a consequence, crowd investors are that much more knowledgeable and comfortable with real estate investments and I expect that this will translate to greater popularity among crowdfunded real estate investments.

With modest leverage, a $1MM crowdfunded investment can be used to make a $5MM acquisition which is significant purchasing power in many markets.

Assuming a maximum $1MM equity raise from the crowd and that the sponsor invests an additional $250,000 (20% of the equity) for a total equity investment of $1.25MM. With conservative first mortgage financing of $4MM (75% leverage) the venture would have the purchasing power of $5MM. The ability to obtain financing is much more likely in a real estate transaction (where the loan is secured by real property) than compared with many other startup industries (where there is a lack of tangible assets to secure a loan). Moreover, if the sponsor raises additional funds directly the purchasing power can increase significantly.

Many real estate investments generate income for equity holders and provide significant tax advantages.

Many real estate investments are income generating for its investors. A common real estate investment strategy involves purchasing an asset and gradually increasing the income over time through a combination of capital improvement projects, improved property management and reduction of property expenses. During this hold period the equity investors may obtain cash flow from the property. This is somewhat distinct from startups and other business endeavors where income is typically reinvested back into the venture and the equity investors do not see any distributions until a capital event occurs (such as a sale of the business). That is, if after property expenses, debt service and reserves there is income, this will be distributed to equity holders. The benefit of income is maximized by the ability to depreciate real estate assets and to deduct interest payments on the underlying debt service.

Real estate sponsors typically understand how to work with partners and have experience with the resulting reporting requirements and restrictions on control.

Real estate sponsors typically raise equity from various sources including friends, family and investment funds and consequently have a reporting infrastructure in place and understand the limits of their authority and when investor and lender approval. Having crowdfunding investors is not much different to real estate sponsors and will not alter how things are done and shouldn’t result in much growing pains. In fact, from the sponsor’s perspective, crowdfunding is an extension and modernization of friends and family fundraising in that it will allow sponsors to leverage not only their direct contacts, but their secondary contacts as well. In addition, crowdfunding allows sponsors to take advantage of social networks in the fundraising process.

Real estate investments are relatively liquid and offer numerous exit potentials.

Investments in real estate, especially in the core sectors of multi-family residential, retail, office and industrial are relatively liquid investments where there is a consistent flow of transactions which allows investors to enter and exit transactions. This is not the case with most start-up opportunities where an exit is limited to a capital event such as going public or getting purchased. Moreover, there are refinancing opportunities with real estate which allow capital to be returned upon a refinance of the senior debt.
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For all these reasons, I expect real estate investors and entrepreneurs to be early adopters of crowdfunding and to pioneer the methods and best practices for crowdfunding investment and crowdfunding platforms which will be used in other industries. Consequently, it is time for real estate entrepreneurs and investors to start planning how they will incorporate crowdfunding into their projects. Visit CrowdMason.com to participate in a dialogue on how to best prepare for crowdfunding real estate investments.

CrowdMason.com is the destination for news, analysis and research on all facets of real estate crowdfunding. Please visit our site at www.crowdmason.com and follow us on twitter @Crowdmason. For additional information or feedback, please do not hesitate to contact us at info@crowdmason.com.

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