rer v43 #3 cannon article

Disruption, Disintermediation and RealEstate Crowdfunding

Susanne Ethridge Cannon, Ph.D.*

Crowdfunding (gathering small sums froma large number of people for a speci!c causeor project) is the latest buzzword in both debtand equity markets, and real estate profes-sionals are gearing up to take advantage ofit. One gauge of the appetite for a bite of thepie is the number of conferences being setup across the country by attorneys, venturecapitalists, academics and a whole crowd ofhangers on.

Google “crowdfunding conference” and 2.7million hits show up, some to promote aspeci!c conference, most to comment on thephenomenon. Add the term “real estate” andthe hits narrow down to just 400,000. Andthe funny thing is that there is no such thingas crowdfunding real estate.

We should probably go back to thebeginning.

EARLY DAYS

According to Paul McFeddrie of wordspy.com, the term crowdfunding was inventedand !rst used in 2006 by Michael Sullivan offundavlog, an early attempt to draw fundingfor videoblogging. The term was likely derivedfrom crowdsourcing, which was !rst usedabout six months earlier by Je" Howe ofWired to describe “obtaining labor, products,or content from people outside the company”

from a large number of both professional andamateur contributors. But as early as 1997artists and charities had been using theinternet to raise funds. Passion and beliefwere the initial drivers, beginning with therock band Marillion's success in 1997 raisingfunds for their US tour. By 2006, severalother donation based or reward based web-sites were raising funds for victims of cata-strophic events or to fund creative endeavors.These include indiegogo.com and gofundme.com.

The former funds charitable causes, artis-tic, design and manufacturing projects, withthe rewards or perks frequently being dis-counted products. The latter is best knownfor raising funds for victims of catastrophe orpersonal tragedy. People tell their story, ortheir friends do it for them, and those whowant to help do so directly.

DISINTERMEDIATION AND REWARD

The common thread among these earlyweb based social investment vehicles is thatit became possible to reach past intermediar-ies and contribute to a speci!c cause, know-ing that the money would be used exactlythere. And supporters of authors, !lm makersand musicians could help out their favorite

*Susanne Ethridge Cannon is Chairman of the Department of Real Estate and the Douglas and CynthiaCrocker Endowed Director of the Real Estate Center at DePaul University. She is the founding director of the RealEstate Center and Chairman of the Department of Real Estate. Dr. Cannon has a B.A. in Economics and a Ph.D. inFinance, both from the University of Texas.

Real Estate Review E Fall 2014© 2014 Thomson Reuters

3

artist with the promise of a free CD or ticketsto the !lm when it was !nished.

The best known site for this supportremains kickstarter.com, which launched in2009 and which seeks backers for creativeprojects that need a speci!c sum of moneyfor completion. The rules are that kickstartervets the projects and unless pledges for aproject reach its targeted goal, the funds arenot dispersed. The backers are not investors.They receive rewards if the project succeeds,and not all do. Failure isn't the only problemthe system faces. Success can lead to someugly scenes when one of the projects be-comes overly so.

Backers of Occulus Rift, a virtual realitygame were dismayed when the inventor soldthe !rm to Facebook for $2 billion, while theirpayo" for early investing was likely just at-shirt. But most kickstarter projects are farmore modest, and more typically provide justenough funding for a band to get its musicrecorded, for example, and the biggest back-ers might get a house party at their home asa reward.

The most successful perks based cam-paign began on kickstarter with $2 million infunding raised for Star Citizen, a space trad-ing and combat simulation game. It is nowbeing funded on its own website and reportsover $49 million raised to continue itsdevelopment. Backers get credit usable toplay the game when it is released.

PEER TO PEER LENDING

Not for Pro!t

Beyond donations and rewards, during themid-2000's there was also a developingpeer-to-peer lending platform, modeled tosome degree on the success of Grameen

Bank and the micro-lending pioneer andNobel Peace Prize winner Muhammad Yunus.

Kiva.org is a non-pro!t conduit for over1.2 million lenders who have made $586 mil-lion in loans as small as $25, with 98.85%repayment rate. These loans are typically fora few hundred dollars and funds are used tostart or expand a small business in 77countries; frequently the business is ownedby a female entrepreneur.

For Pro!t

In 2007 lendingclub.com began makingsmall unsecured personal loans which it sellsto investors. These loans are typically madeto borrowers who want to consolidate debtor pay o" their credit card debt or make amajor purchase. The rate they pay is about30% lower than from a !nancial intermediary,and the investor returns are along a spec-trum from 7.7% to 24.4% depending on theriskiness of the loan.

By 2012 it had not only made loans total-ing $750,000, but had attracted investmentsfrom John Mack, former chairman of JPMorgan, Peter Thompson of Thompson Reu-ters, and Mary Meeker of Kleiner PerkinsCaul!eld & Byers, in sum, signi!cant capitalfrom both venture capital !rms and high networth individuals. Thereafter, it was a rocketlike trajectory, where by the summer of 2014,Google had taken a $200 million stake, the!rm's valuation exceeded $3.7 billion, it hadfunded over $5 billion in loans and wasexpanding into business lending.

Each of these forms of crowdfundingportends to revolutionize its !eld. Still in itsinfancy with only $10 billion total expected tobe raised in 2014, a fraction of the $400 bil-lion or so raised by venture capital, charitablegiving and payday loans estimated to make

Real Estate Review


4

up the total provided by other fundingsources and mechanisms, peer to peer lend-ing is on its way to be a major player. Ironi-cally, banks are now investors and consum-ers can borrow from lendingclub.com at rateslower than the bank itself would havecharged.

This isn't the !rst time that the Internet hasdisrupted markets, although it was a slowpainful start. Remember the early days ofInternet commerce at the start of the 1990's,with its e-malls and laser printer e-blasts?Early adopters of this new medium of per-sonal communication were horri!ed thatanyone would attempt to commercialize thispristine communication tool by sending outeblasts. How naïve was that?

ONLINE TRANSACTIONS

But then came Amazon and eBay. Recallthat neither has yet been in existence for 20years. And each was a disruptive technologythat started out as a garage based business.Practically no one could have imagined thateither idea would have grown to be muchmore than a nice little niche business. But wewatched, participated, and learned about awhole new way of retailing.

What we have learned is that the marketfor antiques, for example, was permanentlychanged by eBay. Suddenly it became pos-sible to buy whatever you wanted online, andit also became possible to establish the valueof items in your local antique store. Want toknow the likely value of your dining roomtable? Chances are that you can !nd one justlike it on eBay.com even though you mightdecide to sell it on craigslist.com, anotherdisruptive agent that essentially destroyedthe newspaper classi!ed ad.

An entirely new market developed in elec-

tronics, both used and new. Ebay generalmerchandise sales totaled $67 billion in2013. The largest categories are house andgarden, and clothing and accessories, withantiques trailing in at only $1.1 billion. In ad-dition, eBay now sells over $6 billion invehicles a year.

It has also sold very high ticket items likeyachts, jets, baseball memorabilia, and evena whole town in Texas and a Tuscan village.At the same time, Amazon has grown be-yond its base business of books and nowseems to sell everything; its 2013 revenuewas $74 billion, all online. At the same timeretailers with a physical presence of everysize now have websites that permit onlinepurchases, an idea that would have seemedimpossible in 1995. Today it is hard toimagine a sticks-and bricks store without anonline presence.

The Democratization of Information

One of the most intriguing facets of theinternet is the accessibility and transparencyof information, and the extent to which thatinformation can be used to establish a value,even if the consumer intends to purchaselocally. Buying a diamond engagement ringno longer means viewing a small array at yourlocal jeweler. Instead you can march in withyour printout from bluenile.com, completewith all the details quanti!ed for the charac-teristics that you are willing to pay for. Oryou can buy online at one of several onlineretailers and bypass the local shop.

The consumer now has a measure ofpower, derived from knowledge that neverexisted before. That knowledge encouragesa measure of trust due to the availability ofreliable online research that can inspire ma-jor purchases.

And then there is the marketplace for

Disruption, Disintermediation and Real Estate Crowdfunding


5

homes. The real estate transaction processconverted practically overnight for housingsearch and valuation, both of which becamenearly transparent. Whether using realtor.com, Zillow.com, Red!n.com, or Trulia.com,buyers and sellers can determine a muchtighter range for the likely price than everbefore, and they can do it without the assis-tance of a real estate broker, who in yearspast controlled the #ow of information.

Do you know anyone who has purchaseda home in the past few years without shop-ping online? And without comparing listedand sold properties in the neighborhood?This has dramatically changed the relation-ship between brokers and their clients andcreated an informed buyer and seller longbefore contract negotiations ensue

REGULATORY IMPEDIMENTS TOCROWDFUNDING

The equity investment world noticed whatwas going on in the world of crowdfundingfor both non-pro!t and for-pro!t lenders, aswell as property search and online purchasesof high ticket items. But it was constrainedby Depression-era regulations in the Securi-ties Act of 1933 and the Securities ExchangeAct of 1934. For most of the last 80 years,raising funds required registration exceptunder Rules 504, 505 and 506 of RegulationD of the 1933 Act.

These unregistered securities are not atrivial part of the capital markets, with salesof nearly $1 trillion raised in about 18,000 !l-ings in each of the past few years, 99% of itraised under Rule 506, discussed below. Infact, capital raised by Regulation D-exemptfund raising is about the same size as theentire public debt market, and four times aslarge as that raised in the public equitymarket. The issuers are hedge funds and

private equity funds as well as venturecapital, !nancial services, real estate andover 10,000 non-!nancial issuers.

The three sections of Regulation D in the1933 Act placed limits on who the investorsare and on their ability to re-sell their securi-ties, and Rules 504 and 505 also limit thetotal amount that can be raised in a twelvemonth period.

While Rule 506 exemptions permittedunlimited capital to be raised, all three privateplacement Rules required stringent and re-strictive steps in marketing and securinginvestors from among persons already knownto the sponsor. Simply put, the Depression-era Rules created two key obstacles to usingthe internet to raise funds for privateplacement.

First was the clear prohibition on any sortof marketing e"ort beyond family and friendswith whom there was a prior relationship.

And second, investments were limited to“accredited” investors: those who have a networth over $1 million or whose incomeexceeds $200,000 individually or $300,000for a married couple.

Obviously it wouldn't be possible to raisefunds on the internet if the existing regula-tions remained in e"ect. Nor would it be pos-sible to tap the wealth of middle incomeinvestors and their IRA's. Further, the Securi-ties Exchange Act of 1934 limited the numberof investors to 500 people at the end of theyear unless the issuer wanted to be subjectto public company reporting requirements.

Something had to change, and that some-thing was the JOBS Act: Jumpstart Our Busi-ness Startups (signed into law in April 2012)designed to “increase American job creationand economic growth by improving access to

Real Estate Review


6

the public capital markets for emerginggrowth companies.

Under the legislation, Congress directedthe SEC to promulgate rules within 90 daysto alter Rule 506 so that the ban on publicsolicitation was lifted, and to remove the 500person limit that was part of the ExchangeAct and change it to 2000. The SEC missedthe deadline by about a year, but eventuallyissued them, and in September 2013 itbecame possible to seek equity investmentby soliciting investors broadly through anumber of mediums including the internet.

This opened up the world of accreditedinvesting to web-based platforms, onlinesolicitations and more. This is not crowdfund-ing, however. It is Regulation D, Rule 506investing. Perhaps we should simply refer toit as Reg D Revised investing, even thoughthe world at large persists in calling itcrowdfunding. It is actually not.

The JOBS Act took several other steps totry to facilitate access to capital for emerginggrowth companies. Without going into arcanedetails, Regulation A previously placed re-strictions on the capital raising ability of small!rms, with a limit of $5 million without requiredregistration under the Securities Act of 1933.Under the 2012 Act, the limits were raised to$50 million for a tier of investment now beingcalled Reg A+. It also created a new class ofsecurities issuer called an Emerging GrowthCompany.

All of these changes do not yet get us to

crowdfunding, but they reveal the extent towhich Congress and the White House agreedon a multipronged approach to increasing ac-cess to capital.

Getting to small, unsophisticated investorshappens in Title III of the JOBS Act, whereCongress directed the SEC to develop rulesfor unaccredited investors to make smallinvestments. This is truly crowdfunding.

The rules as proposed would permit issu-ers to raise $1,000,000 from investments of$2,000 or up to 5% of their net worth frompersons making under $100,000. For peopleearning more than $100,000 the cap is$10,000 of their income or net worth, not toexceed $100,000. See Table 1 created byfundable.com for a summary of permittedinvestments.

While access appeared to have eased sothat a broad swath of investors could partici-pate, the new twist on investment by theseunaccredited investors is that they mustinvest through broker-dealers or a newregulated entity called a “funding portal.” Andthose portals may not have any investment inthe o"ering. The SEC suggests that willprevent a con#ict of interest, but others haveadvised that investors might well prefer tohave their interests aligned with thepromoters. The comments available at theSEC website lay out arguments on both sidesof this issue, as well as an array of otherissues.



7

The crowdfunding rules have been in anextended internal review period, following a90 day comment period that ended in Febru-ary 2014, and are not expected to be !naluntil late 2014. In the meantime, unwilling towait for the US government to act, a dozenor more states have put in place or are welldown the process of establishing intrastatecrowdfunding rules and another dozen areconsidering it.

The tension between on the one handfacilitating the formation of capital that willgrow companies and therefore jobs, and onthe other hand protecting unsophisticatedinvestors from bad actors, is playing itselfout over this long rules-making period.

SECURING CAPITAL FROM THECROWD

The promise of the Internet has alwaysbeen about democratization, disintermedia-

tion, and transparency. Crowdfunding meetsall three standards. Democratization impliesthe two way #ow of information and the pos-sibilities for ordinary people to providefeedback to both public policy and private,corporate, actions. In the event of misbehav-ior on the part of crowdfunded projects therewill certainly be opportunity for comment andcomplaint.

Disintermediation is at the core ofcrowdfunding. The whole point is to get thefunds needed, whether debt or equity, in-vested without a cumbersome intermediaryprocess. And !nally, transparency comesthrough the information provided to investorsor lenders about their speci!c projectinvestment. Business startups and younggrowing companies, regardless of which sec-tor, expect to bene!t from access to capitalby becoming more democratic, providingtransparency and by disintermediating so that

Real Estate Review


8

more of the capital raised goes to theminstead of the intermediary.

Investment in real estate, a tangible prod-uct which lends itself to project speci!cinvestment rather than !rm level investment,looks like a perfect match for both Reg DRevised and Title III Crowdfunded equityinvestment. Of course, real estate developersand operators have a long history of raisingfunds through syndication, but that processhas been under the old Reg D Rule 506: thesolicitation was narrowly circumscribed, in-formation was never a two way street, andwas largely not transparent, and the syndica-tor, or intermediary, took a fairly large pieceo" the top at the start and when the dealwas liquidated.

When the REIT was invented in the 1960'sit was touted as a way for the “little guy” toinvest in a diversi!ed real estate portfolio, butnow the modern REIT is largely owned byinstitutional investors, who may well be pen-sion funds investing on behalf of their con-tributors, but only through the plan sponsorintermediary, not through peer to peer trans-parent investment in speci!c deals. Thequestion is whether revised Reg D investingand/or Title III crowdfund investing will liveup to its potential and will tap the immensepool of investable wealth held by individualinvestors in a meaningful way? We havesome indications.

ONLINE EQUITY INVESTMENT USINGREG D REVISED

Beginning with the work of brothers Daniel

and Ben Miller in 2011 and publicized in 2012as “the real estate deal that could changeeverything,” there has been a great deal oftalk, and some success, using the tools ofthe internet to reach out to potential inves-tors in real estate. The Miller brothers didtheir !rst fundrise.com project in 2011 usingthe Reg A framework, not Reg D, and raisedmoney from local investors in very smallamounts.

At the time they were looking at the pos-sibility of signi!cant funding from a largegroup of people who were at least partiallymotivated by their engagement within theircommunity. Now, a mere three years laterthey are practically a tech company insteadof a real estate developer, employing anonline platform on behalf of dozens of devel-opers across the nation.

The JOBS Act came into being while theywere going down a di"erent path, but theMiller brothers have moved now into the RegD space. The real change from the daysbefore the JOBS act is the ability to seekcustomers on the Internet and other mediafrom investors who are not local and areentirely focused on the cash #ow projectionsof the sponsors.

Crowdnetic.com reports on capital com-mitments in ten industries they estimatenearly $24 million raised across elevenplatforms. Real estate is the second highestsector. See below Figure 1 and Figure 2show.



9

Real Estate Review


10

Based on conversations with key players,the industry is probably raising $5milion to$10 million a week, with Fundrise accountingfor about $1 million a week and havingfunded an array of projects, ranging from asmall neighborhood co"ee shop to a largehotel.

There are dozens, if not hundreds of !rmsbeginning to compete, in the general Reg Dspace and at least 50 !rms focused on realestate. They are all creating web sites thatscreen for accredited investors before lettingwebsurfers get access to the informationabout a current investment. On the websitethey provide a complete summary of the deal

and an introduction to the key developer.They are all building a sta" to accommodatetheir business model.

Both Fundrise and realtymogul.com, forexample have hired marketing and investorrelations professionals and engineers. Whatmay come as a surprise is the extent towhich the !rm's employees provide realcustomer service and even hand-holding. So,while the investment may be handled onlinefrom the customer's perspective, inside the!rm it is seen as a customer service quan-dary, with the emphasis on developing apersonal relationship with each client thatleads to repeat business.

Table 2: Six Firm Comparisons

Acquisition Type Typical InvestmentType

Required Investment

Crowdstreet.com Development andStable: middle mar-ket o$ce and medi-cal o$ce, studentand senior housing,multifamily, retail,industrial,

Preferred equity ormezzanine debt, 1 to7 years

Minimum 5,000

Fundrise.com Rehab or ground updevelopment andhold

Preferred Equity orMezzanine Debt,$150,000 to $2 mil-lion, 1 to 5 years

A very wide range ofpossible investments

patcho#and.com Fix and "ip singleand multifamilyhomes

$100,000 to$500,000 Loan, 1 to12 months, 12%interest

Minimum $5,000; 1%service fee

prodigynetwork.com Prime commercialproperties, bothdevelopment andstable in major met-ropolitan areas

Equity; Internationalinvestors only insome deals

$50,000 and up

realtymogul.com Fix and Flip singlefamily to major com-mercial

$100,000 to $1 mil-lion, preferred equity;promote structuresvary, or debt; 6 to 24months for rehabs,or 3 to 7 years forcommercial proper-ties; example$10,000,000 dealwith $3 million raised

$5,000 minimum,plus investor fee



11

Acquisition Type Typical InvestmentType

Required Investment

realtyshares.com Fix and Flip, 6 to 12months, single familyor single familyportfolio or hold 3 to7 years mid-marketretail, multifamily,industrial

$100,000 to$500,000 Equity,Preferred equity

Minimum $5,000typical, occasionally$1,000

The most active use of the new power toraise funds over the internet right now is inthe single family “!x and #ip” market. Inves-tors in senior secured debt have been earn-ing 12% to 15% returns, or even higher, andgetting into and out of deals in about sixmonths.

The acquisition type, place in the capitalstack and level of required investment variesimmensely. There are !rms that specialize inthese small, mostly unattractive, single familyproperties that are being purchased, reno-vated, and then sold. Others are in groundup development. Still others are doing value-add mid-market shopping centers and indus-trial property. And these deals could be debt,preferred equity, or have a promote structure.That promote may vary from only 10% to ashigh as 70%. Table 2 portrays these di"er-ences for six well known !rms.

There is a long list of real estate playerssetting up websites to attract investors intotheir product type. Once the investor uses anonline form to self-identify as accredited, byanswering a series of questions regardingincome and wealth, the relationship revertsto a more typical broker relationship, com-plete with long sales calls. There is a lot ofpersonal contact and the investment itself islikely to be handled by someone sitting in aroom with a phone and a headset.

The idea of a true online portal for invest-ment, without this level of personal contact,

has not been realized for the most part, al-though the two largest players, fundrise andrealty mogul both contend that theirs is themost sophisticated and successful platform.

SOCIAL INVESTMENT ANDCROWDFUNDING

As mentioned in the previous section, onecommonly held belief when fundrise startedits !rst deal was that crowdfunding would bea mechanism for social investing, particularlyat a neighborhood level, where individualswould make investments in properties withthe idea that they wanted to preserve thelow scale commercial character, perhaps,while obtaining a modest return on theirinvestment. This “double bottom line” style ofinvestment seemed ideally suited for sociallymotivated investors.

That idea has yet to materialize. Althoughfundrise has met with a laundry list of govern-ment and not for pro!t organizations, nonehas been willing to step up with a !nancialcommitment. This sort of project may, how-ever, be suited to true crowdfuding by unac-credited investors.

On the other hand, one of the major prob-lems for real Title III Crowdfunding is likely tobe its cost. The SEC estimates that the costof advertising and web development, compli-ance and CPA review or audit may be as highas $39,000, prohibitively high for a smallraise. Of course the percentage of the deal

Real Estate Review


12

that goes to compliance and auditing dropsas the deals get larger, but then the sponsormust manage the complex reporting andother rules required to protect unsophisti-cated investors.

It is understood that the SEC is overwhelm-ingly concerned about the potential for fraudand abuse of this shiny new toy and theirfears account for the extraordinary delay inpromulgating rules. And those rules are likelyto drastically limit the scale of investment byunaccredited investors because of the cum-bersome buying process and because of thepaucity of knowledgeable investment advi-sors in the investment space.

SUMMING UP

This gets us back to the beginning: Thereis no such thing as crowdfunding for realestate—yet. However there is a thriving,growing market for soliciting investment byaccredited investors, using a wide variety ofinternet and social media communicationtools.

A look back over 20 years of disruptionand disintermediation in patterns for highvalue consumer purchases; home search,valuation, and purchase; and charitable givingand lending suggests that real estate is notimmune, and may in fact be an ideal onlineinvestment for both accredited and unac-credited investors. What we have seen in therecent past is that regulatory frameworksdesigned to protect investors may slow thisprocess, but those regulations can be ad-dressed to deal with market demand for ac-cess to instruments that provide reasonablereturns on investments needed in themarketplace.

The unanswered question today is whetherthe changes in the regulatory framework willresult in investors being lured into high riskdeals and fraudulent transactions or that thedisruption and disintermediation of an 80year old stagnant framework leads to a moree$cient and transparent capital market.



13

Real Estate Review


14

rer v43 #3 cannon article

Documents