A capital idea: SEC changes may make it easier to crowdfund real estate

Crowdfunding has been used to finance independent films, support aspiring novelists and musicians and launch small businesses. Now new rules under review by the Securities and Exchange Commission may shake up the real estate market by making it easier for investors to pool their resources and acquire property.

The idea behind crowdfunding is to raise small amounts of money from a large pool of investors, often family and friends, to be able to fund investment opportunities that would otherwise be out of reach.

Under a proposed rule change, individuals and companies may now advertise to solicit investment for a proposal, effectively ending an 80-year-old ban.  It’s part of the Jumpstart Our Business Startups (JOBS) Act passed in April 2012 that created an exemption to securities law allowing crowdfunding firms to market their products only to what are known as “accredited investors,” people with a net worth of $1 million or more and with an annual income of at least $200,000.

Now the SEC has drafted a plan that would allow crowdfunding from smaller investors, allowing individuals to invest $2,000 or 5 percent of their annual income, as long as that income is less than $100,000.

Some welcome the change, seeing it as creating an opportunity for more people to invest in real estate.

Others worry it will set up situations ripe for swindlers to take advantage of unsophisticated investors.

David Moore runs Charlotte Startup Funding, a website dedicated to connecting local entrepreneurs to supporters of their ventures. Moore said a lot of people are interested in buying real estate through crowdfunding, but that’s not necessarily a good thing.

Many of the entrepreneurs he has met with don’t fully understand the SEC guidelines or the consequences of making these transactions.  Furthermore, they’re uneducated about potential returns, haven’t done due diligence on projects, or haven’t thought about the compliance costs associated with having a public company.

David Massey, North Carolina’s deputy securities administrator, said the SEC’s rule change is not set in stone yet. The commission drafted the proposal that is currently under a 90-day review for public comment, so it won’t go into effect until the beginning of the year.

Massey believes that the SEC has been under tremendous political pressure to make the change, but there’s skepticism among state regulators about lifting the restrictions on soliciting funds.

Massey too is conflicted. “I’m in favor of expanding opportunities for ways to invest, but people have been using the internet for years to steal,” he said. “Promoters of schemes are master salesmen who sell sizzle but not steak.”

Despite his concerns about fraud, Massey believes real estate crowdfunding will explode over the next few years. “It has the momentum of a freight train.”

Investors pool resources

Bob Donlon with Horack Talley has assisted Fortune 500 companies in billion-dollar transactions. He has also represented individual entrepreneurs setting up startup businesses.  Donlon said small investors will not get incredibly wealthy with crowdfunding. He thinks people see venture capitalists making money hand over fist, but even these experienced investors make bad decisions because the reality is that most businesses fail. Unlike small investors, venture capitalists also can afford to take some financial hits.

There’s already a market for investors wanting to get involved in all types of real estate projects, whether it’s fix-and-flip residential properties or apartment buildings, retail spaces and self-storage buildings. Over the past year, internet companies like Realty Mogul, Fundrise, Groundfloor and CrowdVested have formed platforms where accredited investors can pool their resources to purchase properties.

Launched in March, Realty Mogul’s co-founder Justin Hughes saw real estate as an ideal area for equity crowdfunding because of its potential for cash-flow and liquidity.  The company has raised funds for 18 ventures and has fully completed and distributed capital investments for three other projects. Hughes said the company was just shy of $10 million in assets under management.

Currently, the firm is working only with accredited investors and, if the SEC eases restrictions, it may look at working with a larger pool of clients. But according to Hughes, setting the lowest investment limit for people earning under $200,000 may be difficult, given the all the costs associated with regulatory compliance.

By pooling resources, a greater number of investors can participate in property acquisition; however, the move to syndication creates another set of hurdles: expensive financial regulations that eat away at overhead.  The company has to pay legal, tax and filing fees for each person in the pool, so the minimum amount invested becomes an important factor.

‘Share’ not easily sold

To reduce risk, Hughes said Realty Mogul looks to projects where the person seeking funding has a history of success and requisite experience in an area, and it looks at whether the project can generate cash flow like rental income.

“We’re not doing ground-up development,” Hughes explained. “So we’re not riding waves of market conditions.”

Also, there’s an end point to each investment. Every transaction has a life-cycle. For fix-and-flip properties, that’s the repayment of the debt. “An equity transaction will roll off in a few years,” said Hughes.

Still, Hughes said the strategy isn’t for every investor. People need to understand that their money is going to be tied up for a certain amount of time; you can’t just sell your share like a stock trade.

But, he said, “At the end of the day, this is a great alternative for investors, and we try to make it as easy and safe as possible.”

It’s not clear yet whether crowdfunding will truly impact real estate acquisitions. In an informal survey, Real Estate Bisnow recently asked its readers whether they thought crowdfunding was the future of real estate. A majority, 57 percent, said “no,” with one reader predicting that “too many unscrupulous people will ruin it.”

Many respondents did see crowdfunding as a new source of capital for smaller deals in the neighborhood of $5 million.

“The real question is legitimacy of a crowdfunding syndicator in a bidding (and borrowing) process,” one respondent told Bisnow. “Will an institutional seller get comfortable that this type of buyer has the capital to execute? And a lender that they can asset-manage effectively?”