Crowdsourcing Firm Aims To Revolutionize Real Estate Development

Oct 9 2014 | 8:43am ET

Location is everything in real estate, which makes it somewhat ironic that the rules for crowdfunding real estate developments are currently in limbo.

But that hasn't deterred more enterprising entrepreneurs from getting involved in the space—working within the current legal framework (however onerous) while awaiting crowdfunding rules that Dodd-Frank mandated regulators to draft more than two years ago.

The Washington, D.C.-based Miller brothers—Dan and Ben—are two of those entrepreneurs. Sons of a well-known D.C. developer, they are the founders of Fundrise, the first company to successfully crowdfund an equity investment for real estate online.

“Initially,” Dan Miller told FINalternatives during a recent interview, “we just started doing smaller scale development projects in the neighborhoods where we saw tons of growth...We started buying development buildings in that area—$2 million or $3 million warehouse conversions to retail, $10-$15 million mixed-use projects—all relatively small scale but that had a pretty big impact on a neighborhood of that size.”

“We took a few of those deals through traditional private equity New York...and they really just had no understanding of the deals—they'd never been to the neighborhood, they didn't know any of the tenants they were leasing their building to, they only wanted to write $20 million-plus checks, otherwise it wasn't worth their time, which put most real estate deals out of reach.”

“So we thought, instead of dragging in these groups that aren't familiar with the projects...why don't we go out to people locally who understand the deals, who know the neighborhood, who know the tenant?...That was the initial concept—let anybody invest alongside us as the real estate company.”

Turning that concept into a reality, however, would take three years and about $500,000.

Regulation A

The lawyers they consulted initially kept directing them to Regulation D, the regulation under the 1933 Securities Act that allows companies to sell securities without registering with the SEC provided they sell only to accredited investors—people with a net worth of $1 million (excluding the value of their homes) or income of $200,000. That pool of investors currently includes about 8 million U.S. households of which about 1 million are active investors.

“That didn't work for us because we didn't want to limit it to accredited investors, 3% of the population,” said Miller. “Our goal was to open it up to everybody.”

Miller's brother met with a friend who was head of internet enforcement at the SEC and explained what it was they were trying to do. The friend directed them to an O'Melveny & Myers attorney who had previously worked at the SEC “and had a very intricate understanding of all the different possibilities,” said Miller. The attorney guided them towards another exemption—Regulation A. 

“Effectively, [it] was a state-qualified public offering, like a mini IPO,” said Miller. They had to file hundreds of pages of documents with the SEC and state securities regulators in D.C. and Virginia. “It took about 18 months of review, comments, questions and they finally then signed off on the deal in August 2012. And that's when we launched Fundrise publicly.”

The Reg A offering opened the door to retail investors in the relevant states who could invest as little as $100. To make that sort of small-dollar scheme work, Fundrise digitized the entire process—anyone interested in the deal could come to the site, read the details, invest electronically and sign the documents electronically.

Tech Startup

That first project was a success, raising $325,000 from 175 investors for a 5,000 square foot warehouse conversion in Washington D.C. leased to a famous local chef (“a David Chang-type character,” according to Miller). But it was the means rather than the end that would attract the most attention after Fundrise was the subject of an in-depth article by Emily Badger in Atlantic Magazine's CityLab:

“Once the article launched we had real estate companies from all over the country, actually the world, start reaching out to us asking, 'Can I use the software? I love what you're doing and I'd love to reach such investors. I'd love to go online. I'd love to use the technology and manage the whole process.' And that's when we realized the business wasn't in us being a real estate company, but in creating a platform and a network that other real estate companies could tap into to build a digital brand to raise capital, to manage investors.”

They stopped doing their own real estate projects and have spent the past 18 months turning Fundrise into a “curated and vetted platform” for different real estate companies around the country, allowing them to raise capital from both small-dollar retail investors and from higher-net-worth/family office investors.

“We help structure the deal, we help them with all the legal requirements and...we just recently raised our first round of outside capital and we're now moving towards a model where we'll put our balance sheet behind every deal, much like an investment bank—guarantee funding and close through our own balance sheet and then sell down the positions.”

Miller said they have also realized that equity is very difficult to scale—a capital call, for instance, involving 175 investors, many of them inexperienced, is a difficult feat to perform.

“The thing we do most commonly is preferred equity or mezz[anine debt]. If you're a real estate company...65% bank loans are pretty widely available, and then we'll fit from about 65% to about 85% in the capital stack and then the rest will be equity from the real estate company. That way we're reducing their equity burden, they still have a good amount of skin in the game, and we're providing capital, and most banks won't go higher than 65%, 70% so we can do a high-yield, double-digit return investment in that space.”

Secondary Markets

Fundrise charges the real estate company an origination fee and 2% on funds raised while the investor must pay a 30 basis point servicing fee.

Miller said that they'd expected to see the strongest interest in major metro markets but they've discovered that in places like Manhattan, they're “just another source of capital.” Their real advantage is in markets dominated by a few strong sponsors, cities like Portland, Nashville, Chattanooga, Louisville. They also do well in “the Bushwicks of the world,” said Miller, the emerging, dynamic areas of cities where revitalization is happening—like Brooklyn, where they've done five deals compared to one in Manhattan.

“Most of the deals we provide between $500,000 and $5 million and that goes a very long way in one of those markets. Most of the deals are $20-$30 million and below. Whereas in Manhattan, one condo is $20 million so it's hard to be as competitive.”

But that's not to say Fundrise will never make inroads into what Miller calls “super core” markets like New York and San Francisco. Guggenheim Investors, Renren and Silverstein Properties CEO Marty Burger were among those investing in its first fundraising round, which has thus far garnered $38 million (to date).

Still Waiting

While Miller’s business has taken off thanks to Regulation A deals—which they do once or twice a year—and deals with accredited investors, he would like to see the SEC make more progress on crowdfunding rules.

“It does frustrate us because the whole idea from the beginning was, 'Anybody can invest. It really is wide open.' And now we're sitting here with rules that were passed in April 2012 by Congress, the SEC completely sitting on them, delayed, no end in sight and it's just limiting our business from doing what we really set out to do...Most of the capital side right now is catering to accredited family offices or credit funds or higher-net-worth investors when we'd much rather be spending time doing projects that are distributed much more broadly.”

On the bright side, when the new rules are in place, Miller said Fundrise will be able to service what they've discovered to be “huge untapped demand” from people to “invest in their own communities.” All the work of the original Reg A filing he puts down to “prototyping.” When the new rules are in place, what took them three years and $500,000 should take $5,000 to $10,000 and 21 days.

“Those rules aren't in place yet, the true retail crowdfunding it hasn't broken open like we would have thought,” said Miller. “But it's there, it's going to happen and that's when I think the industry is really going to take off, when anybody can invest.”

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