Real Estate Crowdfunding: Are IPOs The Next Step?

The days of real estate developers penciling out a deal on the back of a napkin, putting together a spreadsheet model, showing it to a local commercial bank, and walking out with close to 100 percent loan to value financing for a "can't miss" project, are long gone.

Changes in banking regulations since the Great Recession have for the most part limited new ground-up development projects and redevelopment of struggling properties to those done by equity REITs, or funded by mortgage REITs (mREITs) and non-traditional lenders.

The Big Guys
Private equity giant The Blackstone Group BX, is the largest player in the non-traditional real estate space with ~$85 billion of real estate assets under management (AUM). Blackstone raises huge sums of money, largely from institutional limited partners such as pension funds and sovereign wealth funds.

Related Link: A Flurry Of Real Estate Deals Suddenly Blanket NYC And NJ

However, even Blackstone is now looking to raise money from retail investors, albeit targeting the top tier of high-wealth investors who have portfolios with Morgan Stanley and Merrill Lynch.

During a recent presentation, Blackstone CFO Laurence Tosi revealed that the firm had raised $10 billion from products sold to top tier retail investors. Tosi shared that in the short span of three years, Merrill Lynch had gone from zero to No. 11 on the list of Blackstone's sources of new funds.

What About The Little Guy?
Recently there has been a huge buzz around Internet crowdfunding sites such as Kickstarter which has funded a diverse assortment of budding entrepreneurial ideas. They range from the notorious "potato salad" and more recent "Exploding Kittens: a card game," (with over $6 million pledged), to a variety of innovative 3-D printers and wireless smart headphones.

There are dedicated real estate crowdfunding initiatives, such as: Realty Mogul and Fundrise. Why not invest through those avenues?

A Major Hurdle
However, there is a catch, at least for the time being. Real estate investing is more regulated than side dishes, card games, media or consumer electronics.
When it comes to raising funds for real estate, current laws require that investors have a minimum net worth of $1 million (excluding primary residence), or income of at least $200,000 per year in order to be "accredited," and allowed to invest in online real estate syndications.

Uncertainty Problem
Crowdfunding projects typically have a monetary goal and a finite time to raise money for the project. Since real estate projects require relatively large sums of money, there is a classic "chicken-and-the-egg" problem.

How can a developer purchase land or construct new buildings without knowing that the funding is in place to complete the project?

A recent IBD article suggests that the next chapter for real estate crowdfunding has already arrived, which actually is not really crowdfunding in the traditional sense.

Fundrise - Removing Uncertainty
According to IBD, "last year, Fundrise raised some $38 million from a group of real estate, technology and financial institutions, including China-based social networking firm Renren RENN, Ackman-Ziff Real Estate Group and Silverstein Properties.

Most recently, Fundrise bought $5 million in tax-exempt bonds to finance construction of the 80-story 3 World Trade Center being developed by Silverstein Properties in Lower Manhattan.

Fundrise is giving accredited investors a chance to buy into the bonds with a minimum investment of $5,000, and it anticipates an annual 5% gross return and a hold period of five years."

Are IPOs Next?
Internet real estate crowdfunding by its very nature has begun to spawn a highly fragmented group of competing platforms. As the industry matures and begins to shake out, it is possible that the more innovative and successful online franchises will be rolled up by larger financial institutions, and be rebranded, (think Zillow and Trulia).

These companies may eventually choose to access public markets to raise capital. Unaccredited investors, a/k/a "the little guy," would legally be able to own shares and diversify by having an interest in a portfolio of projects, not just a concentrated investment in one illiquid investment.

Final Thoughts
Investors today can own shares in mREITs and diversified REITs that offer the benefits of scale, diversity, liquidity and provide certainty of a minimum of 90 percent of taxable income being distributed to shareholders as dividends by law.

Traditional real estate crowdfunding of a single project entails a great deal of concentration risk, underwriting risks, as well as development risk in new ground-up projects.

At least on the surface, it appears to be far more prudent for the average small investor interested in real estate to buy shares and invest alongside smart money managed by Blackstone; or buy liquid shares of REIT ETF's -- such as the Vanguard REIT Index ETF VNQ.

In its purest form, crowdsourcing for real estate sounds democratic, but in reality, it is a bad idea for most investors.

Image credit: Shane Kelly, Flickr