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Crowdfunding without the crowd

As small-time investors get pushed to the sidelines, the sector is looking less like the promised populist revolution

These are exciting times for Fundrise, the Washington, D.C.-based crowdfunding platform. After spending the bulk of its five years financing small-scale projects, the firm is currently working on its biggest deals yet — by far.

The company, one of the most high-profile crowdfunding platforms, is raising $10.5 million and $15.5 million for two undisclosed commercial properties in Brooklyn and Atlanta, according to co-founder and president Dan Miller.

The catch: most of that money won’t actually come from the so-called “crowd.”

“For larger deals, 50 percent to two-thirds [of the debt] is sold to institutions,” Miller said.

And other crowdfunding platforms — websites that have traditionally raised money for development projects from everyday investors— are following suit.

California-based Patch of Land is currently working on a $4.5 million investment that will be entirely funded by institutions, rather than Joe or Jane investor.

Other platforms are also rushing to partner up with hedge funds, private equity shops and wealthy individuals. The result is that crowdfunding is starting to look a bit less like a revolution, and more like the traditional financial sector it set out to displace.

Institutions muscle in

Since September 2013, when Title II of the U.S. JOBS Act legalized real estate crowdfunding by allowing firms to raise unlimited funds from accredited investors, crowdfunding entrepreneurs have talked about democratizing real estate investment by allowing small-time savers the chance to buy stakes in buildings. Most crowdfunding firms make money on these deals by keeping a small portion of the invested sum (usually around 1 or 2 percent) as fees.

But now, the growing focus on institutional funds seems to be putting that utopian vision in doubt. It also raises an existential question for the future of the field: does the crowd still have a place in crowdfunding?

“Institutional money is already usurping the crowd,” said Sherwood Neiss, principal at industry consultant Crowdfund Capital Advisors, which advises government and financial institutions on crowdfunding. “I think this is the general direction it will go in. Unless these are opportunities in small towns, I do believe that this will be mainly institutionally funded deals.”

Neiss explained that institutions, such as hedge funds or private real estate funds, see investing through crowdfunding platforms as an opportunity to find deals they would otherwise not have access to — either because they are too small, or because they would never make it onto the institutions’ radars.

Law firm Richards Kibbe & Orbe and Wharton FinTech, a student-led financial technology initiative, recently surveyed 300 institutional investors, and found that 85 percent were interested in getting involved in peer-to-peer loans — also known as crowdfunded debt. They also discovered that 24 percent of those surveyed were most interested in real estate peer-to-peer loans — coming in a close third behind small business and consumer loans.

“These platforms can deliver assets that are more differentiated and offer higher returns. That’s why they’re interested,” said Richards Kibbe & Orbe’s attorney Jahangier Sharifi, who has worked with numerous financial firms on peer-to-peer lending.

Speeding up the money

For crowdfunding platforms, working with institutions offers the chance to overcome some of the most glaring challenges involved in the business model. Although startups like Fundrise or Patch of Land rarely compete for the same deals, they are under pressure to grow more quickly than their rivals in order to win over more customers and investors.

However, the very nature of crowdfunding makes rapid growth difficult.

Most crowdfunding platforms extend loans — equity is increasingly rare — to real estate owners or developers, and fund those loans by issuing notes to a number of small investors, who can chip in as little as a few thousand dollars. But finding a large number of investors takes time, limiting the number of deals a platform can take on. Just as crucially, potential borrowers eager to close on deals often can’t afford to wait weeks until enough investors have signed on, meaning crowdfunders lose out on potentially lucrative deals.

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Bringing on institutional investors is a solution to both problems: it brings cash to take on more deals, and it gives borrowers peace of mind.

Allen Shayanfekr, CEO of Long Island-based crowdfunding startup Sharestates, said the private lending space that crowdfunding companies are competing in is “inherently very fast-paced.”

“We typically have a pretty good advance knowledge of deals, but there were instances where we needed to close within a week,” Shayanfekr told TRD in the spring, shortly before the firm struck a deal with Texas-based Ranger Direct Lending Fund to invest up to $30 million through the site.

Since the announcement, Sharestates’ aggregate deal volume has more than doubled from $4.5 million to $11 million, with another $10 million expected to close by press time, according to Shayanfekr.

“Institutional investors really are critical for scale and the volume a platform needs to do at the end of the day to be profitable,” said Fundrise’s Miller. With the help of big funds, he expects to do another three to five deals in excess of $10 million this year.

“We have dealflow [institutions] otherwise wouldn’t see,” he argued.

Given the advantages of tapping into bigger money players, there is some debate about what role the crowd will play going forward.

Richard Swart, a research scholar at the University of California, Berkeley’s Haas School of Business who studies crowdfunding, believes that small-time investors will “probably not” have a role in funding commercial real estate projects. Instead, he argued, crowdfunding platforms will serve a function similar to REITs: as a way for institutional investors to diversify their holdings.

Miller, however, said he believes there is still real value in the crowd.

“It’s important to us that institutions don’t crowd out the space,” he said, adding that he is sticking with the crowd by keeping accredited investors in the mix and even opening up deals to unaccredited investors in part to “stay true to our business model.”

Patch of Land’s Jason Fritton, whose firm has secured a $25 million commitment from a hedge fund and is working on deals with several other institutions, said keeping small-time investors in the mix is important.

“My crowd is my redundancy and my flexibility,” he said. The way Fritton sees it, institutions often turn off the spigot during downturns, while at least some small retail investors are likely to continue investing. The more individual members a platform has, the more likely it will be able to continue raising cash in rocky economic times.

“That’s where the real power of crowdfunding is going to be. Not right now, but when the market changes,” he added.

While Miller, Fritton and others believe the crowd will continue to play a role, they argue that regulatory changes are needed for the crowd to remain truly relevant.

So far, the JOBS Act gives platforms easy access to money from accredited investors — households with an income of more than $200,000 per year or net wealth of $1 million. But they are only a tiny fraction of U.S. savers. Raising funds from unaccredited investors, in contrast, is limited in size and comes with added paperwork, making true crowdfunding cumbersome.

Title III of the JOBS Act, which would liberalize crowdfunding from unaccredited investors, has yet to be passed. The SEC is currently working on formalizing the proposed rules, but is unlikely to get it done before next year. 

In the meantime, firms have little choice but to bank on institutions.

“Over time, regulations will ease,” said Miller. “At that point we may be able to access more retail investors.”

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