Real estate has a place for crowdfunding
After my last two columns about howcrowdfunding might be used to raise cashfor real estate projects, I was swamped with calls from crowdfunding platforms whose principals told me of their plans to start doing deals in Atlanta.
One of the more interesting points that came up in all of these calls is the question of where crowdfunded cash should fit into the capital stack of a real estate deal. There are several views among the several platforms coming to Atlanta, and how their philosophies compete against each other will be one of the stories that plays out in the space in the next few years.
Crowdfunding in commercial real estate is coming to Atlanta, and savvy project developers and deal facilitators will need to figure out how crowdfunding is going to fit (or not) into their deals.
The Traditional Equity Model
In the traditional model (i.e., where there is a developer or project sponsor who conceives of the idea and then recruits both equity and debt participants) the developer’s equity is like the common stock of a corporation. The developer might get some project fees or management fees from the top, but the developer’s equity deal stands behind the senior debt and the preferred equity.
Equity investors who are recruited into the deal generally get a preferred return. They will receive the first equity out of the deal and their return will generally achieve an IRR of 10 to 15 percent before common equity comes out. Once the preferred equity gets its return of capital plus its preferred return, common equity will get all, or most, of the remainder.
Senior debt sits at the top of the capital stack. Whether the senior lender is a bank or an institutional investor (like an investment fund or a pension plan) the senior lender will have a first priority lien on the project and, in the event of insolvency or bankruptcy, the senior lender will have the first position to recover its loan, plus interest and expenses, before any of the equity gets a distribution.
In a crowdfunded deal, should the crowdfunded equity be common equity (like the developer’s stake), preferred equity (like traditional venture equity that is recruited by a developer) or something else? In the many calls I received over the past week, I heard a variety of opinions.
Competing Models for Crowdfunded Equity
Some said that crowdfunded equity should rank equally with the developer’s equity.
In this view the crowdfunded investors are placing their bets based on the developer’s reputation and ability to bring the project to completion on time and under budget. In the same way that the developer plans to achieve above-market returns on its equity investment, crowdfunded equity has the same incentive. I’ll call this point of view the “Common Equity View”.
A second view is that crowdfunded equity is intending to tag along with the savvy and well-heeled investors who traditional would get recruited into the preferred equity slice of the capital stack. (I’ll call this the “Preferred Equity View”). These investors, traditionally, would be accredited investors who would be making minimum investments not less than $50,000 or $100,000 per deal. They would aim to achieve above-market returns (and the successful ones would succeed) because of their past relationships with the developer.
Once they achieved a good outcome with a developer they would be more likely to invest with that same developer again. Over time, the traditional preferred equity investors developed into a club, where access was restricted both by financial means and the social connections that comes from being a part of the traditional equity investor club. In the Preferred Equity View, crowdfunded investors are looking to get the same returns that traditional equity investors have achieved, even though crowdfunded investors will not be as wealthy or as well connected. In this Preferred Equity View, crowdfunded investors will be looking to tag-along with the traditional preferred equity investor club.
There was a third view, however, that was potentially even more interesting. In this third view, crowdfunded investors will want more of the certainty that comes from a debt investment (like a stated interest rate and a fixed maturity for the investment) and only some of the upside that comes from equity. (I’ll call this the “Hybrid Debt View”). In this view, crowdfunded investors (who don’t have the social connections to the developer or the first-person knowledge about the property that traditional equity investors would have) will want a high degree of certain that they will get back their investment plus interest and will be willing to settle for a smaller share of the preferred equity upside.
I can see the merit to each of these three views. Undoubtedly there will be crowdfund investors who follow winning developers as the Common Equity View predicts. There are also many who argue that one of the chief merits for crowdfunding is the democratizing effect it will have when the great masses of unaccredited investors are able to benefit from the above market returns that have previous been limited to wealthy accredited investors, as the Preferred Equity View expects. (Read this post fromDara Albright for an example of this philosophy).
At the same time, it’s easy to imagine how, at a time when crowdfunding is still new, those investors who try it will want the more stable expectations that come from the Hybrid Debt View.
I think that there will be opportunities for all three views. With the proliferation of crowdfunding platforms I expect we will see this clash of views play out over the next few years. The more successful platforms will be those that can attract the greatest interest on the part of investors and developers and who can fund the most successful deals.