RER V43 #3 Cannon Article

Disruption, Disintermediation and Real
Estate Crowdfunding
Susanne Ethridge Cannon, Ph.D.*
Crowdfunding (gathering small sums from
a large number of people for a speciŽc cause
or project) is the latest buzzword in both debt
and equity markets, and real estate profes-
sionals are gearing up to take advantage of
it. One gauge of the appetite for a bite of the
pie is the number of conferences being set
up across the country by attorneys, venture
capitalists, academics and a whole crowd of
hangers on.
Google “crowdfunding conference” and 2.7
million hits show up, some to promote a
speciŽc conference, most to comment on the
phenomenon. Add the term “real estate” and
the hits narrow down to just 400,000. And
the funny thing is that there is no such thing
as crowdfunding real estate.
We should probably go back to the
beginning.
EARLY DAYS
According to Paul McFeddrie of wordspy.
com, the term crowdfunding was invented
and Žrst used in 2006 by Michael Sullivan of
fundavlog, an early attempt to draw funding
for videoblogging. The term was likely derived
from crowdsourcing, which was Žrst used
about six months earlier by Je Howe of
Wired to describe “obtaining labor, products,
or content from people outside the company”
from a large number of both professional and
amateur contributors. But as early as 1997
artists and charities had been using the
internet to raise funds. Passion and belief
were the initial drivers, beginning with the
rock band Marillion's success in 1997 raising
funds for their US tour. By 2006, several
other donation based or reward based web-
sites were raising funds for victims of cata-
strophic events or to fund creative endeavors.
These include indiegogo.com and gofundme.
com.
The former funds charitable causes, artis-
tic, design and manufacturing projects, with
the rewards or perks frequently being dis-
counted products. The latter is best known
for raising funds for victims of catastrophe or
personal tragedy. People tell their story, or
their friends do it for them, and those who
want to help do so directly.
DISINTERMEDIATION AND REWARD
The common thread among these early
web based social investment vehicles is that
it became possible to reach past intermediar-
ies and contribute to a speciŽc cause, know-
ing that the money would be used exactly
there. And supporters of authors, Žlm makers
and musicians could help out their favorite
*Susanne Ethridge Cannon is Chairman of the Department of Real Estate and the Douglas and Cynthia
Crocker Endowed Director of the Real Estate Center at DePaul University. She is the founding director of the Real
Estate Center and Chairman of the Department of Real Estate. Dr. Cannon has a B.A. in Economics and a Ph.D. in
Finance, both from the University of Texas.
Real Estate Review E Fall 2014
© 2014 Thomson Reuters
3

artist with the promise of a free CD or tickets
to the Žlm when it was Žnished.
The best known site for this support
remains kickstarter.com, which launched in
2009 and which seeks backers for creative
projects that need a speciŽc sum of money
for completion. The rules are that kickstarter
vets the projects and unless pledges for a
project reach its targeted goal, the funds are
not dispersed. The backers are not investors.
They receive rewards if the project succeeds,
and not all do. Failure isn't the only problem
the system faces. Success can lead to some
ugly scenes when one of the projects be-
comes overly so.
Backers of Occulus Rift, a virtual reality
game were dismayed when the inventor sold
the Žrm to Facebook for $2 billion, while their
payo for early investing was likely just a
t-shirt. But most kickstarter projects are far
more modest, and more typically provide just
enough funding for a band to get its music
recorded, for example, and the biggest back-
ers might get a house party at their home as
a reward.
The most successful perks based cam-
paign began on kickstarter with $2 million in
funding raised for Star Citizen, a space trad-
ing and combat simulation game. It is now
being funded on its own website and reports
over $49 million raised to continue its
development. Backers get credit usable to
play the game when it is released.
PEER TO PEER LENDING
Not for ProŽt
Beyond donations and rewards, during the
mid-2000's there was also a developing
peer-to-peer lending platform, modeled to
some degree on the success of Grameen
Bank and the micro-lending pioneer and
Nobel Peace Prize winner Muhammad Yunus.
Kiva.org is a non-proŽt conduit for over
1.2 million lenders who have made $586 mil-
lion in loans as small as $25, with 98.85%
repayment rate. These loans are typically for
a few hundred dollars and funds are used to
start or expand a small business in 77
countries; frequently the business is owned
by a female entrepreneur.
For ProŽt
In 2007 lendingclub.com began making
small unsecured personal loans which it sells
to investors. These loans are typically made
to borrowers who want to consolidate debt
or pay o their credit card debt or make a
major purchase. The rate they pay is about
30% lower than from a Žnancial intermediary,
and the investor returns are along a spec-
trum from 7.7% to 24.4% depending on the
riskiness of the loan.
By 2012 it had not only made loans total-
ing $750,000, but had attracted investments
from John Mack, former chairman of JP
Morgan, Peter Thompson of Thompson Reu-
ters, and Mary Meeker of Kleiner Perkins
CaulŽeld & Byers, in sum, signiŽcant capital
from both venture capital Žrms and high net
worth individuals. Thereafter, it was a rocket
like trajectory, where by the summer of 2014,
Google had taken a $200 million stake, the
Žrm's valuation exceeded $3.7 billion, it had
funded over $5 billion in loans and was
expanding into business lending.
Each of these forms of crowdfunding
portends to revolutionize its Želd. Still in its
infancy with only $10 billion total expected to
be raised in 2014, a fraction of the $400 bil-
lion or so raised by venture capital, charitable
giving and payday loans estimated to make
Real Estate Review
4

up the total provided by other funding
sources and mechanisms, peer to peer lend-
ing is on its way to be a major player. Ironi-
cally, banks are now investors and consum-
ers can borrow from lendingclub.com at rates
lower than the bank itself would have
charged.
This isn't the Žrst time that the Internet has
disrupted markets, although it was a slow
painful start. Remember the early days of
Internet commerce at the start of the 1990's,
with its e-malls and laser printer e-blasts?
Early adopters of this new medium of per-
sonal communication were horriŽed that
anyone would attempt to commercialize this
pristine communication tool by sending out
eblasts. How naïve was that?
ONLINE TRANSACTIONS
But then came Amazon and eBay. Recall
that neither has yet been in existence for 20
years. And each was a disruptive technology
that started out as a garage based business.
Practically no one could have imagined that
either idea would have grown to be much
more than a nice little niche business. But we
watched, participated, and learned about a
whole new way of retailing.
What we have learned is that the market
for antiques, for example, was permanently
changed by eBay. Suddenly it became pos-
sible to buy whatever you wanted online, and
it also became possible to establish the value
of items in your local antique store. Want to
know the likely value of your dining room
table? Chances are that you can Žnd one just
like it on eBay.com even though you might
decide to sell it on craigslist.com, another
disruptive agent that essentially destroyed
the newspaper classiŽed ad.
An entirely new market developed in elec-
tronics, both used and new. Ebay general
merchandise sales totaled $67 billion in
2013. The largest categories are house and
garden, and clothing and accessories, with
antiques trailing in at only $1.1 billion. In ad-
dition, eBay now sells over $6 billion in
vehicles a year.
It has also sold very high ticket items like
yachts, jets, baseball memorabilia, and even
a whole town in Texas and a Tuscan village.
At the same time, Amazon has grown be-
yond its base business of books and now
seems to sell everything; its 2013 revenue
was $74 billion, all online. At the same time
retailers with a physical presence of every
size now have websites that permit online
purchases, an idea that would have seemed
impossible in 1995. Today it is hard to
imagine a sticks-and bricks store without an
online presence.
The Democratization of Information
One of the most intriguing facets of the
internet is the accessibility and transparency
of information, and the extent to which that
information can be used to establish a value,
even if the consumer intends to purchase
locally. Buying a diamond engagement ring
no longer means viewing a small array at your
local jeweler. Instead you can march in with
your printout from bluenile.com, complete
with all the details quantiŽed for the charac-
teristics that you are willing to pay for. Or
you can buy online at one of several online
retailers and bypass the local shop.
The consumer now has a measure of
power, derived from knowledge that never
existed before. That knowledge encourages
a measure of trust due to the availability of
reliable online research that can inspire ma-
jor purchases.
And then there is the marketplace for
Disruption, Disintermediation and Real Estate Crowdfunding
5

homes. The real estate transaction process
converted practically overnight for housing
search and valuation, both of which became
nearly transparent. Whether using realtor.
com, Zillow.com, RedŽn.com, or Trulia.com,
buyers and sellers can determine a much
tighter range for the likely price than ever
before, and they can do it without the assis-
tance of a real estate broker, who in years
past controlled the ow of information.
Do you know anyone who has purchased
a home in the past few years without shop-
ping online? And without comparing listed
and sold properties in the neighborhood?
This has dramatically changed the relation-
ship between brokers and their clients and
created an informed buyer and seller long
before contract negotiations ensue
REGULATORY IMPEDIMENTS TO
CROWDFUNDING
The equity investment world noticed what
was going on in the world of crowdfunding
for both non-proŽt and for-proŽt lenders, as
well as property search and online purchases
of high ticket items. But it was constrained
by Depression-era regulations in the Securi-
ties Act of 1933 and the Securities Exchange
Act of 1934. For most of the last 80 years,
raising funds required registration except
under Rules 504, 505 and 506 of Regulation
D of the 1933 Act.
These unregistered securities are not a
trivial part of the capital markets, with sales
of nearly $1 trillion raised in about 18,000 Žl-
ings in each of the past few years, 99% of it
raised under Rule 506, discussed below. In
fact, capital raised by Regulation D-exempt
fund raising is about the same size as the
entire public debt market, and four times as
large as that raised in the public equity
market. The issuers are hedge funds and
private equity funds as well as venture
capital, Žnancial services, real estate and
over 10,000 non-Žnancial issuers.
The three sections of Regulation D in the
1933 Act placed limits on who the investors
are and on their ability to re-sell their securi-
ties, and Rules 504 and 505 also limit the
total amount that can be raised in a twelve
month period.
While Rule 506 exemptions permitted
unlimited capital to be raised, all three private
placement Rules required stringent and re-
strictive steps in marketing and securing
investors from among persons already known
to the sponsor. Simply put, the Depression-
era Rules created two key obstacles to using
the internet to raise funds for private
placement.
First was the clear prohibition on any sort
of marketing eort beyond family and friends
with whom there was a prior relationship.
And second, investments were limited to
“accredited” investors: those who have a net
worth over $1 million or whose income
exceeds $200,000 individually or $300,000
for a married couple.
Obviously it wouldn't be possible to raise
funds on the internet if the existing regula-
tions remained in eect. Nor would it be pos-
sible to tap the wealth of middle income
investors and their IRA's. Further, the Securi-
ties Exchange Act of 1934 limited the number
of investors to 500 people at the end of the
year unless the issuer wanted to be subject
to public company reporting requirements.
Something had to change, and that some-
thing was the JOBS Act: Jumpstart Our Busi-
ness Startups (signed into law in April 2012)
designed to “increase American job creation
and economic growth by improving access to
Real Estate Review
6

the public capital markets for emerging
growth companies.
Under the legislation, Congress directed
the SEC to promulgate rules within 90 days
to alter Rule 506 so that the ban on public
solicitation was lifted, and to remove the 500
person limit that was part of the Exchange
Act and change it to 2000. The SEC missed
the deadline by about a year, but eventually
issued them, and in September 2013 it
became possible to seek equity investment
by soliciting investors broadly through a
number of mediums including the internet.
This opened up the world of accredited
investing to web-based platforms, online
solicitations and more. This is not crowdfund-
ing, however. It is Regulation D, Rule 506
investing. Perhaps we should simply refer to
it as Reg D Revised investing, even though
the world at large persists in calling it
crowdfunding. It is actually not.
The JOBS Act took several other steps to
try to facilitate access to capital for emerging
growth companies. Without going into arcane
details, Regulation A previously placed re-
strictions on the capital raising ability of small
Žrms, with a limit of $5 million without required
registration under the Securities Act of 1933.
Under the 2012 Act, the limits were raised to
$50 million for a tier of investment now being
called Reg A+. It also created a new class of
securities issuer called an Emerging Growth
Company.
All of these changes do not yet get us to
crowdfunding, but they reveal the extent to
which Congress and the White House agreed
on a multipronged approach to increasing ac-
cess to capital.
Getting to small, unsophisticated investors
happens in Title III of the JOBS Act, where
Congress directed the SEC to develop rules
for unaccredited investors to make small
investments. This is truly crowdfunding.
The rules as proposed would permit issu-
ers to raise $1,000,000 from investments of
$2,000 or up to 5% of their net worth from
persons making under $100,000. For people
earning more than $100,000 the cap is
$10,000 of their income or net worth, not to
exceed $100,000. See Table 1 created by
fundable.com for a summary of permitted
investments.
While access appeared to have eased so
that a broad swath of investors could partici-
pate, the new twist on investment by these
unaccredited investors is that they must
invest through broker-dealers or a new
regulated entity called a “funding portal.” And
those portals may not have any investment in
the oering. The SEC suggests that will
prevent a conict of interest, but others have
advised that investors might well prefer to
have their interests aligned with the
promoters. The comments available at the
SEC website lay out arguments on both sides
of this issue, as well as an array of other
issues.
7

The crowdfunding rules have been in an
extended internal review period, following a
90 day comment period that ended in Febru-
ary 2014, and are not expected to be Žnal
until late 2014. In the meantime, unwilling to
wait for the US government to act, a dozen
or more states have put in place or are well
down the process of establishing intrastate
crowdfunding rules and another dozen are
considering it.
The tension between on the one hand
facilitating the formation of capital that will
grow companies and therefore jobs, and on
the other hand protecting unsophisticated
investors from bad actors, is playing itself
out over this long rules-making period.
SECURING CAPITAL FROM THE
CROWD
The promise of the Internet has always
been about democratization, disintermedia-
tion, and transparency. Crowdfunding meets
all three standards. Democratization implies
the two way ow of information and the pos-
sibilities for ordinary people to provide
feedback to both public policy and private,
corporate, actions. In the event of misbehav-
ior on the part of crowdfunded projects there
will certainly be opportunity for comment and
complaint.
Disintermediation is at the core of
crowdfunding. The whole point is to get the
funds needed, whether debt or equity, in-
vested without a cumbersome intermediary
process. And Žnally, transparency comes
through the information provided to investors
or lenders about their speciŽc project
investment. Business startups and young
growing companies, regardless of which sec-
tor, expect to beneŽt from access to capital
by becoming more democratic, providing
transparency and by disintermediating so that
Real Estate Review
8

more of the capital raised goes to them
instead of the intermediary.
Investment in real estate, a tangible prod-
uct which lends itself to project speciŽc
investment rather than Žrm level investment,
looks like a perfect match for both Reg D
Revised and Title III Crowdfunded equity
investment. Of course, real estate developers
and operators have a long history of raising
funds through syndication, but that process
has been under the old Reg D Rule 506: the
solicitation was narrowly circumscribed, in-
formation was never a two way street, and
was largely not transparent, and the syndica-
tor, or intermediary, took a fairly large piece
o the top at the start and when the deal
was liquidated.
When the REIT was invented in the 1960's
it was touted as a way for the “little guy” to
invest in a diversiŽed real estate portfolio, but
now the modern REIT is largely owned by
institutional investors, who may well be pen-
sion funds investing on behalf of their con-
tributors, but only through the plan sponsor
intermediary, not through peer to peer trans-
parent investment in speciŽc deals. The
question is whether revised Reg D investing
and/or Title III crowdfund investing will live
up to its potential and will tap the immense
pool of investable wealth held by individual
investors in a meaningful way? We have
some indications.
ONLINE EQUITY INVESTMENT USING
REG D REVISED
Beginning with the work of brothers Daniel
and Ben Miller in 2011 and publicized in 2012
as “the real estate deal that could change
everything,” there has been a great deal of
talk, and some success, using the tools of
the internet to reach out to potential inves-
tors in real estate. The Miller brothers did
their Žrst fundrise.com project in 2011 using
the Reg A framework, not Reg D, and raised
money from local investors in very small
amounts.
At the time they were looking at the pos-
sibility of signiŽcant funding from a large
group of people who were at least partially
motivated by their engagement within their
community. Now, a mere three years later
they are practically a tech company instead
of a real estate developer, employing an
online platform on behalf of dozens of devel-
opers across the nation.
The JOBS Act came into being while they
were going down a dierent path, but the
Miller brothers have moved now into the Reg
D space. The real change from the days
before the JOBS act is the ability to seek
customers on the Internet and other media
from investors who are not local and are
entirely focused on the cash ow projections
of the sponsors.
Crowdnetic.com reports on capital com-
mitments in ten industries they estimate
nearly $24 million raised across eleven
platforms. Real estate is the second highest
sector. See below Figure 1 and Figure 2
show.
9

Real Estate Review
10

Based on conversations with key players,
the industry is probably raising $5milion to
$10 million a week, with Fundrise accounting
for about $1 million a week and having
funded an array of projects, ranging from a
small neighborhood coee shop to a large
hotel.
There are dozens, if not hundreds of Žrms
beginning to compete, in the general Reg D
space and at least 50 Žrms focused on real
estate. They are all creating web sites that
screen for accredited investors before letting
websurfers get access to the information
about a current investment. On the website
they provide a complete summary of the deal
and an introduction to the key developer.
They are all building a sta to accommodate
their business model.
Both Fundrise and realtymogul.com, for
example have hired marketing and investor
relations professionals and engineers. What
may come as a surprise is the extent to
which the Žrm's employees provide real
customer service and even hand-holding. So,
while the investment may be handled online
from the customer's perspective, inside the
Žrm it is seen as a customer service quan-
dary, with the emphasis on developing a
personal relationship with each client that
leads to repeat business.
Table 2: Six Firm Comparisons
Acquisition Type Typical Investment
Type
Required Investment
Crowdstreet.com Development and
Stable: middle mar-
ket oce and medi-
cal oce, student
and senior housing,
multifamily, retail,
industrial,
Preferred equity or
mezzanine debt, 1 to
7 years
Minimum 5,000
Fundrise.com Rehab or ground up
development and
hold
Preferred Equity or
Mezzanine Debt,
$150,000 to $2 mil-
lion, 1 to 5 years
A very wide range of
possible investments
patchoand.com Fix and ip single
and multifamily
homes
$100,000 to
$500,000 Loan, 1 to
12 months, 12%
interest
Minimum $5,000; 1%
service fee
prodigynetwork.com Prime commercial
properties, both
development and
stable in major met-
ropolitan areas
Equity; International
investors only in
some deals
$50,000 and up
realtymogul.com Fix and Flip single
family to major com-
mercial
$100,000 to $1 mil-
lion, preferred equity;
promote structures
vary, or debt; 6 to 24
months for rehabs,
or 3 to 7 years for
commercial proper-
ties; example
$10,000,000 deal
with $3 million raised
$5,000 minimum,
plus investor fee
11

Acquisition Type Typical Investment
Type
Required Investment
realtyshares.com Fix and Flip, 6 to 12
months, single family
or single family
portfolio or hold 3 to
7 years mid-market
retail, multifamily,
industrial
$100,000 to
$500,000 Equity,
Preferred equity
Minimum $5,000
typical, occasionally
$1,000
The most active use of the new power to
raise funds over the internet right now is in
the single family “Žx and ip” market. Inves-
tors in senior secured debt have been earn-
ing 12% to 15% returns, or even higher, and
getting into and out of deals in about six
months.
The acquisition type, place in the capital
stack and level of required investment varies
immensely. There are Žrms that specialize in
these small, mostly unattractive, single family
properties that are being purchased, reno-
vated, and then sold. Others are in ground
up development. Still others are doing value-
add mid-market shopping centers and indus-
trial property. And these deals could be debt,
preferred equity, or have a promote structure.
That promote may vary from only 10% to as
high as 70%. Table 2 portrays these dier-
ences for six well known Žrms.
There is a long list of real estate players
setting up websites to attract investors into
their product type. Once the investor uses an
online form to self-identify as accredited, by
answering a series of questions regarding
income and wealth, the relationship reverts
to a more typical broker relationship, com-
plete with long sales calls. There is a lot of
personal contact and the investment itself is
likely to be handled by someone sitting in a
room with a phone and a headset.
The idea of a true online portal for invest-
ment, without this level of personal contact,
has not been realized for the most part, al-
though the two largest players, fundrise and
realty mogul both contend that theirs is the
most sophisticated and successful platform.
SOCIAL INVESTMENT AND
CROWDFUNDING
As mentioned in the previous section, one
commonly held belief when fundrise started
its Žrst deal was that crowdfunding would be
a mechanism for social investing, particularly
at a neighborhood level, where individuals
would make investments in properties with
the idea that they wanted to preserve the
low scale commercial character, perhaps,
while obtaining a modest return on their
investment. This “double bottom line” style of
investment seemed ideally suited for socially
motivated investors.
That idea has yet to materialize. Although
fundrise has met with a laundry list of govern-
ment and not for proŽt organizations, none
has been willing to step up with a Žnancial
commitment. This sort of project may, how-
ever, be suited to true crowdfuding by unac-
credited investors.
On the other hand, one of the major prob-
lems for real Title III Crowdfunding is likely to
be its cost. The SEC estimates that the cost
of advertising and web development, compli-
ance and CPA review or audit may be as high
as $39,000, prohibitively high for a small
raise. Of course the percentage of the deal
Real Estate Review
12

that goes to compliance and auditing drops
as the deals get larger, but then the sponsor
must manage the complex reporting and
other rules required to protect unsophisti-
cated investors.
It is understood that the SEC is overwhelm-
ingly concerned about the potential for fraud
and abuse of this shiny new toy and their
fears account for the extraordinary delay in
promulgating rules. And those rules are likely
to drastically limit the scale of investment by
unaccredited investors because of the cum-
bersome buying process and because of the
paucity of knowledgeable investment advi-
sors in the investment space.
SUMMING UP
This gets us back to the beginning: There
is no such thing as crowdfunding for real
estate—yet. However there is a thriving,
growing market for soliciting investment by
accredited investors, using a wide variety of
internet and social media communication
tools.
A look back over 20 years of disruption
and disintermediation in patterns for high
value consumer purchases; home search,
valuation, and purchase; and charitable giving
and lending suggests that real estate is not
immune, and may in fact be an ideal online
investment for both accredited and unac-
credited investors. What we have seen in the
recent past is that regulatory frameworks
designed to protect investors may slow this
process, but those regulations can be ad-
dressed to deal with market demand for ac-
cess to instruments that provide reasonable
returns on investments needed in the
marketplace.
The unanswered question today is whether
the changes in the regulatory framework will
result in investors being lured into high risk
deals and fraudulent transactions or that the
disruption and disintermediation of an 80
year old stagnant framework leads to a more
ecient and transparent capital market.
13

Real Estate Review
14

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