- Promising efficient and low-cost access to private market real estate, more than 100 online real estate crowdfunding platforms have emerged over the last decade, raising billions of dollars from investors.
- Fundrise and other real estate crowdfunding firms have begun to offer online non-traded "eREITs" marketed primarily to younger investors as a better alternative to real estate ETFs.
- Both FINRA and SEC have issued warnings about non-traded REITs, noting their high fees, lack of liquidity, “dividends” coming from return of capital, conflicts of interest, and lack of transparency.
- Beneath a slick website and marketing materials, these "eREITs" are just your average highly-levered and conflict-ridden non-traded REIT. To be fair, Fundrise spells out these risks on their offering documents.
- While we love the concept of making private real estate more accessible, these firms make misleading claims when comparing their inefficient and high-fee nontraded REITs to low-cost real estate ETFs.
What is Real Estate Crowdfunding?
Emerging from the relative success of internet-based capital raising platforms including Kickstarter and GoFundMe, a handful of entrepreneurial real estate firms have attempted to channel the “crowdfunding” model into the real estate investing world. More than 100 “real estate crowdfunding” firms have been established over the last half-decade, raising several billion dollars of investor assets under the premise that pooling small amounts of capital from many investors opens up new investment opportunities that were otherwise out-of-reach to individual investors seeking exposure to private market real estate. The crowdfunding model has evolved over time into two primary models:
- The traditional deal-by-deal model offered only to accredited investors.
- The nontraded REIT model offered to nonaccredited investors.
Real estate crowdfunding is the result of the 2012 Jump Start our Business (JOBS) Act, which removed the prohibition on general solicitation and advertising of securities offerings provided that the issuer takes reasonable steps to ensure investors are accredited, defined as investors earning a minimum $200k in income and $1 million in liquid net worth. A handful of early "crowdfunding" companies emerged, which offered accredited investors access to deal-by-deal capital raising by connecting a network of capital-seeking developers (typically seeking mezzanine debt) with a network of sophisticated accredited individual real estate investors. These deal-by-deal platforms are essentially an online brokerage platform connecting buyer and seller, opening up access to private market real estate in a way that had never been done before.
(Image: Patch of Land)
Like many of the "disrupters" however (Uber and Airbnb come to mind), the economic benefits don't always accrue to the disrupter. A labor-intensive business model requiring the individual financial evaluation of each proposal and the continued oversight of the project and the developer, this model is generally not a too profitable one for these firms, particularly with a relatively sophisticated investor base of knowledegable real estate investors that balked at insufficient risk-adjusted returns. In 2015, the JOBS Act was revised through Title IV to allow firms to raise up to $50 million from nonaccredited investors. Through these Reg A+ rules, the largest crowdfunding firms have revived the much-maligned nontraded REIT model.
The revised Reg A+ rules were a godsend for many real estate crowdfunding firms dealing with razor-thin or negative margins. Under the new regulations, these firms are able to market and sell investments to smaller, less sophisticated non-accredited investors by adopting the non-traded REIT model, a structure which has long been the ugly duckling of the REIT universe. Both FINRA and SEC have issued warnings about non-traded REITs, noting their high fees, lack of liquidity, “dividends” coming from return of capital, conflicts of interest, and lack of transparency.
(Image: FINRA Nontraded REIT Investor Alert)
To be fair, these crowdfunding platforms using the non-traded REIT model are generally an improvement over the broker-dealer model of selling nontraded REITs to unsophisticated retail investors for up-front commissions ranging from 5 to 8%, essentially wiping out at least a year's worth of returns. Crowdfunded non-traded REITs typically do not charge front-end brokerage fees, but do pass on the steep share offering and advertising costs onto investors, which we discuss in more detail below, and suffer from most of the same issues as your typical non-traded REIT including lack of liquidity, lack of transparency, and troubling conflicts of interest. Firms that now offer these nontraded REITs include Fundrise, Rich Uncles, Realty Mogul, and GroundFloor.
There's certainly nothing wrong with charging fees for specialized investment services, and as any Hedge Fund will tell you, higher fees can be justified and well worth the value in many cases. While unlikely based on the prohibitive fee structure, it may even be worth the value for some of these non-traded REITs. We take issue, however, with misleading marketing materials aimed specifically at inexperienced nonaccredited investors that claim that these high-cost investment products are actually low-cost and efficient, and unwarranted comparisons made between these platforms and publicly traded REITs and real estate ETFs. In part one of this multi-part series, we examine the nontraded REIT model and examine some of the claims made by these firms in comparing their offerings to publicly-traded REITs and real estate ETFs.
A Better Alternative to REITs and Real Estate ETFs?
Promising efficient and low-cost access to private market real estate, an objective not dissimilar from the investment rationale of publicly traded REITs, these real estate crowdfunding firms allow individual investors to access the commercial real estate market for purposes of portfolio diversification and the potential for higher returns and yield than common equities. Adding real estate to an investment portfolio through investments in publicly traded REITs has historically produced superior risk-adjusted returns compared to portfolios without REITs.
Interestingly, many crowdfunding platforms directly cite the performance of publicly traded REITs while simultaneously bashing publicly traded REITs as purportedly inefficient and overvalued investment vehicles. Real estate crowdfunding platforms claim to harness these benefits of the publicly traded REIT structure while at the same time capturing the two most commonly cited benefits of private real estate ownership relative to publicly traded REITs:
- Lower Reported Volatility
- Additional Return from Liquidity Premium
These proposed benefits of private real estate investing, even when applied to the most efficient private equity real estate platforms, has been up for debate and largely debunked by numerous studies. These studies indicate that after adjusting for leverage, over the long-term, private market investors are not compensated for illiquidity and that the less frequent mark-to-market of private market assets is merely masking underlying volatility that is exhibited through the daily pricing of REITs.
(Image: Cohen & Steers)
We can give these platforms a pass on these claims considering that they’re used in marketing materials by essentially every private equity real estate firm across the country. We can even give these firms a pass on the claim that their technology platform facilitates a connection between capital seekers and investors on private market assets and development projects in a way that was not previously done before. When done the right way and at sufficient scale, these marketplace models certainly have the potential to create real economic value. We love the concept of making private real estate more accessible to all investors.
If these real estate crowdfunding firms simply left it there and called it a day, we’d say that real estate crowdfunding represents a sensible alternative to otherwise speculative one-off private market real estate deals. We’d say that for a certain type of speculative and sophisticated investor with the time, knowledge, and risk-tolerance to invest in private market real estate, that crowdfunding represents a meaningful innovation in capital raising. For a handful of these crowdfunding platforms that continue to focus on the one-off projects with accredited investors, this may be the case and in part two of this series, we will take a look at some of the better options for accredited investors.
A New World of Fee Generation
The issues begin to emerge when real estate crowdfunding platforms attempt to market themselves to a wider audience, selling an investment product –nontraded REITs- that are wholly unsuitable for the target audience, or most any audience for that matter. The issues are compounded when marketing materials make misleading claims, comparing these high-fee and inefficient nontraded REITs to the more efficient than publicly traded REITs and real estate ETF alternatives.
In a marketing piece titled, “Vanguard vs. Fundrise: Which is the Better Alternative,” Fundrise makes a series of misleading claims in their comparison of their nontraded REITs to the Vanguard Real Estate ETF (VNQ) claiming “Fundrise eREIT investments are lower in cost for investors than those of the Vanguard REIT ETF.” The firm uses the following misleading chart to support the comparison.
For regulated investment products, FINRA and other regulatory bodies are highly critical of cross-asset-class comparisons in marketing materials. Any comparison must be backed-up, warranted, and supported by overwhelming evidence and accompanied by an explanation of the differences in expected risk and return between asset classes. Falling outside of regulatory jurisdiction, however, Fundrise and other crowdfunding firms take liberties when selling their non-traded REITs to inexperienced investors. Each of these line items represents a misleading apples-to-oranges comparison.
- Investment Advisor: Fundrise is comparing their non-fiduciary "investment advisory" services to the typical services of a financial advisor. Self-directed investors would not incur this fee on an ETF.
- Index/Mutual Funds: The average real estate ETF charges less than 50 basis points, which covers all firm overhead including administration, fund marketing, legal services, and portfolio management. Inexplicably, Fundrise claims 0% in overhead at the fund-level. We show below that fund-level fees average more than 3% per year at a minimum.
- Asset Management: Fundrise compares the "asset management" fees at the fund-level to the typical G&A overhead of REITs at the property-level. Since the properties are held and managed by their affiliated JV partners, the property-level asset management fees are incurred at that level, but not reflected in this chart. The comparable "asset management" fee for ETFs would be 0%.
- Selling Costs: Ignored from this table entirely (for obvious reasons), selling costs for crowdfunded real estate are extremely steep. After a 90-day "grace period," investors that redeem within 3 years are charged 3% of principal, and this is actually pretty good compared to the alternatives. Other platforms charge up to 10%. ETF investors incur only the spread, typically less than 0.1%.
We analyzed the firm’s most recent annual report on their two largest nontraded REITs, the Income eREIT and the Growth eREIT and properly adjusted the estimated fees annual on a like-for-like basis. While we are singling out Fundrise here, these issues are shared across the nontraded REIT model. Giving Fundrise the benefit of the doubt and assuming similar property-level fees and risk-adjusted returns incurred by Fundrise’s affiliated joint ventures as the typical REIT, we see that typical fund and investor-level fees are 7-13x higher in the real estate crowdfunding nontraded REIT model compared to the typical real estate ETF charging 50 basis points, depending on whether the investor sells before the 3-year lockup and incurs the 3% liquidation fee.
Most Investors Should Stick With REITs & ETFs
Promising efficient and low-cost access to private market real estate, more than 100 online real estate crowdfunding platforms have emerged over the last decade, raising billions of dollars from investors. While a handful of platforms represent meaningful innovation for a certain type of speculative and sophisticated real estate investor in one-off private market transactions, crowdfunding platforms have increasingly marketed their products to less sophisticated investors, utilizing the notoriously investor-unfriendly nontraded REIT model.
Both FINRA and SEC have issued warnings about nontraded REITs, noting their high fees, lack of liquidity, “dividends” coming from return of capital, conflicts of interest, and lack of transparency. Beneath a slick SEO-optimized website and marketing materials, Fundrise and other real estate crowdfunding platforms offering these "e-REITs" are just your average highly-levered and conflict-ridden nontraded REIT. As we point out, there's nothing inherently wrong with high-cost investment products, but we take issue with how these firms market the products to unsophisticated investors.
While we love the concept of making private real estate more accessible to more investors, and we think that the platforms offering deal-by-deal projects make sense for a relatively small class of sophisticated risk-seeking self-directed real estate investors, these firms make a series of misleading claims when comparing their inefficient and high-fee nontraded REITs to low-cost real estate ETFs.
For the vast majority of investors, publicly traded REITs and real estate ETFs represent the far more efficient investment vehicle. Publicly-traded REITs and ETFs each represent some of the most significant investor-friendly innovations of the past century. The use of the non-traded REITs model is an unfortunate step back for a real estate crowdfunding model that has significant upside potential in connecting sophisticated investors with capital-seeking developers and asset owners. In part two of this series, we will take a look at some of the better real estate crowdfunding options for sophisticated and risk-seeking accredited investors.
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This article was written by
Alex Pettee is President and Director of Research and ETFs at Hoya Capital. Hoya manages institutional and individual portfolios of publicly traded real estate securities.
Alex leads the investing group Hoya Capital Income Builder. The service features a team of analysts focusing on real income-producing asset classes that offer the opportunity for reliable income, diversification, and inflation hedging. Learn More.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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