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McNellis: The Bears of Crowdfunding

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By John McNellis

You don’t remember the name Timothy Treadwell, but you remember him. He was the free spirit who went to live among the grizzly bears in Alaska every summer for thirteen years. Despite countless warnings, Treadwell frolicked with these massive omnivores while foregoing precautions even the mildly sane would insist upon; he had neither pepper spray nor an electrified fence and never dreamed of carrying a gun. His “I’m one with the bears” approach worked fine until a bear ate him and his girlfriend.

Developers and promoters of real estate don’t necessarily think of themselves as apex predators, but they do sit atop real estate’s food chain. And, if pressed to name a totemic animal, one suspects most would choose a bear, a wolf, a lion or perhaps a killer whale—definitely something on the chewing end of nature’s eternal struggle.

On the other hand, it would never occur to the executives and employees in the burgeoning crowd funded real estate (CFRE) field to compare themselves to the late Mr. Treadwell, but the analogy might not be that farfetched.

Developers and promoters of real estate don’t necessarily think of themselves as apex predators, but they do sit atop real estate’s food chain

Just as, for Treadwell’s purposes, there were good bears (those who preferred salmon) and, ultimately, bad, there are good developers and sponsors of real estate projects—honest, competent and reliable souls—and bad, those who are skilled in little beyond self-promotion and for whom an honest answer takes as much forethought as a lie.

I asked a smattering of greybeards how long it takes to become competent at underwriting loan and equity proposals—that is, until you have enough pepper spray to protect yourself from rogues. A lender at the nation’s leading bank said 10 years, another estimated 5-7 years while a third declared, “You’re not really smart until you work on a thousand deals.” Go to the “about us” section of any CFRE Web site and ask yourself what thousand words its youthful team photo is worth. A couple might be no experience.

Let’s hold for a moment the obvious conclusion that those without experience will have an easier time staying off the menu if they are underwriting good sponsors and compare the two diverging paths CFRE companies are taking. The majority—notably, Realty MogulFundriseProdigy Network and Realty Shares—are setting themselves up as the money partners in the deals they fund. With them, their mom & pop investors do not invest directly with the project sponsor; instead, they invest in an entity controlled by the CFRE company. This entity acts as the sponsor’s money partner or, in the case of a loan, its lender. In either case, it charges a boatload. If you go to the Realty Mogul Web site, fill out the form to become an accredited investor—it only takes a moment—and click on the investments section, you will see it is offering shares of loans paying interest ranging from 9 to 11 percent. Before rushing out to buy a piece of an 11 percent loan, ask yourself this: Who would pay such an astronomical rate when banks are charging only 4 percent? Only borrowers the banks won’t touch—those with little, no or bad credit. In other words, the bad bears.

If you combine CFRE companies’ lack of underwriting experience with a pool of decidedly second-tier sponsors, you have a broken gate at a railroad crossing. How bad the wreck will be remains to be seen, but we do know that a much better class of borrowers (those with whom Wells Fargo, Goldman Sachs, Credit Suisse, etc. would actually do business) produced loss rates ranging from 3-6 percent on their 2003-08 era loans. Scant imagination is required to foresee a CFRE loss rate so high as to derail invested capital.

And therein lies the problem with this approach to CFRE—if it charges more than good sponsors can obtain elsewhere, they will go elsewhere and CFRE will suffer the fate of hard-money lenders everywhere, that is, an over-reliance on substandard sponsors and ultimately crippling loss rates and probable bankruptcy.

This may not be the destiny of all CFRE. A few companies, e.g. RealCrowd, have a different approach, one that might attract first-rate sponsors who would have good deals for their investors. Instead of insisting upon being a sponsor’s financial partner, they act as a simple conduit, introducing their investors to sponsors through their “pure platform.” In this approach, the company charges the sponsor a fixed fee—about $50,000—for placing her project on the Web site and the sponsor, not the CFRE company, sets the deal terms she wishes to offer her investors. That is the key: Sponsors will love the idea of setting their own terms, especially if they’re only paying 1 percent or so to the conduit. And they will prefer the minor aggravation of having 10-30 small investors to deal with post-closing over that of a single, clout-wielding financial partner (the other CFRE model).

If this conduit approach can truly deliver equity in a timely and relatively pain-free manner, it should be able to choose among best-of-class sponsors and thus thrive through offering their quality projects to its investors. And, like every socialite out there, its predators will choose salmon.

John E. McNellis is a Principal at McNellis Partners in Palo Alto, Calif.