Crowdfunding 101 for Real Estate Developers

By Jim Verdonik

I'm an attorney with Ward and Smith PA. I also write a column about business and law for American Business Journals, have authored multiple books and teach an eLearning course for entrepreneurs. You can reach me at JFV@WardandSmith.com or JimV@eLearnSuccess.com. Or you can check out my eLearning course at http://www.elearnsuccess.com/start.aspx?menuid=3075 or http://www.youtube.com/user/eLearnSuccessor or you can purchase my books at http://www.amazon.com/Jim-Verdonik/e/B0040GUBRW

Right now many of our real estate development clients are seeing the national economic recovery take root locally and have promising projects available to them. 

Our region is growing. 

·         People need places to live.

·         Growing businesses need room to expand.

·         Relocating businesses need new facilities.

That spells market opportunity.

Traditional Lending Sources

But many real estate developers are waiting on the sidelines.  They can't get into the game and are missing these opportunities, because their traditional lenders are unwilling or unable to fund new projects, either because:

·         Some lenders are still risk adverse and overcompensate for bad decisions made before the 2008-2009 crash.

·         Other lenders are hampered by new regulations that limit their ability to lend and increase their costs.

Unless your project is blue chip with a big equity cushion to protect against downside risk, you face a greater number of hurdles to obtain bank loans for real estate development projects than you faced ten years ago.

That's one reason why inflation is so low despite the Federal Reserve System lavishing big banks with money.  Inflation doesn't occur when the Fed prints money.  Inflation is the product of too much money chasing too few goods and services.  That is not happening at the rate it did in past economic recoveries, because the banks are not lending money to businesses and businesses are not putting the money to work.  Instead, a lot of money is sitting idle in passive investments like treasury bills.

Even if you find institutional investors or lenders with a willingness and ability to lend, you are usually forced to:

• Do your deal on their terms. 
• Pay high fees.
• Provide substantial collateral.
• Personally guarantee the loans putting your personal assets at risk.

The bottom line is that you either take on substantial personal liability and risks or you give up a big part of your equity.  And this on top of the demanding documentation and oversight requirements that traditional lenders usually require.

Your job is to develop new projects and refinance existing projects as loans become due.  But you can't develop new projects or refinance even successful exciting projects without money.

So, what are real estate developers supposed to do?

We see two basic choices for developers:

• Wait for traditional lenders to loosen their purse strings.
• Learn how to tap into other financing sources.

Market Cycles

In every real estate market cycle, traditional lenders eventually loosen lending standards.  So, if you wait, you will probably eventually get money.  At some point in the lending cycle, most projects become fundable.

But be careful what you wish for.  Timing is critically important.  It matters if your project is funded first or last.

Timing is a primary reason why some deep pocket developers succeed over time while other developers with fewer financial resources fail:

• The people who raise money early in a market cycle are usually able to capitalize on the market opportunity.  They cash out before the market becomes saturated with copycat projects. 
• The people who raise money late in the market cycle when credit has become easier to obtain are often left trying to sell into an overbuilt market.

Which group do you want to be in?

Real estate market cycles have proven over and over again that local markets can quickly change from underserved to overbuilt and that "he who hesitates is lost."

Crowdfunding Alternatives

Luckily for developers (and anyone else who needs to raise capital), many people are looking to invest in real estate and other alternative investment opportunities, because, among other things:

• Bank certificates of deposits are paying very low interest to savers.
• High volatility in the stock market makes many people nervous.

Until recently, it has been difficult to tap into the money that individuals have accumulated and want to invest without going through traditional gatekeepers on Wall Street.  Federal and state securities laws have limited your ability to raise capital from anyone other than institutional investors and lenders or people you know personally or through your business connections.

Most people don't have enough high net worth friends and business associates to raise large amounts of capital.  Besides, if you put all your family, friends, and colleagues into a deal, you might become very unpopular, if your deal goes badly.  These are the same people you rely on to sustain you through difficult times.  Do you really want to risk all these important relationships?

Recent changes to securities laws, however, now make it much easier to both borrow and raise equity capital from individuals.  At the same time, technology is making it much easier and less expensive to both communicate and transact business with virtually everyone in the world.  When we apply these new technologies and less restrictive legal regulations to raising money, we call it "crowdfunding."

But perhaps when you first heard about crowdfunding, it seemed like it was not important to you.  When we make judgments like that, busy people often screen out additional information, because want to stay focused.  Let's explore why not learning more about how crowdfunding applies to your business is a mistake.

Real Estate Industry Using Crowdfunding

Let me ask you a question:  Who is raising more money using the new rules and technologies that comprise crowdfunding:

• Software developers?
• Or real estate developers?

Does it surprise you that the real estate industry is raising more money through different variations of crowdfunding than technology businesses are?

Does knowing that crowdfunding is opening new doors for many real estate developers make you want to re-think your crowdfunding strategy?

Four Types of Crowdfunding

The first step to devising your crowdfunding strategy is to understand that "crowdfunding" is not just one thing.  It's a collection of new securities rules and new technologies that you can use in different combinations.  That's why different people use the word "crowdfunding" to describe four very different things.  The only thing these different approaches to raising money share in common is that they all allow you to sell to a wide group of people, who we call the "crowd." 

We often complain when we do not have choices.  But sometimes having too many choices leads to indecision that causes us to miss opportunities.

Let's talk briefly about all four general types of crowdfunding so that you understand which type you can use in your business. 

·         Five Year History Selling Products and Services.  Most people are familiar with websites like https://www.kickstarter.com/ and https://www.indiegogo.com/ and similar websites that allow you to raise money in "campaigns" that sell new products and services.  People who contribute to campaigns on these websites usually are motivated to spend by the desire to help someone else develop and deliver a new product the contributor would like to have.  This type of crowdfunding is really placing a pre-order and paying in advance.  In other cases, sponsors simply give money to promote products they think will be socially useful, even if they personally do not need the product.  It does not involve making an investment in securities. 

You might think this type of crowdfunding is irrelevant to real estate deals, but the lessons learned from many years of this type of crowdfunding point the way to how to use other types of crowdfunding to raise money for real estate deals. 

The first important lesson is that websites like these have become a multi-billion dollar industry despite the fact that contributors take risks without any hope of earning a return on their investment.  This type of crowdfunding demonstrates that if the amount any single individual risks is small enough, you can raise large amounts of money on very favorable terms from many people.

The second basic lesson is that the "crowd" of investors is often highly interested in special niches that appeal to their personal values and hobbies.  The "crowd" often rewards you if you are doing something that appeals to them personally.  What this means for real estate developers is that when you are marketing to the "crowd," you have an advantage if your real estate project includes some socially useful benefits.  For example, renovating historic buildings, urban renewal, and environmentally-friendly projects attract investors who seek a balance between ROI and promoting a social purpose.  In other cases, developers might appeal to investors interested in supporting their ethnic group or gender or in promoting local economic development.  Five years of crowdfunding experience has proven that these types of social "hooks" can help raise money and allow you to structure deals on better terms than you can if you are dealing with strictly financial investors.

Now, let's apply these basic lessons to the other types of crowdfunding that are more relevant to financing real estate projects.

·         Selling Securities to the Crowd.  The crowdfunding rules the United States Securities and Exchange Commission ("SEC") proposed in July 2013 will allow you to sell $10,000 of debt or equity to anyone as long as you do not raise more than $1 million dollars each year using technology platforms similar to the ones that sell pre-orders for products and services. 

We expected these new SEC rules will become effective later this year, but the technology platforms required to support this market are being built now so that they will be ready to launch as soon the new rules allow.  Literally, dozens of platforms will begin operating as soon as the SEC gives the go ahead signal.  It will be the biggest thing in speculation since the last Oklahoma land rush.  And real estate developers will be major players.

Crowdfunding technology platforms will let you do the entire investment transaction without ever talking to a real person just like the existing crowdfunding platforms work to sell products and services.  Although the $1 million dollar annual limitation might limit the usefulness of this type of financing for some real estate projects, developers have long used the strategy of subdivision to their advantage.  You can use crowdfunding to finance multiple individual buildings or lots – each with its own $1 million limit – as long as you avoid falling within the SEC's rules that aggregate commonly controlled issuers.  A developer by cooperating with builders could combine this type of financing with traditional loans to finance a very large residential development.  Because the SEC's crowdfundng rules impose substantial compliance costs, we think the next type of crowdfunding will be used to finance bigger projects – especially projects that cannot be subdivided.

·         Rule 506 (c) Public Private Placements.  New SEC Rule 506 (c) (which some people call "pseudo-crowdfunding or "pubic private placements") allows you to use the Internet and Social Media to raise unlimited amounts of money with low compliance costs as long as you sell only to "accredited investors" and you take reasonable steps to verify that all investors are accredited investors.  "Accredited investors" include people who have annual incomes of $200,000 or more or a net worth of more than $1 million (not including their primary residence). 

Rule 506 (c) allows you to connect to the big money from a combination of both individual and institutional investors.  The best thing about Rule 506 (c) financings is that Rule 506 (c) offers you maximum flexibility in how you attract investors: 

o   You can use a technology platform that someone else operates. 

o   Or you can use your own website and inexpensive Social Media to attract the accredited investors. 

o   If you don't know how to sell using the Internet, you can hire a consultant to do it for you. 

o   You can also advertise in newspapers, magazines, TV, radio, and other media, if you don't like the Internet and Social Media. 

·         Since Rule 506 (c) became effective in October of 2013, entrepreneurs, including real estate developers, have raised several billion dollars in loans and equity investments.  Investment amounts are rising as more people learn how to use this capital-raising tool.  Here's an example of Rule 506 © oriented platform that funds real estate projects: https://fundrise.com/investments

·         State Crowdfunding.  Finally, in addition to the SEC rules, some state crowdfunding laws allow you to use the Internet to raise limited amounts of debt and equity from investors who are located in your state without complying with the SEC's more burdensome crowdfunding rules.  Currently, only a limited number of states have their own crowdfunding laws, but legislation to allow state crowdfunding has been introduced in many the state legislatures and state crowdfunding will eventually come to most states.  Here's an example of a crowdfunding platform that uses state crowdfunding laws ot finace real estate projects:  https://www.groundfloor.us/

Develop Your Crowdfunding Strategy

So far, we have done two things in this article:

• We have talked about your capital needs.
• We have described four new ways many people are raising a lot of money from nontraditional sources.

What we have not talked about are the legal rules you have to follow to begin tapping into these rivers of money.  They are too complex to deal with in the short space of this article, but we have provided additional information in a dozen articles on our website at: http://www.wardandsmith.com/articles/sec-rule-changes-for-private-placements.

• Feel free to use these articles to teach yourself to become an expert on these new rules.

OR

• You can give us a call, tell us you goals and we can help you devise a capital raising plan to achieve your goals.

We look forward to talking with you.

If you would like to learn more about learning how to grow your business or other issues important to your success, you can reach me at JFV@WardandSmith.com or JimV@eLearnSuccess.com. Or you can check out my eLearning course at http://www.elearnsuccess.com/start.aspx?menuid=3075 or http://www.youtube.com/user/eLearnSuccess or you can purchase my books at http://www.amazon.com/Jim-Verdonik/e/B0040GUBRW

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