Transformation of Equity Financing
When the JOBS Act which of course created crowdfunding came on the horizon, I said to myself, one, this is super cool, but two, this is going to transform the American capital formation industry because it's just about bringing the Internet into capital formation. Something that we haven't been allowed to do for 85 years by publicly advertising private investment. I just said this is this is going to be transformative. Disruptive. Awesome.
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Crowd funding Dominated by Real Estate
Probably 90 percent of crowdfunding is still real estate. When the JOBS Act was enacted most people actually saw it as kind of a Silicon Valley phenomenon and that we were going to see lots of high tech companies; who's going to be the next Facebook kind of thing. Indeed that is what the first sites were really about. And I actually wrote a blog post way back then and said, well what about real estate. Real estate is perfect for crowdfunding. For one thing unlike a social media startup, investors investing from a thousand miles away can see a picture of an apartment building or a house or whatever the deal may be.
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In addition, in real estate equity crowdfunding companies are actually issuing stock and giving people something for their money that is making people investors rather than just donors – in contrast to many crowd funding sites geared to business startups. This is, in part, what makes real estate by far the dominant sector in crowd funding.
Transformative for Real Estate
I don't it's hard to speculate about what impact equity crowd funding is going to have on real estate because it's just the internet and whenever the internet comes to an industry whether the travel or the dating or taxicab or the hotel industry, It is totally disruptive. The internet directly connects buyers and sellers and gets rid of middlemen. So traditionally private real estate transactions are financed through lots of very inefficient and opaque private networks. Who you know, who does your father know, who does your friend know, who does your lawyer know. But this is just a normal thing for the Internet to do.
The internet comes in and says, none of that matters anymore because now you can connect directly with your customers and for real estate developments that means investors. What is happening now and what will continue to happen I'm sure, is that as the word gets out, as the public education process continues, within a few years when a real estate developer wants to raise money the first thing that will come to mind is let me go online. Let me get listed on a crowdfunding site. It just will become the normal way to raise capital. That's what's going to happen.
Impact on Private Equity Funds
The Internet of course first picks the lowest hanging fruit and then it picks a little higher hanging fruit. At the top of the tree there's always fruit that the Internet doesn't pick. In the real estate market the sweet spot now is maybe raising a few million dollars for a developer. That will go up and up, but at some point it won't go up anymore because the efficiencies that the Internet is bringing to bear on the market no longer matter. That is to say, if you're the New York developer who put up the new World Trade Center, if you're raising billions of dollars, that market is already a very efficient market in the sense that everyone has access to the same information and everyone knows who the players are. The Internet doesn't have much to add at that level. In this way private equity firms won't be driven out of business, but they will see their lowest hanging deals disappear and they will move upmarket. That that's just what happens when the internet comes to an industry.
Crowd Fund vs. Private Equity: Better for Sponsors
I'm sure you could find a deal if you looked hard enough where someone paid more in a crowdfunding deal than he or she would have paid to private equity. But by and large crowd funded equity is less expensive for the sponsor than is private equity. The real estate crowdfunding world sort of started with some developers going to a meeting in New York to meet with the private equity folks for the umpteenth time and coming back and saying, we're just not doing that anymore. We're not dealing with those guys. Many of my real estate developer clients have told me that they could get their deal funded by private equity but that they can get a better deal from the crowd.
Industry Challenges
I think investor education is certainly what I would say is number one. Crowdfunding, particularly the kind of crowdfunding in which ordinary investors can participate, is very new. It will take time for information about the crowdfunding opportunities to penetrate.
Indeed, depending on the geographic area, some people have not heard about crowdfunding at all. It is still something that only at the far edges of public consciousness. People are becoming aware that they can invest outside their ordinary choices they have; mutual funds and pension plans. So that's the biggest impediment. And after that there are other impediments to the growth of the industry. I think all of which are pretty transparent if you start checking around real estate crowdfunding sites. The sites can be better. The consistency can be better. The ability to compare apples to apples can be better. The explanations can be better. I always say we're in crowdfunding we're where the car industry was in 1914 its just right at the beginning with almost all of the innovation yet to come.
These things tend not to go on a linear scale. Once it takes off it will grow extremely rapidly.
Standardized Contracts
The benefits to investors of having standardized contracts I think are clear. There are people who have a hard enough time understanding the differences between two real estate investments without on top of that needing to understand the differences between multiples 100-page legal documents that go with each real estate deal. There is no reason at all for deals to have different document sets. Indeed, as I have said , what the Internet does is it squeezes middlemen. Well, in private real estate transactions among the many other middlemen there are these people called lawyers and securities lawyers. And there's a lot of money that gets spent on lawyers in private real estate transactions but does not have to get spent. Should not be spent. And the Internet just has this way of finding inefficiencies and kind of pointing the finger at you and saying, you're getting paid too much for this. So that's definitely going to happen with legal documentation.
Impact of the Next Downturn
There will certainly be a shake out. I'm concerned as to whether some platforms, good platforms, can survive a downturn in the way they depend on the cash flow from doing deals. There will be definitely a cut to people's cash flow and I hope that all the best platforms can survive. I'm a little bit concerned about it and I think the weaker players probably will not survive. And we're also going to see investor losses as well. And we're probably going to see lawsuits. We're going to get negative press. People are going to say you lost money in these crowdfunded deals and we'll be able to say but you lost money in the Dow also.
There will be a public relations downturn and the public will get a little skeptical, but this is just the normal business cycle. It's inevitable that the Internet is going to you know come to dominate the capital formation industry as it dominates other industries. It will be a temporary down and then the industry will pick itself back up.