Lessons from the closing of Realty Shares. Can Investment Crowdfunding really, really scale?

Realty Shares was seen as a successful, at scale investment crowdfunding company — raising $105.6m in VC funding from well known VCs and smart angels in the valley, 1.2million registered users, and $870million closed across 1,160 debt and equity real estate transactions. These figures indicated a solid business model, one which worked to reach a certain scale, but in November 2018 it announced it would be closing shop.

Because the best lessons come from failures, Realty Shares provides a good case study into the varied structures of real estate crowdfunding companies as well as lessons for future platforms to consider. Like any good MBA case study, I hope to stimulate a discussion by providing some opinions and a framework for identifying how crowdsourcing can truly scale. Ping me if you want to add analysis/data/perspective.

The goal is to support Fintech entrepreneurs as well as individual investors around the globe in the quest to unlock the massive potential of investment /equity crowdfunding including:

• diversified capital formation models/resources,
• personalized return metrics,
• liquidity without costly premiums,
• democratized access to higher returns (private market investments education and expanding who is considered an accredited investor),
• diversify deal picking, remove costly/valueless intermediaries, and reform regulation.

Pushing toward these ambitious goals will require innovative business models and a tech stack that goes beyond being a listing site for traditional real estate deals or centralized data analysis (underwriting/AI). Second, to multiply the scale that current investment crowdfunding has reached, platforms have to deliver a trusted multi-party and liquid service that keeps investors coming back. These can be delivered by the collective efforts being poured into dapps on the blockchain. Third, the underlying investments need to match the appetite of a global and highly fragmented investor base. This is reached by a true partnership among real estate veterans, marketers, and robust tech platforms. 

Part I: What is Equity or Investment Crowdfunding?

Skip if you are familiar with Realty Shares, crowdfunding, and private vs public investments: Investing crowdfunding is different than the rewards crowdfunding 2.0 wave that made the concept popular, most notably by Kiva, GofundMe, IndieGoGo, and Kickstarter. Founded between 2005-2009 these platforms saw wide adoption by improving on pain points of earlier adopters including ease of payment, less fraud, identity verification, and blocking nefarious projects. Rewards crowdfunding appealed to people - fans, supporters, micro-philanthropists - who wanted to fund projects they loved, whether it was covering medical bills of a beloved WWE wrestler, rebuilding Nepal after a devastating earthquake, or to develop the first Oculus Rift VR headset. In 2017 alone $5.5billion has been raised worldwide by rewards crowdfunding sites.

Beyond rewards or social good: investment or equity crowdfunding grew out of the same idea of pooling small amounts from many people around the globe, but instead of appealing to the heart, it promises returns (and an ego boost in owning a piece of a swanky building or cool startup) through an equity or debt position1. Investment crowdfunding platforms have caught on in loans, real estate, and startup funding.

I include peer-to-peer platforms in investment crowdfunding because of their critical similarity to crowdfunding in needing to build demand from individuals, ie “peers”, willing to invest/fund a project whether on behalf of a peer (personal loan, thus peer-to-peer crowdfunding) or real estate developer (C2B: Consumer2Business crowdfunding). In 2017 alone $27.5billion has been raised worldwide by P2P and equity crowdfunding sites.

Investment Crowdfunding’s impact on RE &lending Providers (Sponsors): prior to crowdfunding, lending and real estate have had very little innovation in their source of capital and underwriting/operations. With crowdfunding, issuers/sponsors/entrepreneurs can tap new sources of capital by appealing through broad marketing to individuals’ diverse appetites, lessening the reliance on institutional money and therefore the traditional perspectives of those institutions. Individuals love to hear the story behind their investment, they want to feel proud, whereas an institution is focused on scale and unfortunately outdated metrics to determine creditworthiness such as FICO scores.

Since its inception, crowdfunding was not designed to replace traditional institutions but instead augment it with new points of view from the global crowd. In real estate, for example, office space asset managers’ lack of innovation in operations was an opportunity for Wework to establish coworking space. Real estate professionals traditionally sought a singular strategy of securing long-term office leases with as few tenants as possible. These tenants were expected to have large capital and/or credit histories. Wework responded to the changing dynamic in how people saw their workplace, craving an enjoyable work environment with a flexible space coworking model — even more so during the uncertainty post the 2009 recession. Although the company’s capital stack was not crowdfunded itself, its founder (who grew up in a commune) believed in pooling a community's resources together, turning empty buildings into shared space for tenants happy to pay for smaller offices and shared larger common areas that felt like a community. The tenants, in essence, crowdfunded the rent. This community 12 years later created a $45billion dollar business and a powerful new coworking space sought after by traditional Commercial Real Estate (CRE) funds.

Another great innovation story is peer-to-peer lending platform LendingClub. LC is a marketplace for lending that matches borrowers (mostly of personal unsecured loans) with pooled money from individual retail investors and institutional investors willing to fund those loans. In its first few years, by sourcing capital from individual investors seeking competitive returns and access to data to make their own investment decisions, LendingClub was able to innovate on these and other features such as underwriting guidelines, risk rankings and lower acquisition costs versus its brick and mortar counterparts2. 12 years after LC’s founding still, no bank will share its loan portfolio data nor pivoted from the retail model to a great automated online experience (Goldman Sach’s Marcus is the exception made sense because unlike banks like Bank of America or Wells Fargo GS does not have the retail space overhead problem that would require huge disruption). LendingClub has since pivoted heavily to sourcing capital from institutions at a greater scale by leveraging their now established model.

Investment Crowdfunding’s impact on retail (individual) investors: investment crowdfunding has helped make private market investments accessible to many new investors. What are private investments? Simply, equity or debt positions in a company or entity not listed in the public markets (New York’s NYSE, London’s FTSE or NASDAQ around the globe), every investment crowdfunded project is, therefore, a private market investment.

The average American is not aware of their lack of access to private investments, many other countries do not have such restrictive oversight and have not suffered rampant fraud.

Typical private investments are those made into private equity, real estate, hedge funds, or Venture Capital with historically competitive returns. These are only available to the wealthy and institutional investors (retirement accounts such as CalPERs; college endowments such as Harvard Endowment; or sovereign wealth funds such as Abu Dhabi Investment Authority), excluding 90% of the USA population. In turn, public investments such as stocks or bonds carry heavy listing fees and capped returns. For example, in the eve of Uber public listing in Q2 2019, a 5-year CD returns an unaccredited investor 3%, while a private market investment in Uber returns for an accredited investor like rapper/mogul Jay-Z 50X his money. If this feels like the reason why the rich keep getting richer, it is.

One cause for this walled garden is our current regulatory regime that has been largely unchanged since its inception post-WW2/Great Depression. The SEC put regulations in place -mainly the Securities Act of 1933- to protect investors but at a huge consequence of keeping everyday people out of potentially lucrative investments. The regulation separated individuals into two pools: accredited and nonaccredited investors, with only accredited investors being considered in the eyes of regulators as “sophisticated investors” allowed to participate in private investments because they could bare a loss3. While it avoids massive bad PR, obviously, the ability to lose money does not indicate investment savvy and the very American dream has shown that those hungry for knowledge tend to do better at business.

Crowdfunding has pushed back against this status quo by making private investments available to investors in the amount they can afford, $2m from Jay-Z can also be raised as $10k from 200 young investors (following the Uber IPO they would have each made $500k, enough to buy a home)?.

What crowdfunding has done to make private investments more accessible is a huge deal and needs to go further beyond the JOBS act — that requires a company to seek compliance with the expensive regulatory process — to provide a consumer-driven solution in an era of freelancers needing self-driven investment/retirement planning. I am involved with a grassroots movement to embrace a merit-based test for individuals to gain accredited investor status based on proving their market savvy (FINRA currently oversees such tests). With the SEC already hinting that its time to change how we label investor’s level of sophistication, its a matter of a crowdsourced push to make it happen.

Fundrise was one of the first investment crowdfunding platforms to make private investments in CRE available to nonaccredited investors. They were early advocates for the JOBS act Regulations. By doing so, they did not just talk-the-talk, they increased transparency into the bests they were making, unlike REITs, as well as removing the private market listing premium charged by REITs?. Their unlisted REIT available to purchase on their website, dubbed an “eREIT”, has crowdfunded $1.4bn from accredited and nonaccredited investors around the globe. Historically their eREIT funds have delivered 9–12% annualized returns.

Part 2: Lessons from Realty Shares

1. User Experience

Realty Shares did not deliver on a great user experience expected of a company with $105.6m in funding. I have seen a company with less than a million do a better job. Internal organization priorities are usually responsible for less than laser-focus on user experience — even if a company has the best designers, product managers, and engineers, these people need to be supported. I would call this the “marketing-led” company problem that is exemplified to how Microsoft grew, not with the best tech, but with the best marketing and partnerships. This works as long as that is a competitive advantage over your competitors. But with Realty Shares focused on what traditional real estate sponsors/developers do which is sales, their platform did not substantially improve an investor’s experience -nor did it create a substantially larger market beyond those already dabbling in real estate of some sort. 

Realty Share investors complained that the platform did not provide an easy way to gauge investments or track returns. There are really small wins it could have experimented with in providing interactive tools that help non-lawyers interact with the information dumped into legal disclosures. For example, providing a cash-on-cash return calculation and a simple “$10,000 invested over X years” that let investors change their holding options. Really low hanging fruit it should deliver as a platform charging a management fee (more on this in #3 below) and indicative the platform was not used to inform innovation on old school practices - for example crowdfunding ideas not just capital. 

2. Long Term Capital Partner for Sponsors and a Liquid Market for Investors

At real estate conferences, it's common to hear real estate professionals say they can not find enough good deals to place all the capital at their disposal so why would they risk placing a good property on a crowdfunding site. I think it is a fair criticism from a legacy industry that over decades has established a tight network of builders and capital providers. 

To motivate incumbent real estate sellers or development sponsors to shift to a new model they will have to see crowdfunding as a true partner with access to a completely different network — a new capital formation financial ecosystem — that is much more global, nimble, lower investor acquisition cost, logistically easier, and diverse in investment goals and timetables. Realty Shares did not deliver on this largely because it was the sole market maker for investments within their walled garden. Developing a small army of brokers can only get you so far due to expensive brokerage fees and pain in transferring “paper-based” ownership from one investor to another.

This is a challenge Realty Shares and all investment crowdfunding platforms face — a shortfall of the crowdfunding 2.0 model. Looking forward, Security Tokens issued on the blockchain offer an alternative. With a multitude of stakeholders building an ecosystem that is much more global, nimble, lower cost to acquire, logistically easier, and diverse; it's more probable we will see scale we have not seen before (more on this in a second article).

Furthermore, more individual investors can be attracted to a service that goes beyond investing in one building/project/loan, to one that facilitates participation in a new liquid financial services ecosystem. Liquidity builds trust, the ability to shift investment strategies, and when traded outside the friction of outdated financial services institutions, something people feel instant gratification in trading. Here again, I believe security tokens enhance crowdfunding in providing ownership in something tradeable across multiple exchanges, and hopefully one-day more decentralized investor-to-investor. Realty Shares would have had to build a global exchange with different offerings to deliver liquid ownership, basically building a centralized blockchain.

3. Unclear Value Proposition: Marketplace vs Portfolio Manager

Realty Shares’s hybrid business model embracing both qualities of being a marketplace and a portfolio manager is perhaps the most problematic strategic decision. Realty Shares embraced the Amazon marketplace model by setting out to “connect capital with opportunity”, attracting high-quality supply of real estate deals from “sponsors” (real estate developer or sellers), while building up demand from retail and institutional investors. Similar to Amazon, Realty Shares made no product (investment return) guarantees but unlike Amazon imposed fees to both sponsors and Investors (1–2% management fee).

Further, Realty Shares registered as a broker-dealer with the SEC in order to sell securities backed its real estate targets with no fiduciary responsibility to investors (among other market activities)?. Again, I don’t think that crowdfunding will replace entire segments of traditional capital markets because securitization of assets/loans will continue to be an important component to scaling, but I do see a broker-dealer similar to a marketplace for private securities — ideal for investors who do not need investment of due diligence guidance. But for most individuals starting out it makes more sense to invest in a managed fund (with fiduciary responsibility and/or side by side investment) or a platform like LendingClub’s that provided due diligence with its proprietary algorithmic scorecard. This was the nuanced dilemma for Realty Shares.

But with Realty Shares using an investment team to screen deals and act as an intermediary between investors and Sponsors it was not a true marketplace. The model was a hybrid. Realty Shares put a process in place to give it the perception of being a valued advisor. But investors complained that Realty Shares prohibited direct contact with sponsors, playing a middle man by providing its own analysis and translation of information. If you ever played telephone, you know the last person never gets the same message. This led to a lack of trust from investors. Basically a micromanaging broker for individual investments in buildings.

A true marketplace player such as Real Crowd charges zero to investors and a hefty listing fee to its Sponsors. Investors chose what projects to pursue based on information on Real Crowd and do their due diligence by contacting the sponsor directly. The visual below highlights the differences in responsibilities and fees for a marketplace versus a managed portfolio investment crowdfunding platform.

Despite the broker/marketplace type model, Realty Shares also charged an ongoing management fee of 1% on equity and 2% on debt investments. Charging a management fee is a perfectly acceptable activity in investment management, not a brokerage, to pay for the cost of employing an investment team that could execute toward a specific investment strategy. But investors in Realty Shares felt they were not getting portfolio advice, leaving them to make decisions on the information at hand resulting in investments in multiple projects that performed poorly. One investor cited only 4 of 13 investments turned a profit under one sponsor. In a marketplace with the right tools, those bad deals should not have been funded.

Fundrise, a true portfolio manager, creates portfolios investors can choose from that do not require per deal due diligence?. Investors pay an ongoing management fee for a professional manager to deliver on that portfolio’s investment strategy, for example, “Growth” or “Supplemental Income” goals.

4. Two-Sided Marketplace problem: Missmatched Supply & Demand

Matching Supply & Demand is the biggest challenge of a two-sided marketplace. And in the real estate investment crowdfunding space, demand is built with a supply of investments that deliver on 3 main levers: asset type, return, and liquidity. Depending on the target investor pool, the platform needs to find the right balance of these levers.

Assets types include debt and equity positions in commercial and residential real estate. Equity ownership in a building is probably the most well recognized and sought after investment, everyone loves the idea of saying they own a piece of a high-rise or luxury residential building. Debt is less understood but ironically in many cases, a safer investment requiring less operational headache and providing a steady income.

Asset type and return are two sides of the same coin with each asset class delivering unique return characteristics. New development is long-term 4+years, returning money on the successful completion and leasing/sales of the building based on an assumed cap rate. Existing buildings and loans can have healthy immediate income measurable by a cash-on-cash return calculation (a straight forward measure of how much cash you are getting for your investment, an exit is not assumed like in Cap Rate or IRR).

Realty Shares did a mix, providing a varied supply to appeal to every kind of investor — something for everyone. I think this works for a company with an established customer base that is actively doing hundreds of thousands of transactions, such as Amazon. But it takes time for an investment platform with high ticket offerings to build credibility and competency in each asset class (and geography), brick by brick. Realty Shares disclosed it had 1.2M registered users, but I estimated only 34,800 to 174,000 “customers” transacting on its platform (calculated dividing its published $870M in investments raised by an assumed average investment of $25k or $5k per investor, the latter its minimum investment).

Going after a wide variety of assets would require an equivalent breadth of knowledge and operational capacity, ie a large team, necessitating to pass on those costs as fees to investors. Also, in order to provide real data-driven value, in a way that LendingClub has in personal loan rating, it needed a deeper analysis of return and risk profile for each asset class. Quoting a simple Cap rate adds very little innovation and fails to build demand because potential non-real estate professional investors don’t feel they understand the deal’s fundamentals versus other investments. 

Offering loan investments at a time of cheap debt (courtesy of the Fed keeping fed funds rate between 0–2.5% to facilitate post-recession recovery)required taking CRE mezzanine loan positions to deliver higher returns. These I argue take much more savvy management to work out when they don’t perform, thus not a great fit for a marketplace.

Further, Realty Shares went into the residential mortgage origination business, a highly commoditized business. It's very difficult to win in residential mortgages because a borrower will go wherever they can get the lowest rate, a product feature contrary to a platform’s goal to provide investors with above market returns. With 30-year-fixed mortgages rates hovering around 3–4.5% and overall healthier LTVs in the market, a more unique play require hands-on management of riskier second and re-performing loans. Realty Shares tried to create higher returns by pushing generally understood underwriting criteria without the hands-on management forcing an exit because of high defaults. Not developing additional services beyond what the incumbent real estate funds and banks provide today for loans was a lack of service, which ultimately dampened the quality of its investment supply. 

I would argue that delivering instant gratification was another missed opportunity. That satisfaction of seeing your Uber driver get closer and closer to your location turns out to be important for investors as well. Because the typical debt or equity RE deal can take 30–90 days to close, immediate gratification is a huge challenge if the platform does not already own the real estate. A user will not stick around that long to see a project close on Kickstarter or Kiva.

Summing it Up

The lesson here is for each platform to choose its service strategy, focus, and execute on it well. Crowdsourcing is valuable to a strategy that embraces its full value that could mean building out actual services/ops. For example, leveraging the diversity of the crowd’s appetite as a great testing ground for new innovative investment strategies (Wework). Further, embracing an iterative process to find product-market fit (Fundrise) and avoid hard pivots to make money. Focusing on transactions in a more traditional (institutional) way is not a new service.

Footnotes:

[1]Realty Shares stopped taking on new investors and acquisitions in November 2018, while it’s remaining $400million dollar portfolio would be transitioned to a traditional asset manager. It also did not renew its broker-dealer license. 

[2]Investment and equity crowdfunding are sometimes used interchangeably, but some define equity crowdfunding to only include equity positions. Because investments can be made in equity, debt, revenue share, or hybrid convertible notes I don’t think this distinction is relevant to this case study, what matters is that its an investment. Also, the definition can vary based on small technicalities of the legal structure. For example, loan assets can be held in a trust or LLC, where ownership can be of the debt itself or in equity in the entity holding the pool of loans. In either case, those loans, in turn, are collateralized by a building. In a revenue share agreement, no equity is exchanged, only a certain percentage of revenues or profit is passed through to investors.

[3] Lending Club legally is not a loan originator, instead, it is structured as an acquirer with an alternative bank (holding state lending licenses) originating the loans on behalf of LC, which are then sold back to LC fund or passed on to the retail and institutional investors. Under this structure, LC operates more like a “craigslist” marketplace that markets to investors and borrowers to transact on its platform, but does not issue/originate loans like a traditional bank.

Its second activity is being a “broker” by brokering loans from its partner bank on behalf of its investors. It's a broker that provides a lot of information to help investors make their investment decision, this data being their biggest value. By building an algorithmic scorecard, coded into its platform, its collecting a lot of information about each borrower and categorizing the risk-reward level. A true marketplace like craigslist, would not curate loans this way, instead would allow the risk of a loan to be assessed by its users. Lack of information could potentially lead to huge loses for investors, thus LC acts as a mediator. Source: LC financial statements.

[4] According to the SEC an individual is an accredited investors by meeting one of two tests: A) income of $200k or more for the last 2 yrs — $300k for joint filers — with belief this income would be sustained in the next year; or B) net worth of $1 million or more not including their primary home.

Regulations put in place by the SEC/FINRA assume that a money manager is better able to invest an individual’s money, but in practice today the portfolio manager passes on high fixed costs and then retains return over a certain percentage, leaving little for the actual investors. Despite this fact, we keep operating in a gated garden where only large institutions that can afford to comply with expensive regulations and disclosures have access to the best investments. This system has been under pressure for some time from people who recognize they are getting the raw deal and an increasing amount of gig economy workers who will never have an employer-provided 401k — the largest source of money managed by institutions- hence needing to grow their income themselves.

Obama’s Jobs Act introduced Regulation A and CF (Crowdfunding) to allow companies to raise directly from non accredited investors. The regulations today cost a crowdfunding company anywhere from $100k-$300k over 0.5–2 years to hire lawyers to help them navigate the process. As of the end of 2017, 185 qualified offerings have disclosed raising a total of approximately $670million under the new Reg A+.

[5] It’s true not all private investments will deliver return at the level of Uber, but its also true zero CD/stock investments provide anything north of 12%. Ultimately even the savviest and wealthiest of investors spread their money around in low/stable and high-risk bets. In a merit-based financial system, a savvy individual investor should be able to do the same within their capacity to invest (and lose).

[6] Fundrise is a portfolio manager, an unlisted REIT purchased online dubbed an “eREIT”, that acquires debt and equity interest in commercial real estate. Historically their eREIT funds have delivered 9–12% annualized returns. They have crowdfunded $1.4bn from accredited and nonaccredited investors around the globe. Fundrise were one of the first crowdfunding platforms to make private investments in CRE available to nonaccredited investors, increasing transparency into the investments not typical of REITs, as well as removing the private market listing premium charged by REITs.

[7] The best distinction I heard of the role of a broker-dealer versus an Investment Advisor is that the broker will sit across the table from you and execute the sale or purchase of a security for a one-time fee. While an Investment Advisor will sit next to you at the table to help you make investment decisions based on your goals. For that service, they will charge you a % of funds under management. As those assets appreciate so those the amount of fee collected, thus interests are aligned. Further, the Investment Advisor under the Invest Advisor Act is bound to act to the benefit of the investor, and no one else.