Fundrise faces off with skeptical financial services industry over crowd-funded real estate

Linda Davidson/THE WASHINGTON POST - Fundrise co-founder Ben Miller, center, with fellow witnesses Alejandro Cremades, left, and Danae Ringelmann during a House subcommittee hearing on “Innovative ideas for Raising Capital” last week.

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Fundrise, the District start-up that enables individuals to invest in neighborhood development projects, has been featured in The Washington Post, the New York Times and Inc. magazine and on Fox Business Channel. The Atlantic Cities Web site referred to Fundrise’s first project, on H Street NE, as “The Real Estate Deal That Could Change the Future of Everything.”

Co-founder Ben Miller has become a must-have speaker at real estate and crowdfunding conferences, and he even accepted an invitation last week to speak at a House subcommittee hearing on “Innovative Ideas for Raising Capital.”

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His company’s first widely available offering, a two-story building at 1351 H St. NE, attracted $325,000 from 175 investors in amounts as small as $100. Miller says developers in a half dozen other cities have already reached out to his company, and it has between 50 and 100 deals in the pipeline.

But some personal finance advisers, the professionals who help about a third of American households manage their savings, have begun raising pointed questions about whether the terms being offered by Fundrise constitute attractive investments.

Of five fee-only professional advisers asked to review the investment materials associated with one of Fundrise’s newest offerings, 906 H St. NE, all said they would advise their clients against putting money into such an investment. They raised concerns about liquidity, fees, possible conflicts of interests and the developers’ relative inexperience.

Some did not mince words.

“I would never recommend this kind of investment for my clients,” said Russell McAlmond, president of Evergreen Capital Management. “It has almost every kind of risk imaginable that one may have with commercial real estate. If it works and they find a tenant, you may receive some kind of return, but by taking huge risks.”

Said Derek Tharp, of Mote Wealth Management: “They may have noble intentions and it may work, but if anybody does do this, this should be money they could otherwise just flush down the toilet.”

Hottest corridor in boomtown

Miller acknowledges that commercial real estate can be a risky business and says only people interested in holding properties for the long-term, as he plans, ought to play a role. He looks at the process through a different lens; Fundrise isn’t just about investing in real estate, it’s about investing in one’s own community.

It is not uncommon for commercial real estate in Washington to be owned by an out-of-town institution like an investment bank, pension fund or insurance company. Changing that is one of his main drivers.

“Why are we raising money from institutions which have no real relationship with the places in which we are investing?” Miller asked during his congressional appearance last week. “What if we raised money from the people who live there, who care, who get it?”

He said it isn’t just a matter of logic but fairness. “How does an investment company have the rights to invest that the public doesn’t? Goldman Sachs, but not me. That just doesn’t make sense to me,” he said.

Miller’s response was to create an online platform and solicit investments from that same public — a crowdfunding scheme that required he clear an arduous Securities and Exchange Commission process.

Today, the details of his first deal, at 1351 H St. NE, are available for all to see in public filings — a level of transparency not often found in commercial real estate.

In rough terms, WestMill purchased the property for $825,000 using a loan of about $500,000 from BB&T. He’s already signed a tenant, an Asian market, and developing the property will cost another $900,000 or so. The lease is for $150,000 per year after taxes and utilities, and is set to rise 3 percent annually.

Fundrise plans to begin issuing proceeds to 1351 H St.’s investors after the building is refinanced, and thereafter investors should see portions of the rent.

“It’s the simplest real estate deal on earth,” he said.

Maybe, but investment pros say the difference in this deal is that, unlike with institutional ones, many of Miller’s investors have personal money at stake. How many have experience evaluating such a deal’s potential?

‘That’s their job’

Last week, Miller toured 1351 H St. along with some of the other properties that he and his brother Daniel acquired through their development firm, WestMill Capital. Most of them are on the District’s booming H Street NE corridor, which has become a late night hot spot and where thousands of apartments are either under construction or in various stages of pre-development. The District government plans to begin running its first streetcar line in more than 40 years there, this year or next.

With WestMill, the brothers — sons of Washington real estate magnate Herbert S. Miller — acquired properties the traditional way: Putting up some of the money and borrowing the rest. In WestMill’s case, Miller said the equity came from a combination of his family’s money and other private investors who are either friends or partners of the Miller family.

As a skid loader dug out a basement as part of the 1351 H St. project, Miller described how the interior walls had been stripped to expose the original brick surface. The front and back walls will be replaced with sliding glass panels to allow people on the street to see all the way through the building.

“You’re going to be able to stand on H Street and see all the way back,” he said. “It’s going to be one of the coolest things in D.C.”

Investors, many of them neighbors, apparently agreed, putting up their own money to get in on the deal. Now the Millers are expanding dramatically into real estate deals involving public properties, winning a bid to develop a former library site on H Street NE and joining teams interested in developing property on Sherman Avenue NW, on 7th Street NW and even at the former Walter Reed hospital.

As he considers what properties to seek crowdfunding for, Miller is aware of concern from wealth managers. Part of the issue, he said, may be that wealth advisers have a built-in bias against investments that cut out such advisory roles.

“That’s their job to say, ‘I’m looking out for my clients best interests, and that’s why they need me,’” he said.

“Because it is novel, people say, ‘Oh this is scary.’ But the problem with wealth managers is that they don’t have a whole lot experience with real estate. They’re not paying attention to that asset class. So they don’t make the commitment to understand this stuff,” he said.

He acknowledged, however, that if Fundrise is going to continue to make in-roads nationally, it will need to better explain the terms to advisory professionals or maybe alter the terms they offer. “We’ll have to look at that,” he said.

A look at the fine print

The latest deal that Fundrise is offering to investors is a few doors down from the Asian market, at 906 H St. NE. Purchased by WestMill for $1.375 million in June of 2012, the building has two stories and about 6,500 square feet.

Asked to review the investment documents, which Fundrise posts online, several wealth managers, contacted mostly through the National Association of Personal Financial Advisors, based in Illinois, raised concerns in five main categories. Their responses came by phone, e-mail or both.

Because of Security and Exchange Commission rules governing what can be said immediately before a public offering, Miller declined to discuss specifics about the 906 H St. offering. Instead he addressed the wealth managers’ issues by speaking generally about his company’s crowdfunding strategy.

Here’s a look at some of the issues:

Liquidity

Say after a few years you’re happy with your investment in 906 H St. NE. Or you’re unhappy with it. Or you’re just short on cash. In any case, you decide to sell.

Who can you sell your shares to? Only the Millers. There is no other market.

“This is a very illiquid investment,” said Doug Kinsey, a partner at Artifex Financial Group in Ohio. “No one should be surprised if they have difficulty selling their shares in the future. The company basically is the market maker.”

This is not a secret, as the documents for 906 H St. specifically state that “the company does not intend to offer any additional liquidity options to investors.”

Miller says he strives to make clear to investors that these are long-term investments and that one shouldn’t put money in that they don’t want to remain in the property, and the community, for the long-term. Out-of-town financial managers might not understand that. “A lot of this is about social context,” he said.

Control

Minority investors in Fundrise projects have little control over how the property is managed or whether it is sold, leased, refinanced or anything else.

Kinsey said he worried about the possibility that the Millers would need more money for a project, should something go wrong. Given the fact that the Millers already put up enough equity to buy the property in the first place, Kinsey wasn’t sure why they were crowdfunding in the first place. “I don’t really see why the manager/developer needs Class C shareholders, other than to generate publicity,” he said.

Miller makes no apologies for not giving minority investors, who may have no real estate expertise at all, a say in the development. “This is how it works. This is exactly how it works. Real estate is a managed asset, and the manager has governance and control,” he said.

Fees

Nearly every analyst who viewed the documents took issue with the fees the Millers are charging, among them 3 percent of any lease, 1 percent for asset management, 1 percent for financing, as well as $123,734 development fee for the brothers. McAlmond, president of Evergreen Capital Management, in Oregon, estimated that of the $350,000 raised by selling shares, $50,000 will go to such expenses. “That is 14.28 percent off the top,” he said.

Investors will only see returns after the Millers are done “running the revenue through a gauntlet of insider transactions,” said John Maxfield, an analyst at the Motley Fool, the Alexandria financial services firm.

“Generally speaking with these investments, the managing partners bring all the experience and the investors bring all the money,” said John E. Sestina, an adviser in Columbus, Ohio. “After the deal is over the managing partners have all the money and the investors have all the experience.”

Miller said most widely available investments require paying an investment manager of some type, whether a banker or a real estate developer, for their work. “These are really pretty normal fees,” he said.

Potential conflicts

Some advisers raised concerns that the value of shares available to minority investors (Class C) could suffer at the expense of those owned by the Millers. For instance, although the crowdfunded shares could make up 25 percent of the project, those shareholders are only entitled to 17.68 percent of the cash flow.

“No matter what happens to the property, the managers will make money,” said McAlmond.

Miller points out that no one has more money or risk in the deal than he does, including a personal guaranty that puts his own savings at stake. “We are putting our money where our mouth is,” he said.

Expectations

In their prospectus, the Millers project a 7 percent return on investment for 906 H St.

But lots can go wrong in a real estate project. Markets can change. Tenants can struggle.

“These investments are highly speculative, and given the risk factors, it is not unreasonable to assume a 100 percent loss,” Tharp said.

Said McAlmond of the 7 percent goal: “To me, that number only happens if everything goes 100 percent, and that is extremely unlikely to occur.”

Compounding the concern, advisers said, was the Millers’ level of experience. Though they worked for their father at Western Development and later started WestMill, Miller said the best deal he has done to date is the purchase of an AutoZone on H Street NE that cannot be moved for another seven years because of an outstanding lease; in order words, the property has yet to be redeveloped.

So far, though, progress on the company’s initial crowdfunding project, the 1351 H St. NE development, is off to a strong start. Miller has already signed a lease for the entire building, the lot out back and the rear garage for an Asian food market named Maketto. It will be operated by Erik Bruner-Yang, owner of the popular nearby restaurant Toki Underground, in partnership with Will Sharp, co-owner of District-based Durkl Clothing, to combine a foodie’s taste with a hipster’s style.

Miller acknowledges the riskiness of leasing the entire building to local operators—restaurants in particular have high rates of failure—and said it might have been easier leasing to a national chain such as McDonalds or 7-Eleven.

But Miller also is no stranger to the neighborhood and what works there.

“I have financed and developed projects worth at least a half a billion dollar,” said Miller, who has worked in private equity and development for 15 years, 10 of which were with his father on deals such as Gallery Place. “I have managed and run a fair amount of real estate.”

 
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