Investors pile into Fundrise's new "eREIT"
But substantial investor dilution, mammoth $1 million organizational expenses, lack of financial transparency, and questionable marketing spin mar an otherwise innovative product.
January 29, 2016 BY IAN IPPOLITO
(I’m an investor, and not a financial advisor or attorney. So this article, like all content on the site, is purely my opinion only and is not investment advice. Consult your own financial advisor or attorney before making any financial decisions about this or any investment. Fundrise was given an opportunity to respond to the issues in this article, and any response will be posted on this site).
October 2017: this article is more than a year and 1/2 old, and Fundrise has changed some of their offerings considerably since. For the latest information on Fundrise, see the reviews of the top nonaccredited investor sites.
Investors in Fundrise recently received a breathlessly vague email saying Fundrise was about to release something "big". A second email, sent several days later, promised it would be the "biggest financial innovation" since the start of real estate crowdfunding.
These big claims generated quite a buzz among curious investors. A third email lifted the curtain and revealed what it was: an investment vehicle that Fundrise called an eREIT. The eREIT is a public, non-traded REIT that would invest in small-cap commercial real estate.
The list of feature bullet points on the promotional page of the eREIT looks impressive at surface level.
It has a revolutionary low $1000 minimum. (The average crowdfunding minimum is $5000).
Nonaccredited investors can invest (unlike most crowdfunding investments which are only open to accredited).
Certain fees are 1/10th as expensive as nontraded REITs. (Although organizational fees are significantly larger as we'll discuss below).
Investors can withdraw their money any quarter (subject to availability and a small penalty). This is a huge improvement over the majority of crowdfunding equity investments which lock investors in until the property is sold.
The 1% asset management fee is reasonable and is waived by Fundrise if the fund doesn’t make an impressive looking 15%.
What's not to like? (Unfortunately, in my opinion I found several issues in the fine print. I'll discuss them in a moment.) But first…
"Welcome to the hottest club in town!"
The market reacted to the new offering with a bang. Yield starved investors excitedly flooded the eREIT with money. The first $1 million was fully filled in a jaw-dropping 4 hours (without any of them knowing what a single property would be in the portfolio nor what the specific acquisition parameters would be). Then, Fundrise acted like a bouncer at the city's hottest nightclub, and stopped accepting new money, despite tens of thousands of investors stuck on the waiting list.
A few days later the fund announced it had purchased its first property and reopened briefly to raise another $1 million from enamored investors, before closing again. After this, it added 3 more properties (with all four properties ranging from a Fundrise grade of B to D). Each time it raised another $1 to 4 million from clamoring investors, before closing.
"I'm so lucky! Now, tell me again what I bought?"
I did a deep dive of the circulation offering to write this article. Overall I feel this is a very innovative product that unfortunately is marred with flaws. I was bothered by what appears to be questionable marketing spin lacquering over substantial investor dilution and mammoth $1 million organizational expenses. And similar to a previous Fundrise diversified offering, there is a lack of financial transparency, which includes a lack of targets, limits, and detailed financial information, which most competitors freely disclose.
If I were a nonaccredited investor who was positive about the economy for the next several years, and didn't expect to need my money back anytime soon, I still might consider it. But accredited investors have many other better options.
But to understand those, let's first look at the positives of this offering.
REIT of a different feather
Readers of this site know that there are three types of REITs: publicly traded, publicly non-traded, and private REITs. Publicly nontraded REITs (like the eREIT) traditionally have fees that are so extortionary, that FINRA issued a warning about the entire asset class.
But Fundrise has essentially rebooted the public nontraded REIT format. And to their credit, they’ve drastically improved it by building it with features of traditional private REITs: lower asset management fee and granting quarterly redemption. And unlike a private REIT, Fundrise has made the eREIT available to nonaccredited investors.
In addition the minimum investment is a strikingly modest $1000, instead of the pricier $25,000-$5 million typical with private REITs (when they are not offered through crowdfunding). Fundrise deserves credit for addressing this issue, and making the fund accessible to more investors.
At the same time, the eREIT still retains some unwanted vestiges of traditional nonpublic REITs (like investor dilution to handle a mammoth fee) which have caused trouble in the past, and cause an unnecessary burden on performance.
And it's unfortunate that Fundrise, in my opinion, lacquers over these important issues with what appears to be a deceptive marketing gimmick. Let's look at this first, and what really lies behind this idea that Fundrise calls so "radical".
“Do you mean 'radical' like a 'ninja turtle' or an 'extremist' ”?
Fundrise openly brags about its asset management fee structure, calling it a "radical idea that will set a new standard in accountability". They go on to say (very confidently and impressively) that "during the first two years (until Dec 31, 2017), you pay $0 in quarterly asset management fees unless you earn a 15% annualized return. Period."
Wow! This gives the impression that Fundrise is setting a very high bar for itself, and will only be paid if they perform a high-performance leap.
However, after reading the offering document, I came away very disappointed. The fine print allows them to pull a ladder up to the bar, walk up and fall over, and still proclaim victory. If Fundrise does what the document allows, they will be less like a high-performance athlete competing for an Olympic gold, and more like an out of shape weekend warrior competing against himself/herself (and who has already bought themselves a trophy).
"Support for me, or support for you?"
The ladder is built with something that Fundrise calls the “distribution support commitment”.
During those first two years, Fundrise LP has the right to inject cash into the fund by purchasing shares. Normally cash would be used to invest in real estate that would create a profit for investors. Instead, the fund reserves the right to divert that money from investment use to pay investors a "return".
In other words, even if the fund is losing money, the rules are set up to allow Fundrise to "achieve" the 15% hurdle and get paid.
"So what?", you might say. As long I get my 15% for free in the first two years, who cares where it comes from? Well, unfortunately, it's coming from you.
The shares that Fundrise LP bought, still entitle them to a piece of the fund return, even though the money wasn't used to purchase real estate. So this causes the value of your shares to drop (dilution). And it also reduces your ultimate return after the two-year period, to make up for the injected funds. In other words, it looks like you're getting a free lunch, until you get handed a check at the end of the meal.
The more Fundrise has to inject to support the 15%, the lower your net asset value is going to be. And there may be some serious injecting. On top of the usual issues that all estate investments face, there is a $1 million deficit/fee to worry about, which we'll talk about in a moment).
I should also add that this strategy (of using fresh money to pay investors, rather than real estate earnings) isn't just expensive, but it can sometimes be fatal. It's one of the factors that caused so many of the traditional nontraded REITs to become “zombie REITs” that may never be able to pay their investors back. They thought that they would make up ground in the future but never did.
So why would Fundrise choose this structure, with its hindrance to performance and frightening history? Ultimately only they know. I strongly suspect the reason is not malice, but an unfortunate side effect of regulation A+. Unfortunately, this causes the fund to have a gargantuan $1 million fee, that creates an enormous hole for the fund to dig itself out of on day 1.
"Congratulations on the purchase of your new $1 million paper weight!"
Regulation A+ was supposed to revolutionize the real estate crowdfunding industry, because it would allow non-accredited investors to participate. However, most platforms found that the implementation was so expensive and limiting that it wasn’t worth doing.
Fundrise deserves kudos for finding a way to create an offering under it at all. However, a side effect is that they expect the organizational expenses to be a gargantuan $1 million.
How big is this? If the fund has raised about $10 million right now, those properties all have to make a whopping 10%, before the fund can just break even. That is a significant hole to have to dig out from.
Making lemonade from lemons
Fundrise can make the cost more manageable if they raise more money (because the percent of the overall cost goes down). For example, many of the core real estate private REITs raise billions of dollars, which causes the organizational expenses to be a minuscule percent.
However, regulation A+ ties Fundrise's hands, because the law limits them to just $50 million. So the best they can do is raise the full $50 million and lower it to 2%.
A nonaccredited investor might be willing to pay the extra 2% since they have few options. But as an accredited investor, I see little reason to pay this fee for no benefit. I don't care that nonaccredited investors are in the fund, because it doesn't help me. And I can invest in numerous private REITs (especially through crowdfunding) that give me all the benefits of the eREIT (with better transparency), without this extra fee.
And there is an extra risk factor too. Many economists are predicting a recession in the next one to three years. If they are right, then Fundrise could have problems raising the entire $50 million. If that happens, then the expense percentage could climb to higher and more painful numbers.
On top of the fee issues, the fund also has some transparency problems regarding its targeting and limits...
"No, I didn't miss the target. I chose not to aim."
Virtually every private REIT attracts investors by setting targets on the most important parameters. This lets investor know if the strategy matches their portfolio. Additionally, they also set explicit limits to reassure an investor that they won't take speculative risks that are beyond what the investor is expecting.
However the eREIT is disturbingly silent and will not disclose targets, explicit limits and financial details in several important areas. Specifically it has:
No specific target IRR
No specific leverage maximum
No specific diversification targets
No specific target for investment risk based on Fundrise rating of A-E.
No open book policy disclosing low level financial details of the investments to investors
Without being able to see the details of investments, investors can only rely on the Fundrise rating. This itself is not very encouraging, as it appears to be currently averaging about a low C-. (And even this insufficient information is difficult to locate on the Fundrise site. As I tried to double check this information today, I can no longer find it; where I did somehow find it two weeks ago).
The previous Fundrise diversification offering seemed to offset the protection of diversification by including higher risk properties (averaging an even lower D Fundrise rating). I hope that is not what is going on with the eREIT. Time will tell, as more properties are added to it.
The quality of the portfolio is especially pertinent as investments available on the Fundrise site seem to be drying up. I haven't seen any new individual investments on the site since about October 2015; where before it had one of the largest selections.
Fundrise CEO Benjamin Miller, has written that the dry spell is an intentional action to prevent poor quality deals from appearing on the site. If true, then this is admirable. However, it raises an additional question. If there aren't enough deals that are safe enough to put out to individual investors, then what does does this say about the quality of the deals being put into this eREIT? Again, time will tell.
Silence of the Fundrise
I asked Fundrise for confirmation and/or correction on some of the basic facts in this article. After some initial cooperation I was ultimately told that Fundrise could not provide this and that I should just read the contract myself.
I've now given Fundrise a second chance to respond to this article to address the numerous questions it raises and correct any mistakes I might have made, or simply give their official position. If they choose to respond, I will post it here.
If the economy cooperates, Fundrise can raise the entire $50 million, and they put in higher quality assets, then this eREIT investment still might be worth it for nonaccredited investors. It allows them to access small-cap commercial real estate, which is difficult or impossible to do with the public REIT, and too expensive to do with the nontraded REIT.
However, if the economy goes south, or the investments themselves don't do well, then those investors may find themselves substantially disappointed. This dynamic is not helped by the $1 million hole that this small fund has to climb out of, on day 1. Also, such investors need to be long-term. They should not expect to be able to pull their money out anytime soon, without taking a substantial loss due to dilution.
And as an accredited investor, I can see little reason for me to invest in this. The investor dilution, huge organization expenses, lack of targets and maximums, and questionable marketing spin make the eREIT less appealing. In my opinion there are many other cheaper, better featured alternatives.
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Ian Ippolito is an investor and serial entrepreneur. He has been interviewed by the Wall Street Journal, Business Week, Forbes, TIME, Fast Company, TechCrunch, CBS News, FOX News and more.
Ian was impressed by the potential of real estate crowdfunding, but frustrated by the lack of quality site reviews and investment analysis. He created The Real Estate Crowdfunding Review to fill that gap.