Your next investment fund neighbor could be a crowd

(updated with correction)

Institutional investors might find within a year that their real estate funds are co-investing alongside crowdfunding capital.

While in its infancy — with estimated global real estate transactions of around $100 million to date — crowdfunding is growing as a source of capital for real estate, and money managers are taking notice.

The impact on institutional investors will depend on how big the crowdfunding market becomes.

Crowdfunding is “the biggest change since junk bonds in the 1980s,” said Lewis Feldman, partner and chair of Goodwin Procter LLP's Los Angeles office. “There's a $13 trillion real estate market, with over $1 trillion of debt and equity spent each year and $100 million (crowd)funded so far.”

By summer's end, Mr. Feldman expects the first deals to be announced that include crowdfunding investing alongside institutional capital. He declined to identify the transactions or the participants.

Real estate investment managers are attracted to crowdfunding — funding a venture by raising many small amounts of money from a large number of people, typically via the Internet — because it is a cheaper source of capital and less demanding than institutional money. A few family offices and small institutional investors are considering investing directly in properties on crowdfunding websites.

American Realty Capital, Boston, is preparing to start raising crowdfunded capital this year, said Nicholas Schorsch, founder, chairman and CEO of the real estate investment trust sponsor and manager.

Real estate investment banking firm Carlton Group, New York, was the first to raise crowdfunding capital to invest with institutional money in commercial real estate transactions. Carlton Group launched its crowdfunding site in April seeded with $1 billion of transactions. Carlton co-invests its own money in every crowdfunded deal.

Others are preparing to follow.

Private equity and venture capital firms also are taking notice. Canaan Partners — an early investor in what had been called peer-to-peer financing before the 2012 JOBS Act made it possible for entrepreneurs and small companies to raise equity from individuals — this year invested in Realty Mogul Co., operator of the largest online real estate crowdfunding site, said Hrach Simonian, principal in Canaan Partners' Menlo Park, Calif., office.

He expects Realty Mogul to follow the evolution of another portfolio company, Lending Club, a peer-to-peer lending firm that has publicly stated intentions to file an initial public offering this year. Institutional investors, hedge funds and other money managers regularly invest directly in debt transactions through the Lending Club website, Mr. Simonian said. He declined to name them.

Realty Mogul executives are in discussions with other institutional investors interested in investing through the crowdfunding portals. (Mr. Simonian sits on the board of Realty Mogul.)

“We see (Realty Mogul) as the Lending Club of its space, but it's a bigger asset class with a ton of opportunity,” Mr. Simonian said.

“Crowdfunding will not crowd out institutional money but will co-exist with it,” predicts Joey Jelinek, CEO of Groundbreaker.co, a New York-based real estate crowdfunding site.

“Issuers are excited about the prospect of using retail money to counter the onerous terms institutional guys are asking for,” Mr. Jelinek said. “The appeal for those guys is not more money but being able to use retail investors as a check for the institutional investor.”

Some 80% of the transactions listed on Groundbreaker are from private equity real estate managers seeking crowdfunded assets to invest alongside existing institutional capital, Mr. Jelinek said.

Many times, the real estate money manager is seeking crowdfunding for its co-investment in its own real estate fund, he said. In other cases, the crowdfunding is a separate limited partner, Mr. Jelinek said.

So far, crowdfunding only makes up a small minority share of the capital.

“A home run for crowdfunding today is $3 million, but crowdfunding is doubling each year,” said Goodwin Procter's Mr. Feldman.

Because crowdfunding is minority capital, the institutional investors call the shots on the deals and the crowd is offered a take-it-or-leave-it proposition, said Mr. Feldman, whose firm represents real estate managers involved in crowdfunding-institutional capital deals.

Because there is no secondary market now for a person's interest in a crowdfunded deal, crowdfunding capital has to wait until the deal is exited, like institutional investors do. This might change if a secondary market develops.

Institutional investors contacted by Pensions & Investments have not yet been approached by their real estate managers about crowdfunding co-investors. Many weren't aware managers were considering co-investing with the crowd.

The impact on institutional investors depends on the magnitude of the crowdfunded dollars, said Bob Jacksha, chief investment officer of the $10.9 billion New Mexico Educational Retirement Board, Santa Fe.

“Do we really need more capital in an asset class that seems to already be sought-after and well-funded by institutions?” Mr. Jacksha asked.

For the deals that are in progress, there are still details being worked out, Mr. Feldman said.

Institutional investors in general are annoyed by the idea that their money manager will get crowdfunding for the general partner commitment to their real estate fund, he said: “They want their GP to still have skin in the game.”

For their part, real estate managers want to wait until they are sure the crowdfunding intermediary has actually raised the money. There are few lenders willing to offer credit facilities that take the risk of failing to crowdfund the needed capital, he said.

So far, real estate managers are not selling properties directly to the crowd, Canaan's Mr. Simonian said: Realty Mogul users “don't list properties for sale, just raise money to buy them.”

Managers could bring deals they see on online auction sites to real estate crowdfunding sites, some of which are listed by other real estate managers, he said.

Ultimately the impact on institutional investors will depend on how much capital is raised and how many wealthy individuals choose to invest in real estate online.

“I am curious to see how much money can be raised through crowdfunding channels,” said Cedrik Lachance, managing director of Green Street Advisors Inc., a Newport Beach, Calif.-based real estate research firm. “Until significant amounts are raised, we are unlikely to see crowdfunding vehicles investing alongside institutions in commercial real estate.”

While crowdfunding potentially opens another capital source, “there are many other ways to finance real estate,” he added.