[Editor’s Note: Below is the full text of our 241st Weekly Transmission, originally delivered direct to the inbox of more than 600 GEM members on February 1st, 2023.]

Real estate crowdfunding (aka fractional ownership) has been around for about a decade. During that time, individual investors have poured more money into it compared to other crowdfunding opportunities, such as equity investments in start-ups and small businesses. Ironically, crowdfunding laws were initially designed for these two latter opportunities, but given the size of the real estate market and comparatively less risk involved in fractional ownership of real estate, it’s little surprise investors have felt more comfortable there.

Despite growth in the sector over the past several years, the fractional ownership market is far too large to be fully served by just a few companies. Many companies are needed to adequately serve distinctly different types of investors, e.g., accredited vs non-accredited. Cadre, for example, serves only high-net worth accredited investors with at least $25,000 minimum, but some larger deals require a $100,000 minimum investment (think deals involving hundreds of millions of dollars per building). Other companies such as Fundrise attract an entirely different type of non-accredited investor with low minimum investments of just $5-$10, in many cases. The segments of real estate are also vastly different, commercial real estate vs. residential vs. farmland, etc., and require different expertise served by different companies.

Regulations governing the companies that offer fractional ownership dictate what type of a customer each must attract—this invariably changes the company’s marketing, property listings, and more. Reg D, for example, covers accredited investors and large commercial properties or large multi-family (which is commercial in itself but some differentiate multi-family into a different type of investments). Reg CF, on the other hand, comes into play with smaller, lower-value properties—most likely SFR, condos, or small commercial. Reg A+ can apply both to commercial or SFRs.

All fractional ownership businesses also face unique challenges for success (or even survival), with deep importance placed on choosing the right legal structure and factoring in the cost of legal compliance. It takes an enormous amount of time and money to secure the many regulatory approvals and then maintain them annually with SEC or FINRA. We learned this first-hand, the hard way, with Building Bits, notwithstanding all other business challenges customary to any new company. Overall, this business is very capital intensive with low margins and requires a fast scale-up once you have raised the capital. A lot of profit projections rely on the anticipated appreciation of the property at the time of the sale. In a downturn market, such as the one we are likely to experience now, the less capitalized companies will face tough challenges. LEX is the latest casualty, but may not be the last.

To offer fractional ownership in real estate is no longer a novelty, nor is it the main differentiating point. To truly differentiate in a segment of the fractional ownership market is to make ownership liquid. This requires additional regulatory approvals and huge costs to operate your own exchange or Alternative Trading System (ATS) or pay fees to an existing exchange, like NASDAQ. Companies creating real-estate related tokens aim to solve this issue, with several announced projects in the works, but the sustained success has yet eluded them given that the technical side of tokenization is the easiest part. Legal and regulatory hurdles are the stumbling blocks. No matter what you do with tokens, you must still follow existing regulations, which require a company to follow legacy procedures in transferring stock ownership, using licensed brokers, employing stock transfer agents, etc. And if a company wants to do everything on-chain, then there is another issue to consider: How to address the ownership’s chain of custody. With the legacy system, I don’t have to worry about losing my title or stock certificate. In fact, I do not even remember where the title to my house is. Yet, I do not have to worry about losing the ownership of my house or selling it without having the original title. The escrow company takes care of all the title issues, and if I need a new title I just get it from the county’s records. With tokens, what happens if your token’s custodial wallet is hacked and the token is transferred to another wallet without your knowledge, or if you keep the token in a non-custodial wallet and you lose access to it and lose the recovery phrase? You lose your ownership of the asset. Or better yet, someone else gets a hold of your recovery phrase and creates a new wallet with your token in it. We’ve seen news about such instances too many times. In all of these scenarios, the new owner of the wallet becomes the owner of your token, which represents the ownership of the asset.

The fact is, there are still more questions than answers at this point. It will be interesting to see how this all shakes out—despite having taken a startup swing at the sector myself, there is still enormous untapped market opportunity in fractions.

the GEM BRIEFING

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