Property crowdfunding: the potential and the pitfalls
Published: 5 February 2015 | Author: Bernard Clarke
Over the last decade or more, the internet has transformed the mortgage market – just as it has so many other areas of activity. It has opened up new ways of marketing products and managing relationships with customers (bringing benefits for customers, too). It has brought changes to the way lenders administer their businesses. And, more recently, some parts of the market have seen the effects of a new internet-driven phenomenon – property crowdfunding.
As a form of peer-to-peer lending, crowdfunding essentially brings together those with funds to invest with those seeking finance for a commercial venture. It often involves a company or special purposes vehicle (SPV) setting up an internet platform through which those seeking funding can attract investors. The SPV or company usually charges a fee to cover its own costs and to make a profit.
Crowdfunding is a global phenomenon, and has attracted funding for a wide range of purposes. It has shown potential to raise funds for all manner of projects, from Bollywood films in India and commercial property deals in the USA to charitable help for the pensioner Alan Barnes, for whom an online appeal raised more than £300,000 after he was mugged outside his Gateshead home.
Forbes estimated that the global crowdfunding economy had grown to be worth more than $5 billion in 2013. Despite rapid growth, however, crowdfunding remains tiny compared to the mortgage market - with the Forbes’ estimate equivalent to only around one-fifth of what UK lenders advances to borrowers in a single month.
There are, however, a number of ways in which crowdfunding could augment the UK mortgage market. It has a wide range of potential applications, including opportunities for:
- developers to seek funding for the construction of new property – operating essentially as a means of peer-to-peer bridging finance;
- investors to buy shares in a portfolio of properties, allowing them to spread investment risk; and
- investors to access the buy-to-let market by buying shares in an individual rental property, rather than purchasing one outright.
There are already a number of websites offering investors the potential to buy shares in rental properties, although this activity continues to be dwarfed by the mainstream buy-to-let sector. New buy-to-let lending last year totalled more than £26 billion – and outstanding assets in the sector are worth more than £183 billion. So, crowdfunding is an emerging phenomenon, but no more than a peripheral one for the buy-to-let sector at this stage.
How does it work?
Some crowdfunding websites operate by advertising individual rental properties, in which would-be investors are invited to buy shares. This may prove attractive to those who do not have sufficient funds to buy a property outright, even with a buy-to-let mortgage.
The site may list a purchase price for the property, estimates of gross and net income yield, and a funding deadline. If it attracts enough interest – and investors commit enough funding – it can be bought through an SPV, with a number of individual investors owning shares. The SPV then charges a fee for operating the property as a landlord. But if the offer remains undersubscribed, the purchase does not go ahead, and funds are returned to those who had committed to invest.
In a discussion paper published late last year, the Royal Institution of Chartered Surveyors (RICS) noted the similarities between these websites and property investment clubs, although there were also some crucial differences. Technology was facilitating speed purchasing, the paper said, so that “buying shares in a house becomes as easy ordering a book on Amazon (or perhaps making an online bet), which is unprecedented.” But is this good, or bad? And could it turn ugly?
Crowdfunding offers a number of possible attractions to would-be investors:
- It can provide an income stream and capital growth at a time of low investment returns elsewhere. It should be borne in mind, however, that prospects for the sector may change in different market conditions – and that property prices and rental yields may rise and fall. The attractions of investing in the sector may change as a result of prospects for growth in property prices, movements in interest rates, and potential returns on alternative investments.
- Crowdfunding may offer access to the buy-to-let sector to smaller investors, who cannot afford – or do not want – to buy a property outright. Depending on how popular it becomes, and how easy it is to buy and sell shares in a property, crowdfunding has the potential to make it much easier than before to invest on a small scale in the sector.
- If there is a ready market for shares in property, crowdfunding also potentially brings greater liquidity to investing in the buy-to-let sector. Buying and selling shares may prove attractive to some investors who do not want to trade directly in property assets, which cannot be bought and sold quickly and easily. Some platforms have set up secondary exchanges to allow investors to buy and sell shares – although valuing them may be an issue.
- It is also possible for investors to avoid direct liability for stamp duty, legal fees and property advertising costs, and the commitments of operating directly as a landlord. But these costs do have to be met as part of the process, and may be covered in fees charged by those operating the platform, which could reduce returns for investors.
… the not so good…
- Although investors can avoid some of the costs and complexity of buying property and being a landlord, there may be other complications. The SPV administering the property may be liable for corporation tax, covered by charges payable by investors. And they may be liable for capital gains tax. This can be treated as a deferred liability, but could affect the value of shares in the property.
- Returns may also be affected by charges for maintaining or repairing the property. (Buy-to-let investors do, of course, face similar costs.) It is possible that rental income is insufficient to cover the costs of exceptional property repairs, and companies or SPVs therefore often reserve the right to take out a loan secured against the property. This may have to be repaid out of future rental income.
- Crowdfunding investors are usually "passive." They typically have no say in running the SPV or managing the property, and their shares do not usually have voting rights.
- As the RICS report points out, investors are committing funds to finance a venture in which “sponsors implicitly accept the risk of failure and non-delivery.” Failure to meet the investment target could lead to a loss of confidence in the platform – or in the sector more widely. While property crowdfunding has been a success in the USA, according to Forbes, it has mainly been so as a means of funding investment in commercial, rather than residential, property.
…and the potentially ugly
- Property crowdfunding has yet to be tested in all market conditions. In many countries, the property market typically goes through cyclical variations. Given the size and relative lack of development of a market so far in property shares created by crowdfunding, it is not clear that it would always function effectively in a downturn.
- Investors should consider how they might be affected if the company of SPV running the platform gets into financial difficulty, or even fails altogether. Property ownership can be ring-fenced, and it may be possible to set up a new body to administer the property on similar terms. Failing that, the property could be returned to those investors who own shares, but that could prove to be a difficult, time-consuming, complicated and risky exit strategy.
- In its discussion paper, RICS also foresaw the potential for wider instability that could “constitute a new form of liquidity shock to the housing market, exacerbating house price volatility and, in doing so, bring(ing) with it new policy challenges from a monetary and macro-prudential policy perspective.” Given the current size of the market, macro-prudential risks may be small at this stage, but RICS observes that the “financial and stability risks potentially connected with buy-to-let crowdfunding will probably rise with its popularity.”
The regulator’s view
The regulatory approach to crowdfunding – and to the buy-to-let sector more generally – is evolving, and will affect future developments.
Earlier this month, the government announced that it intends to consult early in the new parliament on the financial policy committee’s recommendation that it should have new powers over the buy-to-let market. The aim of the proposed consultation is to build an in-depth base of evidence on how the operation of the buy-to-let market may carry risks to financial stability.
On crowdfunding specifically, the Financial Conduct Authority (FCA) has noted the rapid growth of the sector – albeit from a small base – and wants an approach that provides protection for consumers, without creating unnecessary barriers to investing. Since April last year, it has regulated loan-based crowdfunding (mainly peer-to-peer lending), a sector that it estimated to be worth almost £1.3 billion in 2014, having grown by around 170% compared to the previous year.
Earlier this month, the FCA published a review of the regulatory regime for crowdfunding, in which it reported on recent developments in the sector – and set out some concerns. Although it did not refer specifically to the property sector, it identified a series of problems with crowdfunding websites, including:
- a lack of balance, with emphasis on the benefits rather than the risks;
- insufficient, omitted or the cherry-picking of information, creating a misleading or unrealistic picture; and
- the downplaying of important information, including risk warnings.
Over time, the FCA has also said it wants new prudential rules so that firms operating in this sector have capital to help withstand financial shocks.
Property crowdfunding remains a niche venture compared to the much bigger and well-established buy-to-let market. But is has already shown the potential to grow rapidly, and clearly may grow further. Potentially, it also offers opportunities to augment the buy-to-let market by providing new options for investors.
However, crowdfunding also presents its own challenges for investors, and has yet to establish itself fully. Nor has its ability to operate been tested in all market conditions. The regulatory environment is also evolving, and this will have future consequences – both for the established buy-to-let sector and for the emerging property crowdfunding option.