“Crowdfunded Real Estate — Possibilities And Pitfalls”
Law360 03/10/14 Michael D. Rechtin, Adam J. Falkof
Real estate crowdfunding may be on the verge of rapid and sudden growth through the JOBS Act and numerous real estate crowdfunding platforms across the country. Generally speaking, real estate crowdfunding is large numbers of investors funding a real estate enterprise with small individual investments.
Real estate crowdfunding platforms have various methods of raising capital. Developers, through these platforms, could offer membership shares in a single-purpose entity that owns a specific building or property in return for the investor's funds.
Unlike other crowdfunding vehicles for other industries (like Kickstarter), investors in crowdfunded real estate transactions generally would receive a return on their investment rather than tokens from the project (T-shirts, autographed pictures, etc.).
Crowdfunding has not historically been used by businesses to raise capital because offers and sales of securities to the public generally require compliance with the registration requirements of the Securities Act of 1933. The JOBS Act crowdfunding provisions may not be relied upon until the SEC adopts final rules implementing securities-based crowdfunding.
While other authors have covered the corporate consequences of crowdfunding, very few, if any, have discussed the impact of crowdfunding on retail leasing. Most landlords and retail tenants, as well as their leasing lawyers, have retail lease forms that have been sufficient for decades. In the crowdfunding deal context, the landlord and tenant should consider additional provisions that take account of the unique relationship between such parties.
A Different Kind of Real Estate Investor
Real estate crowdfunding investors, especially unaccredited investors, can be different from typical investors. These investors often purchase shares because of emotional or social interests rather than a desire for financial gain. An investor may enjoy telling his friends that he owns a portion of a certain building, desire to fund a project in a struggling neighborhood, or want to support a local development for a specific type of tenant.
Most importantly, crowdfunding investors generally want to stay involved with their investment, even if an operating agreement extremely limits their investor rights. Their involvement can range from shopping in the tenant's store to sending a tweet or Facebook message encouraging their friends to support the tenant.
The real estate crowdfunding platforms allow developers to attract investors from a specific demographic or with a particular ideology. For example, real estate crowdfunding platforms can allow landlords to limit investors to particular zip codes to ensure that only local investors can purchase equity interests in a project.
The presence of a large number of active local investors requires a retail lease that reflects this new dynamic. Retail leases should contain unique provisions, both for the landlords and their tenants that respond to new opportunities and challenges presented by crowdfunding.
The Landlord's Marketing Team: Rent Enhancement Provisions
Crowdfunded landlords have an excellent opportunity to increase the tenant's revenue, and thus, the tenant's ability to pay the landlord rent, by utilizing their investors as informal marketers for the tenant’s business. For example, if the tenant operates a restaurant, the landlord can ask investors to help generate business through social media or by visiting the restaurant with friends.
In return for its investors supporting the tenant’s business, the landlord should seek a rent enhancement provision in the lease. Rent enhancement provisions can be challenging in this context because of the difficulty of capturing the investors’ efforts. Additionally, investors may become frustrated if some of a building’s investors actively support a tenant’s business while other investors passively collect the same return from afar.
Crowdfunded landlords may choose a rent enhancement provision that uses the tenant's payment system to capture increased business from the crowdfunding investors.
For example, the landlord could require that each time an investor patron uses a special card at the tenant’s store, the tenant’s payment system would record the purchase as an investor-linked purchase. At the end of the month, the tenant would return a scheduled percentage of the investor-generated business to the landlord, who could distribute a portion of the increased rent to investors.
A flaw with this system, however, is that it does not capture investor efforts outside of direct business, such as social media postings, and may not work if the investors live far from the tenant's business.
A different rent enhancement provision is for the tenant to pay the landlord effectively percentage rent, i.e., increased rent if the tenant's revenue exceeds certain predetermined amounts. While this mechanism may capture a wider swath of the investors' efforts, it may be hard to determine the tenant's revenue without the investors' efforts, and if the tenant's business is failing, the tenant will not be obligated to pay percentage rent even if a substantial portion of the tenant's business is derived from the investors' efforts.
In addition to investors directly generating business for the tenant, investors may support the tenant's business indirectly through social media activity. An investor's activity may be as simple as taking a picture of the food in the tenant's restaurant and uploading the picture to the investor's profile on a social media platform, such as Facebook, or as extensive as a series of positive reviews of the tenant's business on business review sites such as Yelp.
In order to capture investors' indirect activity that supports the tenant's business, a more technologically sophisticated system could require the tenant to pay increased rent based on social media or brand-awareness metrics. A number of technology vendors offer metrics to track a company's social media performance, and a competent data gathering protocol could reflect the neighborhood's view of the tenant's business. This system's flaw, however, is that even if the landlord and tenant can agree on the system's metrics, the investors may not be actually driving the increases, and social media success may not translate into business for the tenant.
Tenant Protections from the Crowd
If the tenant is entering into a lease with a crowdfunded landlord in large part due to the promise of increased business from the landlord investors, the tenant should consider requiring the landlord to disclose its investor list, and include the zip codes of the investors’ primary residences. A crowdfunded landlord with a national investor base presents a much lower value to a tenant than a locally funded landlord.
Tenants should also be concerned whether the party acting on behalf of the landlord has authority to make ordinary business decisions and bind the landlord. Tenants should rightly be nervous that a landlord backed by hundreds of investors may not respond quickly to basic tenant needs, such as a broken door or damaged roof. Therefore, tenants should require crowdfunded landlords to disclose to the tenants the provisions of the landlord operating agreement that grant the manager of the landlord the right to make ordinary business decisions, such as maintenance and repairs, without consulting investors, and to amend, sign, and renew leases, consent to subleases, and agree to almost all common real estate transactions.
The investor's personal involvement with the building may increase the possibility of an upset investor protesting the tenant's business or otherwise harming the tenant's reputation. As a result, tenants should require landlords to represent and warrant that the landlord has authority to buy out an investor's share if an investor threatens or damages the tenant's business.
Landlord Provisions to Keep Their Crowd Happy
Crowdfunded landlords should also seek certain lease provisions to enhance their relationship with investors. In particular, crowdfunded landlords should have use restrictions in their leases that mirror any social goal in the landlord's investment documents. For example, if a developer markets the crowdfunding opportunity as being environmental sustainable, the retail tenant's lease should compel the tenant to comply with landlord's sustainability initiatives for the project.
The landlord should also seek special walkthrough and event hosting rights to maintain a strong relationship with investors. The event hosting rights do not need to be adverse to the tenant — a tenant may even take the opportunity to host an after-hours sale for the crowdfunding investors.
The Future of Crowdfunded Real Estate
Discerning the future of crowdfunded real estate is difficult, as platforms operate in different markets with distinct methods of funding projects. The greatest promise for crowdfunded real estate, at least for unaccredited investors, lies in Title III of the JOBS Act. Whether the corresponding SEC crowdfunding regulations (which are still not finalized and are quite complex) eventually open a major gateway for crowdfunding real estate is challenging to predict.
If crowdfunding does take off, however, current retail lease forms will need to adjust to a new reality with a different type of real estate investor.
Originally published in Law360, March 10, 2014