The Real Estate Deal That Could Change the Future of Everything (http://www.theatlanticcities.com/neighborhoods/2012/11/real-estate-deal-could-change-future-everything/3897/)
The brothers â€" sons of a well-known Washington, D.C. developer â€" had begun acquiring properties themselves in the city’s emerging neighborhoods where traditional capital seldom goes. Real estate developments are typically financed by wealthy investors who live in the suburbs, or by Wall Street funds even farther away. In a neighborhood like Washington’s H Street Northeast corridor, this means that local projects often can’t find backing, or that far-flung investors put up safe, formulaic products in their place: say, "the glass shiny office/condo building that’s horrible," Dan Miller says, grimacing.
This model â€" with its broken connection between a neighborhood’s desires and its investors' bottom line â€" seemed to the brothers illogical. Why couldn’t people in the community invest in real estate right next door? Why couldn’t the Millers raise money to purchase a property on H Street from the very people who live there? The neighborhood is a quirky mix of barbershops and hip beer gardens. It’s not the kind of place that investors from wealthy Chevy Chase, Maryland, quite get.
"I remember walking home and being like, why can’t we do this?" says Ben, the older of the two brothers, at 36. Dan, 25 and with a shaggier beard, sits next to him in the conference room of their WestMill Capital office, a prime Dupont Circle spot located upstairs from one of the city’s remaining independent bookstores. "Why can’t you be an investor in one of our deals? You live nearby, you’re young, you get it. Why is it that you don’t have this option? That’s unnatural, almost."
In fact, what he’s describing is virtually impossible. You can invest in buying your own home. But you can’t buy into a true real estate deal unless government regulators believe you're wealthy enough to know how to handle your own money. Until now, the Millers themselves have been restricted to raising funds from accredited investors they personally know. This is how the system works: If you want in, you must know the right people and have enough money â€" six or seven figures' worth.
Most American cities as we know them today weren't built this way. Historically, hotels and restaurants and shops were built by local people investing in their own neighborhoods. "And now, people are invested in nothing local!" Ben exclaims. "Everything’s remote, everything’s on Wall Street, everything's in mutual funds."
As he gathers steam talking about this, his indictment sweeps out from H Street to the real estate industry to the financial system to the roots of the recession. And the connection between all of these things matters in your neighborhood because the question of who gets to invest in property ultimately determines the answer to what gets built.
The Millers have invested the last two years and nearly a million dollars in trying to answer this question: Why can’t small-time investors put their money in their own communities? Then, finally, in August, they successfully took a single property on H Street public. Under a new company called Fundrise, the Millers invited anyone in the area â€" accredited or not â€" to invest online in this one building and its future business for shares as small as $100, in a public offering qualified by the Securities and Exchange Commission. By the time the deal closed last week, 175 people had together invested $325,000, for just under a third of the whole project. If the rest of this experiment works like the Millers hope it will, the idea embedded in this one unassuming storefront could have an impact on communities everywhere.
"It’s really potentially a radical transformation of urban planning, of development, of investment, of local government," Ben says. What the Internet has already achieved disrupting commerce, media and communication, he warns, it's about to do to finance, remaking the very places where we live.
• • • • •
Thirteen-fifty-one H Street NE looks like any other long-neglected commercial property in this part of the District of Columbia, with the lone indicator of its coming revival an oversized liquor license application now taped to a front window where a metal security grate has been rolled up.
It's a tan-colored two-story brick building, once home to a dollar store on the ground floor and the family who owned it living above. The marquee out front, since removed, had promised a truly random collection of stuff: beauty aids, tools, party favors, perfumes, automotive parts, food, electrical supplies. When the Millers first eyed the property in the summer of 2011, many of those dusty products were still sitting on the shelves. The store hadn’t been regularly open in years, and when the Millers pulled the paperwork on the property, it turned out 1351 H Street NE hadn’t had a valid certificate of occupancy since the 1950s. The family who owned it was still living upstairs.
The whole neighborhood has been through decades of disinvestment following the 1968 riots. Only in the last few years, as a series of restaurant and bar openings has renewed interest in the area, has the city rolled out plans to connect the community to the heart of the District with the city's first streetcar line. Even that project has offered equal parts disappointment and promise. Streetcar tracks already embedded in the road today pass right in front of 1351, but the H Street line, plagued by years of delays, may not start running until 2014.
H Street is today gingerly suspended between its blighted past and its coming fortune. Median residential sale prices in the past year alone in the neighborhood are up more than 50 percent, but every third building on the H Street commercial strip still looks abandoned. The 1300 block contains properties in every stage of rebirth. The United Church of God sits at one end with a number of bars at the other. There’s a two-year-old "Dangerously Delicious" pie shop directly across the street from the longstanding Smokey's Barbershop & Oldies. The renovated Atlas Performing Arts Center anchors the block, but just up the sidewalk from it stands another redevelopment project with a sign in the window for something unspecified "coming in summer 2012" that's clearly still a long way off.
Many of the properties on H Street NE are still owned by the families or investors who've held them for decades. Most of these people, though, don’t have the funds to renovate now that the neighborhood is rebounding. "There’s this gap where there’s tons of people who would love to open a restaurant and lots of guys who'd be happy to lease their properties," says Brandon Jenkins, WestMill’s head of product development. "But there’s a million-dollar gap in between, and who puts that money up is really difficult."
The Millers purchased the 1351 building in October of 2011 for $825,000, with funds raised from accredited family and friends and a bank loan the brothers personally guaranteed. At the time, they were still months away from figuring out what the building would become and if the community could invest in it, too. "People want to do this kind of stuff we’re talking about," Ben says, referring to local projects tailored for specific communities. "But the existing system’s not there. It’s not designed for urban infill. It’s designed for suburban growth."
• • • • •
The history of modern financial investment has been the story of people and their money moving farther apart into abstraction, to the point where most of us don't know where our investments (if we have any) have gone. But shorten the distance between those two points, and things start to change. Put your money into a building you can see in your neighborhood, and suddenly you might care more about the quality of the tenant, or the energy efficiency of the design, or the aesthetics of the architecture. This proposition is like "Broken Windows on steroids," Ben says.
"But the middle-man process strips out every single thing except for pure financial return," says Dan, a Wharton Business School graduate.
"And it’s pure financial return," Ben interjects, "for who?"
"It was a really, really bad meeting. It was probably one of the worst meetings I’ve ever been in."
Investors primarily concerned with a quick return have given us what real estate developer Chris Leinberger calls a disposable built environment. We've taken a 40-year asset class in real estate, he says, and turned it into a five-to-seven-year one. This is one byproduct of the weird reality that it's easier for people who don't live in your community to invest in it, that it's easier to finance new suburban strip malls than to redevelop an empty storefront.
Regulators have long sought to protect inexperienced investors from fraud. But the financial system we've built has perpetrated plenty of it anyway â€" and on a massive scale. Besides, the Internet has already changed these expectations. Politicians and regulators don’t want small-time investors to lose all their money, but every day, people are voluntarily giving it away on Kickstarter. Why not give them the possibility of some return better than a commemorative poster?
When the Millers first started mulling this, they had no idea if what they wanted to do was logistically possible. They went to one Washington law firm, and then another trying to find out whether real estate securities could be sold online to unaccredited investors. No one, it seemed, knew the answer, which required an apparently non-existent expertise at the blurry intersection of securities law, real estate and technology.
"Then we said, 'who are Goldman’s lawyers? Let’s go find Goldman Sachs' lawyers,'" Ben recalls. The brothers managed to land a meeting in New York with one of the bank's legal teams (which one they won’t identify). Ben remembers sitting in the conference room with a real estate lawyer, explaining that he and Dan wanted to raise money from small-time investors for small, local projects.
"He looked at me," Ben says, "and he said, 'Why would you bother with the little people?'"
Ben was floored. And then he said something he probably shouldn’t have.
"Because they’re getting screwed by Wall Street!"
Replied the Wall Street attorney: "That’s your opinion."
"The meeting was so awkward," Ben says now. "It was a really, really bad meeting. It was probably one of the worst meetings I’ve ever been in."
• • • • •
In 2011, $1.3 trillion were raised through "Regulation D," an exemption that allows people and companies to raise funds from accredited investors without registering a public sale through the SEC. This is the money that funds many smaller companies and other real estate deals. These offerings get a free pass from heavy regulation precisely because it's assumed that accredited investors know what they’re doing (and have their own attorneys on standby).
The SEC does, however, have a little-used mechanism â€" Regulation A â€" that permits small offerings to unaccredited investors in exchange for time-consuming and financially costly scrutiny by both federal and state regulators. In 2011, 19 such offerings were filed with the SEC. Only one was eventually qualified: a revival of the Broadway musical Godspell. This is the arcane regulation on which the Millers set their sights. Their proposal seemed wholly unrelated to Broadway, but in fact what bound together Godspell's investors â€" mostly musical enthusiasts â€" was a personal stake in a local, tangible project.
"Some of the most viable securities crowdfunding projects are going to probably be those local ones: mom and pop shops, restaurants, food trucks that people can actually see and know and trust and almost touch," says Daniel Gorfine, the director of special projects at the Milken Institute in Washington, where he's been following what he hopefully calls "the democratization of finance." "What’s Ben’s doing with Fundrise is exactly in line with that," he says.
In all, the Millers went through half a dozen law firms, spending hundreds of thousands of dollars along the way, before finally landing in the summer of 2011 at O’Melveny & Myers, a firm staffed in Washington with several former longtime SEC hands. There, for the first time, someone told them that their plan was perfectly possible. Painstaking, but possible.
Among all the regulators they went on to encounter, no one had ever seen this tool used for a piece of real estate. The Millers, their lawyers and regulators at the SEC and with the District and the state of Virginia would spend seven months going back and forth over the mammoth regulatory filing. When the Millers filed their initial paperwork in early December of 2011, they were required to mail seven printed copies to the SEC, from a pile weighing 11 pounds. It took the printer in the corner of their Dupont office six hours to spit it out.
The Millers weren't seeking approval for their broad business plan, for the replicable concept of inviting unaccredited small-time investment in a physical property. The entire filing â€" and all this time and money â€" dealt just with this one building, 1351 H Street NE.
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http://www.theatlanticcities.com/neighborhoods/2012/11/real-estate-deal-could-change-future-everything/3897/