Realestate Crowdfunding Is A House Of Cards. PeerStreet's Bankruptcy Reveals Why.

When Michael Burry decided to invest in a mortgage technology company, he made headlines.

“The Big Short hero heads to start long-term mortgages,” CNBC reported in December 2015, days before Burr's Hollywood debut, which played a role in sounding the alarm about the housing bubble which led to the Great Recession. Dance

Berry's "long" site was PeerStreet, a real estate financing site that allows qualified investors to purchase mortgage-backed residential real estate, typically rental properties. Crowdfunding emerged in the wake of Burry's famous financial crisis, promising small investors private equity-style returns.

“What happened during the crisis was that there was virtually no signature,” Berry said at the time. “For the next generation alternative lending model, it's important to be in control. There's already someone at the door controlling your credit risk.”

After just eight years and $121.9 million in funding, including from Silicon Valley giant Andreessen Horowitz, Berry's optimism proved wrong. PeerStreet and its subsidiaries filed for Chapter 11 bankruptcy protection on June 26 after its lending business fell to $5.4 million from $695 million in 2021.

I feel smart, but I feel cheated by what they are trying to do here. Brown Mincher, PeerStreet investor

PeerStreet attributes its collapse to a sharp drop in demand amid rising rates. But the bankruptcy filings reveal the empty promises of real estate financing that arose from the ashes of the global financial crisis to “democratize” real estate investing and give small-timers the chance to reap the benefits previously enjoyed only by the very rich. . . Thanks to hundreds of millions in venture capital, this pocket of investments has grown into a $14 billion industry by 2022, backed by giants like Yieldstreet, CrowdStreet and, for a time, Fundrise.

Insider reviewed hundreds of lawsuits, spoke to bankruptcy and crowdfunding experts, and interviewed six PeerStreet investors and a former employee to find out what went wrong. We found that the majority of the company's loans were "non-performing," meaning that the majority of PeerStreet investors made loans to defaulting borrowers.

More importantly, many PeerStreet investors who thought they were getting a portion of the loan from the property found that wasn't the case, at least according to the company. PeerStreet told a federal bankruptcy judge in Delaware that it sold financial instruments that act like mortgage stocks rather than mortgages, giving the company the right to sell the loans in bankruptcy.

The estate's case is before Judge Laurie Selber Silverstein. Depending on how it handles the situation, many PeerStreet investors continue to lose large portions of their investments, raising questions about the viability of the real estate financing business model for Main Street investors.

PeerStreet CEO Brew Johnson told Insider he was "unable to comment at this time."

PeerStreet investor Brown Mincher told Insider that a ruling in favor of PeerStreet would "destroy people's trust in crowdfunding platforms in general."

Like many PeerStreet investors Insider spoke to, Mincher has an excellent track record. He is a technology entrepreneur who has successfully exited several businesses and has experience as a real estate buyer and direct lender for real estate projects. He founded a $250 million community bank and chaired the creditors' committee in another bankruptcy case in Delaware. He also wrote a book on personal finance.

But the scale of potential losses from PeerStreet's collapse surprised even sophisticated investors like him.

“I feel smart, but I feel deceived by what they're trying to do here,” Mincher said, citing testimony from a notice taker who said he felt “victimized” in court documents. investment fraud”.

Crowdfunding has found its place in the social media age, with pioneer LendingClub launching on Facebook in 2007. The idea is simple: instead of asking someone for a business plan, whether it's a startup, a product or of an investment in real estate. - Contact a bank or a large investor to obtain money to realize the idea, the investment can be co-financed by small investors.

The most popular version, seen most often on Kickstarter, is rewards crowdfunding, in which someone with an idea for a gadget asks for money to make it and then rewards early investors, usually after the product itself has been created.

Another form of crowdfunding, equity crowdfunding, works a bit like the stock market, but without the complicated and expensive process of an initial public offering. An asset, be it a business, a property or an expensive work of art, is divided into shares. Short-term investors can then buy a portion of the asset and share in the profits.

With PeerStreet, investors (in most cases) receive a promissory note that serves as collateral for a residential real estate investment. As long as the owner of the property manages to pay the mortgage, the investor receives a monthly payment proportional to his share.

Ian Ippolito, founder of Real Estate Crowdfunding Review, said PeerStreet had an excellent reputation in the fast-growing crowdfunding community when it launched in 2013, but as its popularity grew, the quality of offerings on the platform has declined in significant way. real estate aggregation platforms.

It's a common story, Ippolito says, with the crowdfunding company's popularity to the point that transactions are fully funded in 30 minutes or less, prompting him to increase the number of transactions on the platform. The increased demand for transactions is accompanied by a “desire to reduce subscriptions.”

PeerStreet did not respond to requests for comment, but its executives would not comment on its desire to operate as a "two-sided marketplace" rather than an investment manager. Marketplaces that simply connect buyers with sellers perform better when there is more volume moving through them, meaning the incentive is large investments rather than high-quality investments. This applies to many real estate lenders, whether they are selling debt-related securities or equity investment shares.

“If you go up there with a development group, there's no way they're going to do their due diligence,” says John McNellis, principal and co-founder of development group McNellis Partners and author of the lead research program. . . Real estate development books for sale.

He said that many crowdfunding companies have an interesting investment plan: “It's on our website. It may or may not seem like an investment. You decide."

It is perhaps no coincidence that, according to industry experts, including a former crowdfunding founder, growing demand for deals often coincides with capital injections from venture capitalists, reinforcing the cycle and worsening underwriting standards.

Burry was an early investor in PeerStreet and secured the company's creditworthiness in 2015, when it was still in its infancy. Until 2016, the company was also backed by Silicon Valley venture capital firm Andreessen Horowitz. In 2019, PeerStreet had raised $121.9 million in venture funding, and the total amount of loans funded exceeded $3 billion. (After five years in business, it hit $2 billion just a year ago.) The company's rapid growth continued during the pandemic, but its lending volume fell sharply as interest rates rose.

The collapse exposed deeper problems, including large numbers of loans in or near default. When PeerStreet spoke to Insider, the court documents revealed a fact that left industry insiders worried: 54% of the company's loans were overdue more than 30 days after the bankruptcy.

Ippolito and McNellis say crowdfunding companies never line up to get the best deals because they tend to target banks or institutional investors, which have higher underwriting standards. The emphasis on quantity has made things worse, leading to a wave of low-quality deals.

"They call it democratization of ownership. I call it sheep shearing," McNellis said, adding that the crowdfunding industry regularly taps Main Street investors.

PeerStreet's failure also tests a fundamental tenet of crowdfunding: It offers small investors the chance to own assets, whether they're part of a business or a mortgage.

Bankruptcy filings show that the El Segundo, California-based company says it controls the loans and therefore should be allowed to sell them at auction to repay its creditors. PeerStreet's lawyers pointed out that the investment agreement says that bonds sold on its platform are unsecured. Rather than being part of a mortgage secured by real estate, they are a financial instrument that acts as part of an unsecured mortgage.

More than 50 investors sent letters to the judge, and the vast majority of them said they considered themselves wealthy investors. They also argued that they had the right to decide what their investments would be. Investors who spoke to Insider said they wanted to see the loans mature in hopes of recovering their investments.

Users of the site point to the company's marketing, such as a message on the company's website stating that the notes offered by PeerStreet are senior loans that "are in the safest part of the capital." The report adds: “This position is less risky as these investors will be the first to receive payments and would prefer little debt and equity in the event of default or foreclosure.” In conversations with Insider, several investors quoted Burry in a 2015 press release: "PeerStreet banks are backed by real estate."

Berry declined to comment for our story, but the bankruptcy filings show he has a lot to lose, too. In addition to his investment in the company, he was a user of the site, with more than $600,000 in investments and about $9,000 in cash in his PeerStreet account.

PeerStreet's largest investor, Pacific Funding Trust, which owns a quarter of the bonds on the platform, also opposed PeerStreet's attempt to sell the loans, arguing that the bonds purchased were actually part of the loans. .

At an Aug. 4 hearing, a bankruptcy judge put PeerStreet's sale plan on hold until the ownership issue is resolved, citing Pacific Funding's objection and letters from small investors. Judge Silverstein said the case is extremely complex and that it will take time to resolve the dispute.

One of PeerStreet's lawyers tried to move forward with the deal, arguing that a judge could allow the sale until ownership could be determined. The judge disagreed.

“If you don't own them, you can't sell them,” Silverstein said.

PeerStreet investors who spoke to Insider said the outcome of the case could determine whether they pursue real estate financing. The next hearing on the property is scheduled for Wednesday.

“If they let PeerStreet confiscate my investments that they promised not to confiscate, I don't see why anyone would fund again,” said Sean Quinn, an investor and former labor relations manager at PeerStreet.

Doug Lyon, an engineering professor at Fairfield University and an investor in several crowdfunding platforms, told Insider that even if he successfully emerges from bankruptcy, he plans to continue investing in platforms other than PeerStreet.

“This is where the money goes to die,” Lyon said of the site.

Real estate financing is limited to investors with a home value of at least $1 million, including the home, or an annual income of $200,000. As a result, some investors have hundreds of thousands of dollars at risk, according to bankruptcy court filings.

According to Ippolito, unsecured instruments are common in the world of debt financing, which PeerStreet pioneered. One of the largest crowdfunding platforms, Yieldstreet, uses a similar registration form that is not directly linked to the underlying loan, Ippolito discovered while reviewing the company's investment contract.

According to CEO Jason Fritto, Patch of Land operated with a similar underwriting structure before shuttering its startup in 2020, which allowed it to extend the life of its loans by moving away from crowdfunding. Eventually the company was sold and the platform was demolished.

Of course, platforms that offer equity instead of debt usually offer investors an actual share of the asset instead of a promissory note. They do this by creating an entity known as a special purpose vehicle to purchase the property. Investors therefore participate in the actual business in proportion to the amount of money they invest and should therefore have more autonomy in the event of failure.

Of course, shareholders are often the first to suffer failure.

I don't see why anyone would raise money again if they allowed PeerStreet to seize my investments that they promised not to seize. Sean Quinn, PeerStreet investor

PeerStreet investors also dispute the company's previous statements about how the bankruptcy will be handled. In a post on its website, PeerStreet wrote that its investment was made in a "non-failing company" and that a third party would step in and ensure the investment "ceases PeerStreet's operations." investors continue to receive interest and principal payments.

Instead, the company froze all payments to investors and lobbied in court to sell loans to repay its debt. Some of that money could be returned to investors, but the amount is unclear, according to bankruptcy experts.

The company said it will sell the loans in tranches of similar loans and then pass the proceeds to bondholders after accounting for each investor's assets to limit losses.

But investors said the company could easily put the proceeds of any sale into a big pot as seniority to pay off its debt. In that case, the platform's bondholders would lose to hedge funds Magnetar Capital, which owes $27 million, lawyers and even real estate agents, according to bankruptcy experts.

Kirk Brett, president of the bankruptcy group at Adler & Stachenfeld, which was not involved in the PeerStreet bankruptcy, said the distribution issue is being handled in several ways, including the scenario of big banks fearing investors.

“I don't think this has been discussed in previous cases, and you can tell because there aren't many references in the case law on this issue,” Brett said.

The real estate crowdfunding industry is riddled with accusations of negligence.

In 2018, the Securities and Exchange Commission charged iFunding's CEO and founder and another company employee with misappropriating more than $1.17 million in investor funds and making false statements to investors. In 2021, two people were ordered to pay more than $2 million in fines and restitution after the SEC accepted their claims.

Most recently, CrowdStreet was the subject of a Delaware bankruptcy court investigation after raising $53.8 million in two deals that never closed. In July, a trust document on the matter said the money had been "misappropriated" and much of it had been transferred to entities linked to the developer, Nightingale CEO Eli Schwartz.

CrowdStreet responded by blaming Nightingale and saying it was considering legal action against Schwartz and Nightingale. Nightengale did not respond to the allegations, but an attorney told the court that the trustee was working to resolve the dispute with the company's investors after it became known that the Justice Department and the Securities and Exchange Commission were investigating the case.

Meanwhile, the SEC on Tuesday accused Yieldstreet, one of the largest crowdfunding platforms, of defrauding investors by withdrawing $728.5 million. The Securities and Exchange Commission said the company failed to inform investors that borrowers on the $14.5 million shipbreaking project had not previously repaid similar loans to the Yieldstreet company. Investors lost millions.

Yildstrit agreed to pay more than $1.9 million, without admitting or denying guilt. In the filing addressed to Insider, the company said it "persists in seeking the return of our investors through ongoing litigation and efforts to recover debts both here and abroad."

Ippolito told Insider that the industry, which previously had hundreds of operators, has shrunk to about 20 platforms over the past decade.

Some, like Yieldstreet, have expanded into other alternative assets, including art and private lending, which have turned into high-yield commercial real estate sites as banks refuse to lend. Several operators have joined. Others have stopped working. Others, like Fundrise, moved away from crowdfunding in favor of a BREIT-like private real estate investment trust model later proposed by Blackstone.

Fritton, former CEO of Patch of Land, said Fundrise is a future model for real estate crowdfunding. Accredited investors willingly invest money in real estate transactions, but the fund structure can provide greater protection to both sponsors and investors.

The individual investment market favors the number of investments, but the fund requires the sponsor to act as a more traditional investment manager, which ideally leads to more rigorous underwriting standards.

Funds can also better cover unavoidable but incidental operating expenses that arise when dealing with physical investments, such as a broken elevator or water heater or repairs after a flood. Instead of requiring each individual property to have sufficient liquidity in the event of such events, the fund can maintain a large liquidity reserve that can be used across all its properties when such problems occur. This means the sponsor is less likely to turn to investors and require more capital to complete necessary repairs.

According to Fritton, funds can also protect individual investors from bankruptcy if an investment fails. If investors invest all their money in a deal that fails, they will lose everything, but if they invest it in a fund, a failed deal will not destroy all their investments. “I don't know what your guarantee is,” - said Fritton, some deals will fail.

Fritton gave an example of a deal that looked perfect on paper: the sponsor was the CEO of a public company with extensive experience and a fantastic credit history. This was the company's first failure.

"I have not paid any cents for this credit," - said Fritton.

Podkast «Лидеры толпы» — ep. 206 with Bruce Johnson (founder and CEO of Peerstreet)