Pre-funding: The Killer App of Real Estate Crowdfunding

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Revolutionary technology is rarely useful or successful right away. Gutenberg’s printing press was a commercial failure until he decided to print the Bible. PC’s were obscure curiosities until the invention of the spreadsheet. Even the Internet was just an academic toy until the invention of the web browser.

Those “killer apps” transformed sleepy technologies into explosive ones. Killer apps take time to invent, but spread like wildfire. And real estate crowdfunding just came up with its own “killer app,” which will transform the industry. That killer app is called “pre-funding.”

Like all killer apps, pre-funding solves a huge problem. Real estate investing can be very profitable, but one poor quality investment can sink a portfolio. So most marketplaces highlight their “superior due diligence” in vetting the investments they sell. Unfortunately, they can’t all be the best. Some sites do a great job, the majority of them do a fair one, and a few are arguably borderline negligent.

So how do most investors differentiate them? The answers are a little scary. One investor said, “I chose the one that had the nicest webinar.” Another “picked the one that seemed the most popular.” Many simply went with the first one they signed up on. Random guessing works fine in a rising market, but will most likely be catastrophic when the real estate cycle changes. Investors need a better way.

New York Real EstateThankfully, pre-funding provides that. Pre-funding means that a marketplace actually pays the sponsor the entire investment amount before making it available to investors. This forces the marketplace to have “skin in the game,” and gives the marketplace an extra incentive to do the maximum due diligence possible.

As an example, let’s say a sponsor needs $400,000 to purchase a duplex. Most marketplaces don’t pre-fund, so they don’t give the sponsor the money until their investors (hopefully) purchase all of it. Once the investors do, the marketplace transfers the money to the sponsor (minus fees). The marketplace never puts its own money at risk, so it’s hard for an investor to know if that “superior due diligence” in selecting the investment was real or not.

But a pre-funding marketplace demonstrates confidence in its due diligence by putting its money on the line. The company gives the sponsor $400,000 upfront, and only then does it put the investment out to investors. If investors don’t purchase the entirety, the company owns part or all of the investment itself. So if the marketplace didn’t do a good job in vetting, it will pay the price along with the investor. This visible demonstration of alignment of interests is an incredible and transforming invention.

Pre-funding also has other advantages: it enhances return and makes the investment more dependable. In a non-pre-funding marketplace, an investor’s money sits idle until all investors have funded the investment. This can depress the return unnecessarily. And, if other investors don’t want to fully fund it, the investment is canceled, so the investor cannot participate. With pre-funding, the money starts earning right away. And the investor is guaranteed to be able to participate.

ROI investment graphPre-funding is a killer app for sponsors too, because they know they will get their money – and get it really fast. On non-pre-funding sites, they might have to wait weeks or months, just hoping that enough investors will want the investment, before they know if they will be paid their money or not. By then, the opportunity they were funding may already have disappeared. Those hassles disappear with pre-funding. Additionally, pre-funding sites have a larger pool of sponsors to choose from, which gives them more opportunities to provide higher quality investments to investors.

Pre-funding requires deep pockets to implement, so currently only three sites provide it on every investment. They are: Patch of Land, Fundrise, and Acquire Real Estate. However, as more and more capital flows into the industry every month, this will change rapidly. A handful of other sites say they currently pre-fund some investments, and others say they are planning to provide it in the future.

It’s only a matter of time before pre-funding and real estate crowdfunding become as synonymous with each other as the browser is with the Internet. It will transform the industry as we know it today, and lead to explosive acceptance and growth.

 


 

Ian IppolitoIan Ippolito is an investor and serial entrepreneur. He has been interviewed by the Wall Street Journal, Business Week, Forbes, TIME, Fast Company, TechCrunch, CBS News, FOX News and more. He is also the editor of The Real Estate Crowdfunding Review, which reviews all the sites and provides investor analysis and tools.

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