Since the beginning of this year, the German government has undertaken a review of the crowdinvesting regulation introduced in July 2015. It has now officially released its conclusions and is proposing several changes to the existing law, including a most controversial exclusion of real estate projects. Invited to defend their views vis-à-vis the financial commission of the parliament, representatives of the German Crowdfunding Association have challenged the government’s position and presented substantial counterarguments.
German Crowdfunding Law, KASG
The German crowdfunding law is called “Kleinanlegerschutzgesezt”, often abbreviated KASG, which literally means “Law for the protection of the small investor.”
This law is one instance of a country-specific crowdfunding regulation which specifies under which conditions crowdfunding securities may be offered to retail investors while being exempted from publishing a full-fledged prospectus. As a reminder: crowdfunding regulation at European Union (EU) level was so far deemed “premature” by EU authorities and is therefore not included in the Capital Markets Union, the EU’s effort to harmonize capital market regulations at EU level. Hence, each EU country currently issues its own regulation which creates a legal patchwork and hinders cross border deals.
The German government’s arguments for ruling out real estate
The German government’s report firstly notes that German real estate projects represent 10% of the successful projects and 33% of the capital raised through crowdinvesting, that is €36 million. Projects are typically residential property development, mostly construction, the reminder being renovations. German real estate crowdinvesting nearly doubled in size last year while the growth of startup crowdfunding slumped.
The government finds this trend negative. It justifies its proposal to exclude real estate from the scope of the crowdfunding exemptions as follows:
- The large share of real estate in crowdinvesting represents a deviation from the intention of the legislator which was to foster the funding of high-growth startups.
- There is no lack of funding for real estate projects. Social real estate, for example, can be funded through schemes that are specific to social housing.
- Real estate crowdinvesting could be considered as a form of deregulation of real estate finance which could, bearing in mind the role played by real estate in the 2008 financial crisis, create a price bubble, and ultimately pose a threat to financial stability.
Note that these critics do not make any mention of the protection of retail investors which is supposed to be the focus of the KASG law.
However, this topic was addressed elsewhere by the German financial regulator BaFin:
- Current real estate crowdfunding offerings make use of the subordinated debt instruments (shareholder loans and subordinated loans are the only securities authorized under the current KASG law). This could mislead retail investor to believe that their debt is more senior and more secure than it actually is.
- There are potential conflicts of interest if, for example, real estate promoters create a platform and therefore are judge and jury for the quality of the projects presented on the platform.
The government should enlarge, not limit the scope of crowdfunding regulation
The German Crowdfunding Association expressed its profound disagreement with the government’s critics of real estate crowdfunding and its recommendation to exclude it from the scope of the KASG law.
Firstly, considering the general issue of crowdinvesting, the association notes that, even though there is not yet a harmonized crowdfunding regulation, there is a willingness at EU level to improve SME’s access to alternative financing that should encourage the German government to foster crowdfunding instead of limiting it. The association recalled its proposals to enlarge the KASG instead. Secondly, the association recalls that the government previously stated in answer to a request by the Green Party that its investigations had shown no sign of misconduct relating to crowdfunding or crowdfunding platforms. On the contrary, crowdfunded companies have proven to have a significantly higher survival rate than other startups and SME
The benefits of real estate crowdfunding for retail investors
The government’s concerns appear to be due to the fact that it had not anticipated the rapid growth of real estate crowdfunding. However, the strong demand should not be a cause for concern. Rather, it should be seen as a confirmation of the validity of the real estate crowdfunding business model. Real estate crowdfunding brings multiple benefits to retail investors and to the market at large that the government does not seem to have taken into consideration.
- The success of real estate crowdfunding confirms the need to create more living space and help solve the tense housing situation in Germany.
- It gives retail investors the opportunity to participate in the real estate market boom and in the profits of the property development market with a small minimum investment.
- It gives them also the possibility to diversify their portfolio (hence lower their risk) across sectors and maturities. They can also diversify their investment within the real estate sector as multiple platforms display multiple projects covering diverse segments and geographies.
- It gives them a very transparent form of real estate investment which is already quite well regulated for investor protection as it stands.
- The vetting of real estate projects by the platforms is a major plus. So far, no investment failed.
“The arguments of the federal government would be understandable if real estate crowding had caused problems or complaints. But that is not the case. Real estate crowdfunding is rather the flagship segment of crowdinvesting as there have been no failures or other disadvantages for investors. This speaks to the merits of the professional work done by platforms,” said Björn Maronde, Founder & CMO, Exporo.
Unfounded critics and concerns
The Crowdfunding Association and crowdinvesting platform leaders found many of the government’s arguments “incomprehensible” and offered point-by-point rebuttals:
- Crowdfunding counters price bubbles and real estate overheating. As it finances the construction and renovation of properties, real estate crowdfunding fosters the supply side of real estate, not its demand side, i.e. the purchase of real estate. It therefore increases the real estate supply and thus directly counteracts price increases and the potential overvaluation of the real estate market. In short, it works in the interest of financial stability. The current real estate market boom is in no way due to crowdfunding, which is much too small to influence market prices, but rather to macroeconomic factors such as the currently low interest rates.
- Crowdfunding helps finance real estate SMEs and innovative entrepreneurs. There is no sensible criterion for distinguishing real estate financing from other types of business financing. The real estate project developments financed through crowdfunding platforms must but be classified as operational, entrepreneurial activities. They often present innovative projects by smaller property developers.
- The risk of subordinated debt instruments is not specific to real estate. The current KASG law restricts crowdinvesting to shareholder loans, subordinated debt. This can mislead investors who may not realize that they’re holding junior debt and sharing much of the risk for a fixed reward. However, it impacts startup investors more than real estate investors. It would therefore be more appropriate to open crowdinvesting to all securities, including profit sharing securities, rather than to exclude real estate from crowdinvesting.
In conclusion, the Crowdfunding Association expresses its desire to work with policy makers to resolve this issue as soon as possible:
“We take the concerns expressed by policy makers very seriously. […] If necessary, we are most disposed to participate in the possible amendments to the KASG legislation, should the specificities and needs of the real estate sector be more clearly taken into account,” said Fritz von Stechow, Head of AK Real Estate in the Federal Association Crowdfunding, Zinsland
About the growth and competitiveness of Germany’s alternative finance
From an outsider point of view, one could add that the real estate issue has a strong bearing on the more general issue of the growth and competitiveness of Germany’s alternative finance.
Currently, the German crowdfunding market is disproportionately small. It is surpassed on the Continent by the French market (28% smaller GDP) and dwarfed by the UK market (15% smaller GDP).
Real estate crowdfunding is part and parcel of creating a strong alternative to established finance. There is no denying that it appeals to retail investors, including those who cannot afford to buy real estate property. If appropriately regulated, it can give to these investors a first start in learning the risks and rewards of crowdinvesting.
In addition, as underlined by the German Crowdfunding Association, it helps sustain the interest of more seasoned investors in crowdinvesting as it offers them the possibility to diversify their portfolio with shorter maturities while awaiting the returns from their long-term startup investments.
In this context, one cannot but agree with the German Crowdfunding Association that “ruling in” should be a priority over “ruling out”.
The health of the incumbent German financial market is not such that it could not use a strong alternative.
Therese Torris, PhD, is a Senior Contributing Editor to Crowdfund Insider. She is an entrepreneur and consultant in eFinance and eCommerce based in Paris. She has covered crowdfunding and P2P lending since the early days when Zopa was created in the United Kingdom. She was a director of research and consulting at Gartner Group Europe, Senior VP at Forrester Research and Content VP at Twenga. She publishes a French personal finance blog, Le Blog Finance Pratique.