Is Fundrise as Good as It Seems?

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Scrolling through my Facebook feed, I stumbled upon an ad for Fundrise, which promise incredible returns from crowdfunded investments in real estate. The company, which combines investments as small as $1,000 from individual investors to make larger loans and equity investments, boasts on its track record page that its managed funds beat the S&P 500 Index by 8.5 times over in 2015.

Fundrise has a number of funds that have varying investment strategies. A recently formed fund by the name of Fundrise West Coast Opportunistic REIT has a stated goal to generate returns by investing in real estate projects in large metropolitan areas like Los Angeles, San Francisco, Seattle, and Portland, for example.

But all that glitters may not be gold, and though Fundrise isn't a scam in the sense it is going to run away with your money, its claims should come with a few asterisks.Deep in its filings for its so-called eREITs are pages and pages of conflicts of interest and risks that investors should give particular attention.

Complex conflicts

All funds carry fees, but Fundrise's fees appear particularly high and especially conflicting.

At virtually every step along the way, the fund's managers will seemingly collect another fee from investors. When the fund managers find a deal to invest in, they carve out an origination fee of up to 3%of the loan amount. The company's filings state simply that "we will not be entitled to this fee," referring to the investors in the fund. Management thus has an incentive to offer loans with higher origination fees (which flow to management), offset by lower interest rates (which would result in less income for fund investors).

Likewise, managers collect ongoing management fees equal to 1% of the funds' net asset value on an annual basis, in addition to servicing and property management fees, which will vary from 0 to 0.50%of assets.

But that's not all. Fund management also stands to collect every time Fundrise sells a property on behalf of its investors, collecting 0.50% of the gross proceeds after repayment of property-level debt. Notice that this fee rewards management for activity, not investment returns. Buying and selling a property at a loss would theoretically generate earnings for fund managers at the expense of capital losses for its investors.

Big commitments

One of the trickier issues with real estate and loans to real estate operators is that the assets are typically illiquid. In some ways, REITs offer a solution to this problem by enabling investors to sell shares to other investors, or back to the REIT manager.

Should you want to sell your shares, though, expect to pay a price. Investors who have held their shares for fewer than 90 days can redeem their investment and receive their investment back, minus any dividends received during the period, resulting in no return, or perhaps a slightly negative return when taxes on dividends are taken into account.

Those who hold shares for a period ranging from 90 days to five years will be able to redeem their shares at a discount ranging from 1% to 3% of their current value as estimated by the funds' manager. Only after holding for five years or more can investors redeem their shares at 100% of their then-current net asset value. In every case, the redemption amount will be reduced by "third-party costs" which are not quantified in its SEC filings.

Substantial risks

Make no mistake: Fundrise borrowers aren't the kind of borrowers who might seek out a bank loan. A recent SEC filing for an established fund under its umbrella reveals the company is frequently making loans with eye-popping interest rates of 9% to 12% to fund projects that include condo conversions, apartment renovations, and more speculative land acquisitions.

One of the firm's recent investments provides a good framework for what a typical investment might look like. Fundrise made a $4.7 million loan to a real estate investor group who intend to rezone a commercial property, complete construction drawings, and obtain new financing to build a 140-unit apartment project and repay Fundrise's high-interest loan, which carries a rate of 12% per year.

Fundrise offered a candid explanation of the investment, saying that the project plans were "unclear" but that it believed there were "several exits scenarios" for the investment at above its cost basis for the loan. This kind of lending isn't for the faint of heart, but it's the kind of lending Fundrise will have to do to generate the kind of eye-popping returns it claims in its advertising.

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