Dan and Ben Miller began tugging two years ago at a simple question they believe is central to the failings of the American real estate industry.
The brothers – sons of a well-known Washington, D.C. developer – 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 – with its broken connection between a neighborhood’s desires and its investors' bottom line – 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 – 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 – accredited or not – 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?"
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 – 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 – Regulation A – 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 – mostly musical enthusiasts – 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 – and all this time and money – dealt just with this one building, 1351 H Street NE.
• • • • •
Toki Underground opened up on H Street NE in March of 2011. It's a 27-seat ramen noodle shop wedged – kitchen and all – into 625 square feet of the second floor above a neighborhood bar. Everything about the place is startlingly unconventional: The space feels dominated by the stairwell just to get in it. The walls are decorated with grinning plastic knicknacks collected in Asia. The signature cocktail – bourbon, pepper honey liquor, scotch – comes with a skewer of porkbelly perched on the rim.
Toki is the kind of place that traditional capital can't envision. If outside money builds formulaic chain restaurants and cookie-cutter condo/office buildings, local money – at least in a neighborhood like H Street NE – wants to support niche noodle shops where the ramen is as cheap as the cocktails are pricey. Toki has become a cult destination. On a Saturday afternoon, the line outside is already 50-deep by the time doors open for the 5 p.m. first sitting.
Before the Millers knew if their SEC filing would be successful, they queried the neighborhood on what people might want to see in the 1351 building, one block east of Toki Underground. Over and over again, people asked in the online portal for daytime retail, a local market or another dining option. Toki Chef Erik Bruner-Yang and Will Sharp, the creator of local menswear label DURKL, wound up concocting a plan that covered all three. Their hybrid concept: an Asian-inspired market called Maketto that would include DURKL’s retail up front, a coffee shop by day upstairs and a new restaurant from Bruner-Yang spreading, with outside vendor stalls, into the courtyard and massive garage behind the building.
The plan would be a daunting sell to traditional investors. "Seeking investors in general is a very difficult process," Bruner-Yang says in an email, "and seeking restaurant investors is even more difficult as each aspect of the business from the concept to the menu to the talent are all scrutinized and monetized."
The Millers signed Maketto to a lease this spring without knowing if they'd be backing the project entirely on their own, or with the help of the community. Bruner-Yang and Sharp, meanwhile, were signing on to an open-ended experiment that might radically change their relationship to their customers-cum-investors. "Once I was able to see the space,” Bruner-Yang writes, “I had much more confidence in this project."
By the time he saw the building, 1351 had been gutted, bearing no trace of the decaying dollar store. The building stood as it does today, with the linoleum peeled up from the floorboards, and the drywall scraped off, revealing great red brick walls.
• • • • •
The SEC finally qualified the project in June of this year, and the Millers were permitted, after a last round of questions, to open the deal online in August. There remained just one key question: Who would actually want to invest in this?
Fundrise was offering this basic proposition: a share of ownership in the building along with a stake in 30 percent of Maketto's potential profits. Maketto's rent alone on the 10-year lease is projected to yield an 8.4 percent annualized return on investment. But that factors in neither appreciation on the building nor unspeakable things that might happen to it. The Millers were barred from making any kind of "forward-looking statements," or projections on the likely success of the whole thing.
The boilerplate language in the accompanying legal documents actually makes the idea sound pretty terrible. "A basic principle of investing in a small business is: NEVER MAKE A SMALL BUSINESS INVESTMENT THAT YOU CANNOT AFFORD TO LOSE ENTIRELY,” blares the Consumer Guide to Small Business Investments (caps and all) that the Millers must post on the website. In their offering circular, they had to state repeatedly that they had never successfully executed anything like this before.
So who wants in?
Julia Robey Christian, managing director of the H Street Playhouse, was familiar with the building from the earlier efforts to solicit community input for its tenant. "I had always gotten the whole crowdsourcing concept for coming up with an idea. But in my mind, I kept rolling around how do you close this loop? How do you make this crowdsourcing work for the investment part?" she says. "I couldn’t believe they had figured it out."
She invested $200. The head of the H Street Community Development Corporation invested. So did one of Jenkins' neighbors. One afternoon Molly Fitzgerald, Fundrise's communications director, was having trouble opening the front door to the property, and a guy from the Rock & Roll Hotel, a nightclub next door, came out to help – he turned out to be an investor. Ben spoke on a crowdfunding panel at DCWEEK earlier this month – two people in the audience were investors, too. Every one of the 3,250 shares the Millers offered was taken by last Wednesday, with the average investor putting in close to $2,000.
Part of the idea is that proximity can stand in for financial sophistication. Maybe these small-time investors aren't comfortable parsing all of the relevant legal documents. But they know the business owner who's moving in. And they can actually see the building. "It’s much different," Dan says, "than the idea of someone sending you an email from Nigeria."
Most crowdfunding projects start from the point of view of small business owners: Where are they supposed to get money? The Millers are primarily interested in this other side of that equation: If you’ve got money, where do you put it? Commercial real estate, generally speaking, has been a lucrative investment space. And until now, almost none of these people have been able to get in on it within their own communities.
"I see traditional real estate investment and development as a very clubby environment," says Ari Perlman, a corporate strategy consultant in Northern Virginia who also invested. He's long been curious about real estate. "But I haven’t had access," he says, "which is why I think [Fundrise] is really interesting."
Robey says she doesn’t care if she sees a penny on her return. Perlman, on the other hand, does. Natalia Moreno, a 24-year-old communications consultant and food blogger, says she bought her one share with the ease of buying a book on Amazon (Perlman had a lawyer friend look over the paperwork). Moreno has regularly been bewildered by the shape of her own changing neighborhood in the city, and she wanted to play a part, however small, in one of those decisions on H Street. She had her eye for a while on one vacant second-floor space above a Starbucks, facing onto the fountain in Dupont Circle. "I remember sitting in the park and looking up," she says, "and saying 'wouldn’t that be the coolest little speakeasy bar?'"
It became, instead, the second floor of that Starbucks.
• • • • •
Thirteen-fifty-one H Street NE is really a proof of concept. The Millers have invested more in beta-testing their idea there than they spent buying the property in the first place. The end goal is to show that it's possible for people to invest in their community elsewhere on H Street, or in other parts of Washington, D.C., or in any city. And fellow developers have already called.
In one of their stranger moments of serendipity, former Los Angeles city council president Eric Garcetti found out about Fundrise through a mutual friend involved with the Democratic Municipal Officials. He met with Ben on a Washington visit and now works the concept into his stump speeches as he's running for mayor.
"There’s a real disconnect between capital flows in real estate and the communities to which money and opportunity go," Garcetti says from Los Angeles. He was skeptical at first that average citizens would want to bridge that divide. The investment sounded too risky. But the culture is changing, he says, particularly among technological early adopters and Millennials who are demanding all kinds of new hands-on roles in their communities. "In neighborhoods like mine," Garcetti says, "where people are very savvy about the particular grind of the particular kind of coffee that’s in a particular café, I think they’re going to be pretty well-informed real estate investors."
Scaling the idea, however, won’t simply require finding those investors. There will also have to be more Millers out there, developers interested in urban infill who will anchor projects and then responsibly manage them. It’s easy to predict how other people might pervert this idea. With the 1351 property, the Millers have taken on the majority of the risk, and they will be subsidizing the costs of managing the building and the investment. Another developer, though, could craft a project with wily math: with fees for raising money, fees for construction management, fees for website maintenance, fees for unlocking the door each morning – all of which would cut into the public's return on investment.
Clearly, an economy with truly democratized finance will need more regulation of some kind. While the Millers were trudging through their Regulation A filing, Congress unexpectedly took up crowdfunding and baked a new regulatory exemption for it into the JOBS Act, allowing unaccredited investments by most people of up to $2,000 a year. It may be next summer, though, before the SEC writes the rules for how to use the new legislation. In the meantime, the Millers have already submitted another Regulation A filing for a different property they own on H Street (byzantine SEC rules forbid them from admitting that they have another public sale in the works, but we just looked it up in a public database). They figure they'll try everything. Maybe they can perfect this cumbersome Broadway musical route. Maybe they’ll start using the JOBS Act. Some of the biggest questions – like how investors will be able to extract their money – the Millers haven't solved yet. They plan next month to bring all of their investors together to talk about what happens next.
Inevitably, people will have to figure this out by doing it.
"That’s the only way we’re really going to learn," Gorfine says. "I think the funny thing is everybody feels that way. Even the SEC is in the unenviable position of having to come up with rules in a vacuum. Until you really see this in action, it’s going to be hard to know: how do you best regulate this to both protect investors, but also not snuff out the potential of this before it even gets started?"
The Millers figure they will have some control over who mimics their idea, because no one else would willingly go through the expensive legal headache they voluntarily took on to figure this out. If you’re a developer, why would you relearn their lessons when you can simply list your investment on the already existing platform that is Fundrise? The Millers say they won’t partner, however, with anyone they feel doesn’t share their values.
This is where their business is ultimately heading: the Millers are creating a tech company, not a real estate one. And this surprises even them. In some ways, they are very much not of the Internet culture, where start-ups act fast and first and figure out the law later. The private car service Uber is a classic example.
"Our view is this is securities law," Ben says. "You’re taking peoples' money. You’re not taking them on a cab ride. You do it by the book."
Tech entrepreneurs keep telling him we don’t get you guys, and he takes this as a compliment. They always want to know, bemused, "what’s in it for you?" And it’s a good question. "For us, God," Ben says, leaning back in his chair as if to take in something massive in front of him, "imagine if we become the platform for how people participate in and build and invest in their environment."