The Democratization of Real Estate Investing

• Publication year: 2022
• Author: Written by William Schumann

THE DEMOCRATIZATION OF REAL ESTATE INVESTING

Written by William Schumann^*

I. INTRODUCTION

As former United States Supreme Court Justice Louis D. Brandeis wrote in his book Other People's Money, "Sunlight is said to be the best of disinfectants."¹ By that he meant when it comes to investing, company disclosures act as the "sunlight" which "disinfects" the investments of fraud.² In this paper, I apply Brandeis's philosophy to the securitization of real estate investing. I will argue that this securitization is democratizing real estate investing, which overall is a positive development. Although there are significant financial risks involved with this democratization, substantial disclosure obligations will mitigate these concerns.

In Section II, I explain how past speculative real estate investing has led to dire economic consequences. In Section III, I will explain the intricacies and attributes of the traditional form of securitized real estate investing, Real Estate Investment Trusts ("REITS"). In Section IV, I will explain how the Jumpstart Our Business Startups ("JOBS") Act has facilitated the democratization of real estate investing. I will focus on crowdfunding and Special Purpose Acquisition Companies ("SPACS") within the real estate investment sphere. I will conclude by noting that although the JOBS Act has set the stage for a proliferation of securitized real estate investing, such a phenomenon does not endanger investors.

II. RISKS OF REAL ESTATE INVESTING: A BRIEF HISTORY OF REAL ESTATE HIGHS AND LOWS

Whether an investor is directly purchasing a property or investing in a real estate security, the success of the investment is tied to the underlying value of a property. As history has shown, just like prices for stocks, commodities, or other investment vehicles, real estate prices are susceptible to volatile behavior. As Robert Shiller explained in his book Narrative Economics, most people view real estate as a "personal asset" that is detached from the overall economy.³ People tend to attribute a substantial amount of social value to real estate.⁴ Like other material possessions, the real estate someone owns impacts how that person compares their own success in life with the success of other people.⁵ However, more than investors in other assets, real estate investors are easily influenced by a uniqueness bias.⁶ The uniqueness bias causes people to believe that the location of their real estate is "unusually attractive."⁷ As Shiller writes, these people "fail to understand that new [properties] can be constructed in what are today cornfields or forests."⁸ Over the years, such a mindset has caused real estate investors including homeowners to let their emotions guide their real estate purchases in lieu of logic or reason.

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A. NATIONAL REAL ESTATE CRASHES 1. THE SAVINGS AND LOAN CRISIS

As the 20th century progressed, real estate fiascos took on a national profile. In the late 1980s to early 1990s, real estate prices across the US plummeted partly as a result of what is known as the "Savings and Loan Crisis."⁹ Originally, savings and loan institutions, otherwise known as "thrifts," were primarily meant to provide families with financially conservative and affordable home mortgages.¹⁰ People would deposit money in a thrift, and the thrift would pay those people interest on their deposits.¹¹ The thrifts would lend those deposited funds as home mortgages with a fixed interest rate.¹² The thrifts' profits equaled the spread between the interest rate they paid depositors and the interest rate mortgage borrowers paid them.¹³ In the early 1980s the Federal Reserve, under the leadership of Paul Volcker, raised interest rates significantly to combat rising inflation.¹⁴ This action significantly increased the interest rate thrifts had to pay their depositors.¹⁵ Because thrifts issued mortgages at fixed rates, their cost of capital significantly increased while their revenue remained stagnant.¹⁶

In an effort to help struggling thrifts, Congress expanded the thrifts' lending and investment powers.¹⁷ Where before thrifts could only lend to families for home purchases, now thrifts could lend money to commercial real estate developers.¹⁸ This change, combined with the creation of thousands of other banks across the country, led to fierce competition among these lenders to issue real estate loans.¹⁹ Consequently, these lenders started to loosen real estate underwriting standards by lowering their required debt-service coverage and loan-to-value ratios²⁰ These lending institutions made these changes on the presumption that real estate prices would continue to rise indefinity.²¹

During this period, ordinary homeowners also tended to believe that real estate prices would continue to increase. In 1988, Robert Shiller surveyed homeowners in metropolitan areas across the nation to determine whether they thought housing prices would continue to rise.²² Shiller found that overall people expected "very high" home price increases over the subsequent 10 years, especially in "boom cities."²³ He concluded there was "evidence of a high level of social contagion," by which he meant the expectations of increasing home prices were easily transmittable from one person to the next.²⁴

National housing prices hit a cycle peak by 1988.²⁵ In some metros such as Boston, housing prices had peaked as early as 1985.²⁶ Between late 1990 and early 1991, housing prices nationally declined almost 15%.²⁷ However, California housing prices continued to increase during this period.²⁸ According to a subsequent report issued by the Federal Deposit and Insurance Corporation (the "FDIC"), by 1990 Californians adopted a mentality that "California was different" and thus impervious to the economic woes impacting the rest of the nation.²⁹ The Federal Reserve Bank of San Francisco issued a report in early 1991 concluding that "[n]either theory nor data support the notion of an impending 'bust' in housing prices."³⁰ After that report was issued, California housing prices declined and bottomed out in October 1995.³¹ From March 1990 to October 1995, California housing prices fell on average over 20%.³²

During the Savings and Loan Crisis, real estate losses were not limited to single-family homes. Commercial real estate, which for the purposes of this paper includes any nonresidential property such as office buildings, retail centers, and industrial properties, experienced a sharp price decline from the late 1980s to the early 1990s.³³ The FDIC estimated that national commercial property prices dropped over 50% between the late 1980s peak and 1993.³⁴

2. THE GLOBAL FINANCIAL CRISIS

By the mid-1990s, real estate prices across the country started another upward swing.³⁵ This upward swing continued for over a decade.³⁶ This boom was driven by a period of low interest rates, loose mortgage underwriting standards, proliferation of residential mortgage-backed securities, and excessive speculation in real estate investments.³⁷

By 2006, housing prices hit a new national high.³⁸ In March of that year, Federal Reserve Chairman Ben Bernanke stated that although the US housing market's growth might slow, "strong fundamentals support a relatively soft landing in housing."³⁹ He added "I think we are unlikely to see [economic] growth being derailed by the housing market."⁴⁰ Nevertheless, housing foreclosures and mortgage defaults soared over the next several years.⁴¹ Nationally, from 2006 until housing prices bottomed out in 2012, home values dropped 32% on average.⁴² Some metros experienced declines of more than 50%.⁴³ Chairman Bernanke's prediction proved wrong.

The significant drop in US housing prices derailed the global economy causing what has become known as the Global Financial Crisis. To understand why, we must look to the deterioration of mortgaged backed securities ("MBS").

An MBS was and still is a financial instrument consisting of thousands of individual home loans.⁴⁴ Their creation involved multiple steps.⁴⁵ First, banks loaned money to people looking to purchase a home.⁴⁶ However, the banks did not keep these loans on their balance sheets.⁴⁷ Instead, the

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banks sold the loans to major financial institutions.⁴⁸ These banks planned to sell these loans so they bore no risk if a borrower defaulted.⁴⁹ The major financial institutions packaged these loans together⁵⁰ and divided the packages into separate pieces otherwise known as "MBS tranches."⁵¹ Professional credit rating agencies such as Moody's, S&P, and Fitch, then analyzed the loans within these tranches to determine each tranche's creditworthiness.⁵² Finally, the MBS tranches were sold to other investors consisting of pension funds, investment banks like Bear Stearns, and municipalities across the globe.⁵³ Those investors expected to derive their revenue from the underlying mortgage payments.⁵⁴

As the Securities and Exchange Commission ("SEC") later discovered, three of the nation's largest credit rating agencies—Moody's, S&P, and Fitch—continually used antiquated mathematical formulas and flawed housing market assumptions to analyze the tranches.⁵⁵ They gave high credit ratings to MBS tranches filled with risky, poorly underwritten loans.⁵⁶ From large Wall Street institutions to small towns in Norway, entities across the globe invested the equivalent of trillions of U.S. dollars in MBS tranches.⁵⁷ When millions of homeowners started to default on their mortgages in 2007, the MBS tranches made up of those mortgages collapsed in value.⁵⁸ As a result, many found themselves financially ruined.⁵⁹

Real estate woes were not limited to the residential sector. By 2009, the National Association of Real Estate Investment Trusts estimated that commercial property prices across the nation had dropped over 20% from the prior peak.⁶⁰ According to the National Council of Real Estate Investment Fiduciaries index, an index which tracks national quarterly commercial real estate returns, commercial real estate profits...