Sara Hanks is, was, a corporate and securities lawyer of thirty plus years before the financial crisis of 2008+ happened. She was recruited by Senator Elizabeth Warren, who at the time was Chair of the Congressional Oversight Panel for the Troubled Asset Relief Program (TARP), a program set in place to put a floor under potential collapse of the financial system. Sara started the week that the Dow Jones hit bottom although they did not know that until later. After working on oversight issues on Capitol Hill, Sara became aware of all of the various pieces of legislation that eventually became the JOBS Act, and, while finding it of great interest, was also around folk at the American Bar Association who said things like, ‘oh my goodness, they're going to defraud my grandmother!’
Wanting to provide a solution to the defrauded grandmother problem, Sara started talking to a couple of friends she had come to know through the Congressional Oversight Panel and, together with them, set up a company to provide reassurance to people in crowdfunding that the companies were legitimate.
From that point the company expanded and now does all aspects of compliance for online capital raising. Whether it is under Regulations CF, Regulation D 506 (C) or regulation A. and although they did not initially found CrowdCheck as a law firm, because they were securities lawyers by background, people kept asking them securities law questions and they eventually started thinking that they could provide counsel on these matters also. They set up an in-house law firm and provide a complete legal disclosure compliance package for all aspects of JOBS Act type fundraising.
Attraction of the JOBS Act
It was the ability to democratize the capital raising process to permit everyday people to take control of their own financial lives that attracted Sara to the Act. For early stage companies or projects, real estate included, sponsors could now not just go to people who they always go to for capital but could reach out using the Internet to a broader source of capital, giving people more investment opportunities. Its seemed like a good thing on both sides both for the company or project and for the investors providing it was done in a compliant way and providing that everybody knew what the risks involved were which is where Sara saw CrowdCheck coming in.
The easiest of the JOBS Act regulations to comply with is probably Reg D because there is really nothing there. A sponsor is going out to accredited investors only under 506 (c) where, really, the only rules are do not lie and do not make misleading or fraudulent statements. A sponsor still has information is presented in a way that new investors understand. Just because somebody is accredited does not mean that they necessarily understand what all the risks are and, from SEC studies, we know that there are some 12 million accredited households in the US, but that only half a million or so regularly invest as accredited investors. There is a big disconnect. There are some accredited folks who should not be investing in anything, and there is a whole new investor class out there who could but maybe do not understand what they are getting into when looking at a Regulation D offering. And the next level of complexity from a compliance and education perspective, is, of course Reg A where both accredited and non-accredited investors can invest alongside each other.
The Sophisticated Investor
When the concept of crowd funding was introduced, the idea of an accredited investor was supposed to be a proxy for someone who either had experience or could buy experience. They were rich enough to be able to hand this over to a financial adviser and say ‘tell me, financial adviser, is this a good thing for me or not?’ It was always an incredibly blunt tool. The SEC has recognized that for quite some time viz. that the mere owning of various sums of money or earning various sums of money does not necessarily mean that you are automatically able to make investment decisions. On the flip side some folk can be incredibly sophisticated people and yet not accredited, including many SEC staffers among them who are not accredited yet but could make just as good decisions. This could change as leadership at the SEC changes and it is possible that the definition of the accredited investor will probably be expanded at some point in the near future, and these changes could include, for example, adding a level of sophistication by reason of examination. This could capture people who hold FINRA examinations, for example, or who have business experience as another possibility, irrespective of income or net worth.
Potential Changes to the Act
There is unlikely to be any major change to the JOBS Act, perhaps some minor chipping around the edges but to the extent anything goes really wrong then there could be some pulling back, but even that would take some time. First there would have to be the scandal, everybody would need to know about the scandal, and then there would have to be regulations passed to address them. For the foreseeable future, therefore, at most there will be minor fiddling with the edges of the various provisions of the JOBS Act.
Real Estate Compliance
What CrowdCheck does in the real estate space is really boring (!) They do the corporate diligence to make sure that the entity that owns the property was properly organized and then the entity that is doing that is issuing the securities was properly organized and that the two of them have a relationship. The standard structure that seen in real estate is property-owning-company, which may be an LP Limited Partnership or it may be an LLC, and then the issuer which is issuing to the crowd, holds interest in the LP or else LLC holds the property. CrowdCheck verifies that all of those are properly incorporated or organized and that they have authorized the issuance of the securities at both levels and what they very frequently find is that the paperwork around the property owning entity especially can be very sloppy.
For example limited partnership Number Four owns property Number Three, and the issuer saying they are selling interests in property Number Two. There is a tendency sometimes in real estate for successful sponsors to just pull out the last set of documents and mark them up. Another area that they see is the use of cascading pyramids of limited liability companies all the way up because, of course, one of the things that they have to do is check that nobody who is a ‘bad actor’ is involved in the sponsor.
Sometimes they will see several different layers of LLCs which may have been used in order to disguise the fact that there is a bad actor involved who did not want to be disclosed. CrowdCheck’s rules are that they have to go all the way until they hit a human being or an incorporated company. Anyone who comes to us with a pyramid of LLCs will find that they just go through all of the these.
As important a protection as they are for investors, compliance services are not mandated and a lot of the platforms have very limited resources and they are not making a huge amount of money. Compliance services are, therefore for many, a kind of a luxury to a certain extent although one could make the case that not being sued for sloppy paperwork is not a luxury. Indeed, soon after the JOBS Act was enacted, CrowdCheck probably was working with maybe 12 to 15 real estate platforms – but of those platforms only one or two of them still exist. The biggest issue that the failed sites faced was one of deal flow; a lot of them had problems getting enough projects. If a site only got one or two sad looking condo complexes their platform, people are going to come along and see that they are the same deals that were there 12 months ago.
There were three companies involved in a series of discussions with the SEC. Two of them were real estate companies. Sara wrote an article, ‘the lemon squeezer’ article, which came out as a result of a fuller understanding of just how far the SEC would let people go when it came to high pressure, very flashy ads on TV or radio. The issue is that in Regulation A prior to qualification by the SEC – which is the point at which the SEC says no more comments you can go off and sell your securities now – until then an issuer is just trying to solicit interest. During the period up to qualification the issuer can advertise on TV and on the radio. You have to give a disclaimer which you can verbally say telling when the filing has been made with the SEC where that the offering document can be obtained. But until then, an issuer can do these very flashy ads that are almost startling to people with traditional securities backgrounds.
In short, prior to qualification once an issuer is qualified and allowed to take money, the rules change and the SEC says at that point you can only use methods of communication that include the delivery of the offering document which of course you can do if you if you are online – but that cannot do on the TV or radio. So you cannot use TV and radio under present interpretations by the SEC to advertise your company or your real estate project.
During the next downturn, as Warren Buffett says, when the tide goes out you find out who has been swimming without their shorts on, and that is when we will see things start getting dodgy. That is when you start seeing who has not done the paperwork. The tragic thing there is that so many of these platforms are so thinly capitalized that when something goes wrong, just one or two deals go completely wrong, people will start to lose faith. There will not be anything left for anybody to sue, either on the project or for the investors in the platforms themselves.
The next downturn you will see evidence of some sloppiness and that will lead to probably further extinction event of platforms. It is likely that there will also be some consolidation of the various platforms. Many of them are just too small and they are complete niche players, and somebody might scoop in there and roll several of them up.
With respect to downturns leading to changes in the JOBS Act, this is possible if people actually blame the JOBS Act for things going wrong – there are a lot of people who are very cynical about the JOBS Act, concerned about defrauding grandmother. However, any future changes are probably going to come from people suing which tends to happen a lot faster than regulatory change.
Max Sharkansky’s firm, Trion Partners, is in the business of value item multifamily residential real estate. They started out around 2005/2006, right before the recession. Prior to that Max was a broker at Marcus and Millichap and his partner, Mitch Paskover, was working on the debt side at HFF in mortgage banking. They started buying deals towards the end of 2005 and as Max had been brokering multi-family deals in the San Fernando Valley at the time, they naturally started buying multi-family in the San Fernando Valley. That is where they had access to off market deals and market knowledge, and then from there it just snowballed.
They bought two deals in 2005, a few more in 2006, and then at the end of 2006 the partners formed Trion. They continued to buy through the last cycle in 05, 06, 07 and sold most of their portfolio in 2008 prior to the crash. They saw what was happening with Mitch being in the capital markets and Max being in the transactional markets. Their properties when they saw vacancies starting to tick up, and rents starting to tick down. They saw what was happening to the market and so they sold out in 2008. As they were selling in 2008 they changed their acquisition strategy from a value add multifamily. The old model no longer worked so they started targeting non-performing debt secured by multifamily, even though at that time in 2008 there was a logjam in the market and nothing seemed to work. Lenders wanted to sell non-performing debt at 90 cents on the dollar irrespective of the value of the underlying real estate, and Max was looking at deals based on the value of the underlying real estate.
As the market slowly changed, they were able to buy from one local banks and from there they ended up doing about 20 deals during the downturn in 09, 10, 11, 12. About 15 of these were note acquisitions and deals and five were REOs. By that time they had a fully built out their management infrastructure and while their competitors were straight buy the note/foreclose/sell because Trion were operators they were buy the note/foreclose/renovate/lease up and then sell. And it was in having this infrastructure that allowed them to buy the REO products as well. Coming out of the downturn in 2012 they just went back to the value add business and [as of date of podcast call] had approximately 17 properties in their portfolio with an 18th in escrow. Their aggregate portfolio value is around $240 million and they have a gross track record of over $300 million on over 40 deals.
It was a wild, wild west especially during the downturn. Trion grew very organically during that time. They bought their first few properties with their own capital. Both Max and his partner had been pretty strong producers at their respective firms so they had some dry powder and bought their first few properties using that. Then they started to syndicate out to friends and family and colleagues. Mitch reached out to some of his HFF folks to some of Max’s Marcus folks invested and it grew very organically.
During the downturn it became extraordinarily difficult to raise money so they bought a lot of stuff with high octane debt and their own capital. As they got a little further along and developed a track record and more of infrastructure it became a little bit easier to raise money. At the time it was still all friends and family and introductions through referral. They had met some family offices who were able to write larger checks and they were using a lot of expensive debt. Indeed, they were buying notes with other debt, putting debt on debt which was very helpful in allowing them to close.
Two Models of CFRE
Max heard about CFRE through the news when the JOBS Act passed. They started calling around. They did some deals with a RealCrowd, RealtyMogul, RealtyShares and have found them all to have been great to work with. The whole process has been very successful and it has been a large boon to their business. It has provided access to capital that they would not otherwise have had access to, and it has allowed them to supplement equity capitalizations when they very much needed the capital.
Max has found that there are two basic models by which the CFRE websites operate. There is the LLC model which would be like RealtyMogul and RealtyShares where you interface with the platform directly. This model is more like dealing with an opportunity fund, where the sponsor interfaces with one originator, call it, or a deal guy. With that person, the sponsor does a walk through, the deal guy does their own underwriting, there is a lot of Q&A back and forth and the process is not dissimilar from an opportunity fund. In this model, there is no interface with their investors as that all happens behind the platform’s own curtains. Sponsor does not know who the investors are, they do not interface with them before the acquisition, and neither do they interface with them after the acquisition as they are operating: All communication is with and through the platform.
The other model is more of the technological platform model, which is like RealCrowd and CrowdStreet. In that model the sponsor is effectively paying the platform to post their deal on the site. They still vet the sponsor who still goes through a process of sorts, and when a deal is posted on the site there is a flat fee paid to the platform, not a percentage of how much they raise. In this model, the sponsor interfaces directly with investors. Investors, in this scenario, will contact the sponsor based on the posting and with questions about the DD materials. Max has had a lot of dialogue, and Q&A with investors this way, and has even met people on site at properties. Their first property raise through RealCrowd was in 2013and they have investors who have been with them since then doing multiple deals. Even though the process is different, either model works very well.
CFRE Site Input to Operating Agreements
There can be input to operating agreements from the platforms but it generally depends on what portion of equity they are taking. If the deal requires a check of $10 million plus and the platform/investor is taking $1.5 million, they are really not going to have much input into the operating agreement. On the other hand, if they are raising $4 million and the investor is taking $2.1 million then they are absolutely going to have some input on the operating agreement. This is not dissimilar to an opportunity fund or any JV type partner that would go in and mark up the operating agreement and go back and forth before coming to a final contract.
There is a time and place for both models and Trion has used both very successfully. With regard to other sponsors, it really depends on their business as a sponsor and how they want to grow and what they want at a particular time on a specific deal. If they have a deal and do not want the brain damage of talking to a lot of people just do not have the time, then going with the LLC model might make more sense. Here the sponsor will only interface with one person in the raise and the platform gets paid when the money is raised. If the sponsor has a business where they are trying to grow out their Rolodex of high net worth investors and have come to the conclusion that this is the way they want to grow their business for years to come then perhaps the marketplace model is better suited.
In both models, the platforms do the bulk of the marketing. The sponsor does very little. The sponsor might participate in webinars that would be a form of marketing, but these are coordinated and produced by the platforms. In these, the sponsor will discuss the investment and give investors an opportunity to dial in and listen to the dialogue and the Q and A about the investment and then they can submit their questions at the end of the webinar. Beyond that, though, sponsors typically are doing much of the marketing.
Platforms did not start out guaranteeing to sponsors that their raise would be successful, but it seems that the industry is moving in that direction. Fundrise is active in the preferred equity, mezz space and they do guarantee a certain amount but that is a little bit of a different business than the raises that Trion has done.
Max thinks that the opportunity to invest equity in deals through crowd funding is a great improvement for investors over the way it used to be. There is a lot more transparency so some of the more egregious terms that you would see in the old days are not really there as much anymore. For example, back in the olden days you would see much lower preferred returns and much higher promotes. Back when Max started in the old cycle it would not be uncommon to see 50:50 after a 6% pref. and today that is a thing of the past. It is a relic because people have transparency and they have a window into what other sponsors are charging and what is market.
Trion has adopted a cookie cutter approach on preferred returns and promote. For the most part they take a 70:30 split after an 8 pref. and that has worked for them – although some sponsors charge a little bit more. Typically Trion does not do waterfalls but other sponsors will. Other sponsors do but Max and his partner prefer to keep it simple. They do not charge an asset management fee because they self-manage. Some sponsors will outsource their management so they do take an asset management fee. It really depends. It's all case to case, and there is not necessarily a right or a wrong way. There is a very broad spectrum of how to operate.
Platforms do not generally have input into the operating agreements, or attempt to leverage controls that a sponsor has over their deals primarily because, for a sponsor doing a syndication, they need to have controls. In this regard it is very different from the private equity model where the PE firm will have input into key decisions in the deal, and Max has seen some control layers with some of the crowdfunding groups in the LLC model if they have a substantial portion of the equity, say 60 or 70 percent or more of a deal because they own so much of the asset.
The Fremont Deal
Trion purchased a deal that they fully financed and then backfilled using RealtyMogul. It is an 88 unit in Fremont California which is in the East Bay and the Bay Area. Many people have heard of Fremont because it is the home of Tesla auto manufacturing. Tesla is one of the hottest cars out there and it is a rapidly growing car company and because of that there has been an extraordinary amount of growth in Fremont not just because Tesla but also because of AMD some of the other local employers. If you look at it on a map, the town is very strategically located as the gateway to Silicon Valley. The town has an awful lot of overflow from Silicon Valley and the peninsula and Trion loves the market and we love everything about the real estate with regards to the asset itself.
The deal presented an incredible value add opportunity and is very typical of what Trion buys. They bought the asset from the family that bought it from your original developer in 1966. Their basis was nothing; the debt was nothing, and they had been operating the building for occupancy for decades, with little capital put back in. Trion will spend twenty $25,000 per unit on interiors, fully upgrading the interiors. They will tear everything out, and will put in brand new kitchen cabinetry, high gloss very European looking, quartz countertops, stainless steel appliances, full wood vinyl plank flooring, washer dryer in every unit – which is a huge selling point for renters. There will be all new fixtures, all new finishes in the bathrooms, tubs, vanities… basically the units will be like brand new units and they can deliver the finished units to the market place 25% below what a renter would be paying for a brand-new class A property.
The project thesis is to stabilize the building at a low 6 percent cap rate on cost and exit five years from inception at a high four cap which is where properties were trading at time of purchase. The company will grow the rents organically once stabilized at around 2.5% to 3% per year. The project was underwritten to a five-year hold, with a deal level 19% IRR and an investor level IRR around 17%.
Trion paid it $26.5 million for the 88 unit asset, which works out at about $300,000 per unit and $300 a foot because the average unit sizes are right around 1,000 square feet. At time of purchase, the price per pound was one of the lowest that had traded in that market in the prior couple of years.
With regards to the structure with their investors, the deal is a standard Trion formula of 70:30 after an 8% pref. They do not take an asset management fee as they self manage for which they take a property management fee. They have their own crew so they also take a construction management fee.
The minimum investment when they were going directly to their own investors was $50,000 but on the CFRE websites typically that is lower. The Fremont deal was a very large raise for Trion at a total equity of $10.5 million, and they started syndicating the equity with $50,000 to $200,000 investors. They also had a few larger investors who took up some allocation but they were not able to fully fund by closing so the partners put in the shortfall and then went to CFRE to backfill.
It took Trion about 45 days to finance the deal, which included 20-25 investors, and then another few weeks to conclude the CFRE tranche – which, typically in using the marketplace crowdfunding platforms, Trion expects to gets 7-10 investors for a given deal. Max will usually meet the new investors, the CFRE investors, before the close. It can be something as simple as a few e-mails or sometimes he has had them come to his office. There have been times where he has met them on site at the property if it is in L.A. or if the property is in the Bay Area and they happen to live in the Bay Area he might meet them there.
Mitigating Downturn Impact Risk
One of the things that Trion does that really helps them hedge risk is low debt. They do not put an extraordinary amount of debt on their properties. Fremont as an example is levered to about 68/69% percent of cost. Once they refi out of it they will be right around the same leverage at 65/70 percent of the new value based on the increase in NOI.
Real estate doesn’t kill people; debt kills people.
Max is a strong advocate of CFRE. He thinks sponsors would be crazy not to do it. Whether they are a young sponsor or an old sponsor, a groups that has been around for a few years doing it, or a group that has been around 25 plus years doing it. It is a phenomenal supplement to a sponsor’s investor base and anyone would be crazy not to do it. It is a win, win, win, for all involved. Max has not personally invested in other sponsor’s deals in CFRE because he needs to use all the capital that he has for co-invest and in keeping their own deals but otherwise would certainly consider such investing.
Easy for Some
Max’s Trion is a very niche investor. They are not jack of all trades and masters of none. They do not buy five different asset classes all over the country, but rather focus on buying value add multifamily 60s and 80s vintage in four markets; San Diego, L.A., Bay Area, and Portland. Their business model is simple and Max finds that he does not have to explain real estate concepts to investors because it is a fairly straightforward business. It is the business of apartments; they are taking an older apartment, fixing it up, and making it like a new apartment. They explain the details to investors and they try to keep it as layman as possible. It is not, as Max says, rocket science.
Looking to the Future
Having been founded only in 2013, CrowdStreet’s growth trajectory has been very rapid reaching the $200 million milestone of equity placed just four years later in 2017 and exceeding 70,000 investors in the same year. The company focuses on bringing institutional quality deals with a diversity of both asset types as well as risk profile so that investors can create a truly diversified portfolio of commercial real estate. The platform plans to incorporate easy to use tools to compare and contrast the offerings in a transparent for way for member investors who have multiple investments on the marketplace to be able to view their portfolio in a very constructive manner.
Though impossible to predict, the company attempts to remain cognizant of the inevitability of a real estate market recession and how to address investor anxiety understanding that no-one wants to be the last one in on a deal, so to speak. Being conscious of leverage rates that developers are using and where are soft places in certain markets, CrowdStreet tries to give a little bit more clarity of what the outlook looks like at any point in time, from an overall economic as well as from a real estate perspective.
Tores’s background is squarely in the Internet and software space for the last 20 years of his career and in bringing technology into industries that have not adopted the Internet and software for the betterment of their customers as well as the operating efficiencies. He also has a background in financial services, though he does not like to confess to this, and early in his career started in banking. This gave him a good appreciation for lending and for the financial institutions and the financial services and consumers. It served him well when he met Darren Powderly his co-founder at CrowdStreet some years later. Darren comes out of the commercial real estate space and was a partner at a well-known firm in the Pacific Northwest. He was looking for a co-founder who had built Internet and software based businesses before in order to facilitate his vision for a marriage between technology and an industry that traditionally has not adopted technology to really transform real estate investing.
The partners met in the summer of 2013 and Darren had already come up with the concept of CrowdStreet and the idea of democratizing access to commercial real estate investing. The whole idea of CrowdStreet emerged out of the Great Recession of 2008 and the idea that that too much capital is sitting in too few hands could have some negative implications. This tallied with the passing in 2012 of the JOBS Act which was created by Congress and the President at the time, to further decentralize finance by updating regulations that had been around for over 80 – the securities laws. Subsequent rulings, Title 2 of the JOBS Act and Titles 3 and 4 further helped to solidify what was going to happen. By the time Tore met Darren in 2013 those other things had yet to come out, but Tore felt that Darren had a great vision about how to reform finance and as their skillsets were complementary, they teamed up and launched CrowdStreet in April of 2014.
One of the largest challenges they faced early on, and it is not uncommon when trying to transform and disrupt and industry, was that there is a lot of education needed initially. The legislation and the securities laws had been changed but there were still a lot of questions and ambiguity about it. In the early days of the company, they had to do a lot of evangelizing and a lot of educating of commercial real estate developers, operators, and investment firms who were intrigued by the idea but really had more questions than they had answers. Tore found CrowdStreet was to be part of a subset of a subset people out there sharing knowledge and information, and many times connecting them to other experts whether it was attorneys who worked on the SEC in legislation to enable this to happen, or whether it was some of those early adopters who had taken the plunge and were the innovators. So that was really one of the biggest hurdles which was really getting the industry to understand that this new opportunity was possible; that it was legal and that it would actually benefit their business as well as benefit many consumer investors across the country.
The way of traditionally doing business for sponsors, the commercial real estate developer who is going out and acquiring either an existing asset, it could be a senior housing facility and office multifamily complex storage facility or whatever their specific asset type and geographic focus was, was very different from what had become possible. For decades the way they have traditionally done it was they would put together a private placement, they would do a Reg D 506 (B) offering with a traditional form B filing, and they would go out to those individuals who they knew and had a substantive relationship with to raise their capital. Usually that equity amount that they were looking for was anywhere between $3 million and $8 million because their project value was in that midmarket $20 to $40 million range. So these guys were flying underneath the radar of getting a big institutional check of $10 or $20 million, but they had definitely built up a network of high net worth investors that they cultivated and built a relationship with for years. So they had a great way of going out and probably financing between five and ten acquisitions each year, sometimes doing ground-up but a lot of times it would be value add to an existing asset.
What CrowdStreet has to share with these developers was that Title 2 of the JOBS Act, which was passed in September of 2013, had created what's called the Reg D 506 (C). This said that you can do that private offering but now you can make it public and so you can actually generally advertise. Developers, for the first time since 1933, could solicit investors from the general public and therefore could use the Internet to promote their offerings – in way, to securitize offerings with the caveat that all those investors have to be verified as being accredited investors. There can be an unlimited number of those investors however, with the extra step of needing to have a verification process. The CrowdStreet marketplace was set up as a medium to go and advertise and they have now attracted thousands of accredited investors to register on the platform because they are looking for access to great sponsors with great deals.
One of the key benefits for sponsors and is the ability to reach investors outside of their immediate geographic location. Sponsors have traditionally built up relationships in the off-line world with investors and many times the way gain new investors with their deals through referrals and word of mouth, but it only goes so far and is usually confined to a geographic region. So first and foremost, what sponsors really like is the fact that by putting their offering on the marketplace like CrowdStreet, they are making their deals available to a wider population of investors who could be in Seattle, Washington, or in New York City or in San Diego, or Los Angeles, Florida; all over the country looking at their offering at 10:00 at night. sitting on the couch sipping a nice glass of wine with their spouse and looking at their offering and deciding whether they want to invest. Many times in the off-line world sponsors have one on one meetings with investors that are very time consuming, so the efficiency of online is really important to them. The second key aspect that's tied to that, is not only the acquisition of new investors and the efficiency by which they can do that, but by facilitating the mechanics of investment itself. By automating and streamlining the fundraising process from review of the information entirely at the fingertips of the investor, through the actual investment itself, deciding how much an investor wants to put in, to signing documents and then funding their investment and then post fund raising. Everything is automated on the CrowdStreet platform. In addition to this, another thing that sponsors like is that the ongoing communication with investors is done through an online channel which brings with it many more efficiencies and the capability that now that they have maybe up to 50 more investors that they are working with, they can actually do it in a very efficient manner.
One way that this online communication is facilities is, for example, how they distribute K1's. Most deals are set up as an LLC, which is a traditional format and the format is no different when they are putting their offering online. As they bring investors in they distribute capital to them on a monthly or quarterly basis based on the cash flow. At the end of the year, because it is an LLC structure they have to distribute K1's. In the traditional way, they either have to mail those out or if they get electronic consent they can e-mail it out with a password protection. But e-mail channel is always not always the most secure and so one of the ways that CrowdStreet not only makes it more secure but also more efficient is by having what they call an investor room when they log into CrowdStreet. When log into their investor room investors can see the performance of their investment they can see all of their executed documents and then when the sponsor comes to that wonderful tax season where they are trying to distribute hundreds if not thousands of K1's they can simply drag and drop and the K1's which get uploaded automatically into each individual's investor room. The individual investor will get an email communication, not with an attachment because of security concerns, that if they log into their secure investor room, they have access to a secure K1 document. This minimizes security concerns caused by sending a PDF document over an unsecure channel, and improves communication by sending documents to many with literally one click of a button instead of having to do individual one to one communications.
Many times when sponsors were raising capital the ‘traditional’ way, they were faced with a lot of email exchanges and a lot of phone calls so they come from a world where investor relationship management could be pretty cumbersome because it was usually a manual process. One concern sponsors have is that when they bring their offering online that now they will be fielding calls by vastly more investors and going to have to answer a lot more e-mails. Tore understands this concern from his perspective of having brought industries online to seeing what can happen in those circumstances. The consumer that comes to a site and gets exposed to a brand and a company through an online channel, does not generally want to take that relationship offline. Consumers do not go to Amazon.com to buy a product because they want to call the company and learn more about the product; they want to go review and see everything and read about everything about that product online and be able to make a best educated decision without dealing directly with the company.
Part of CrowdStreet's responsibility is to make sure that when they take all of a sponsor’s offering materials, they digitize them and put them into a Web environment that is really easy for an investor to access whether it is the sources and uses information, or the table of the deal economics or other due diligence materials. Many times before questions even start coming in via email, the CrowdStreet investment team helps to coach sponsors to think of all the Q and A things that are going to happen and prepare ahead of time to put the answers at fingertips of the investor from the outset. Of course, this does not guarantee that investors will not pose questions, but what CrowdStreet does is to run webinars so that for every offering, investors get invited and can register to join a one hour webinar with the sponsors talking about their deal. During this time the sponsor fields questions and when you have 100 or 200 investors participating, part of that community aspect is that an investor can pose a question during that time and the other investors have the benefit of listening to the response. This, Tore sees, as being an enhancement compares to the off-line world where usually that would have to be done many times in a one on one relationship that investors used to have with the sponsor. Not only is communicating with so many investors simultaneously beneficial to sponsor, but it benefits the investor also. Here you have created a community where other investors can get better educated and they can learn by hearing from other investors. So, there are lots of benefits; sponsors can minimize the noise factor by spending an hour talking about a deal that is recorded for other investors to listen to later; and investors learn from the crowd of other investor questions.
Confidentiality and Privacy
Sometimes sponsors express concerns about confidentiality of information and there is a fine balance between how much a sponsor wants to publish and how much is behind a firewall. CrowdStreet implements a confidentiality agreement that investors have to agree to click through which adds that extra degree of security and comfort about what a sponsor might want to expose.
One of the criteria CrowdStreet looks at when determining if a sponsor is proper for the marketplace is have they worked with investors in the past. How have they done from a performance perspective for those investors from the perspective of demonstrating experience in fielding questions. That said, the CrowdStreet investor relations team functions like a concierge service where if they can play air traffic control and if a question comes in that they know is contained in a particular document, they can point that out to the investor so that it does not even have to go across to the sponsor. But obviously there are questions that they are not in a position nor legally can they field about the deal. If it is not a factual document piece, they will escalate to the sponsor only those questions that are required. CrowdStreet also allows investors the ability, through the online channel if they have feedback or key questions, to submit that question directly online. Then the sponsor can choose at their leisure when they have time available to respond to it or ask CrowdStreet to send them a document or other information.
Crowd Sourced Questions
Sharing these questions and answers in an open forum is something CrowdStreet has looked at: How to further expose these community aspects for the betterment of the investor community but also for the sponsor. There is a little bit of concern for all of this to be open in a complete forum environment. Today the questions that get posed by the investors are going directly through the channel directly to either CrowdStreet’s Investor Relations team or the sponsor's Investor relations team and there are some privacy concerns with making all questions fully open. One has to be very cautious about for both the investor as well as for the sponsor, but if CrowdStreet gets consent on both sides perhaps full exposure is possible and the platform is looking at how can they provide a more forum environment that both sides feel comfort in and that they can gain more benefit by exposing more. It is a is a sensitive matter. People are investing and it is not as easy as looking at a review on Amazon about a product, for example. You are talking about people spending thousands of dollars investing into deals. It's a whole different level.
Since the advent of crowd funding real estate, from a deal structure perspective on the distribution of capital on a current basis, CrowdStreet has not seen sponsors change the structure of their deal to align with online investor requirements for having cash flow. Most sponsors have already come up with their waterfall structure before them come to the platform. They have come up with what their anticipated current yield is on a particular investment and that has not changed much. Maybe sponsors have become more conscientious about the fact that that the online investor with whom they have yet to build a relationship does like a current yield, but investors do understand that certain deals will not have a current cash flow to it – whether it is a ground up development or whether it is a redevelopment. Sponsors are very clear from the onset that it could be maybe an 18 month timeframe or 12 month timeframe until there is any current cash flow from a project. Investors know that maybe on that redevelopment there is no current cash but that there is a higher IRR potential that is maybe over two years instead of over seven years. What CrowdStreet has seen is that investors like to create a diversified real estate portfolio where they can pick and choose from projects that are cash flowing currently versus those that might be more realized on the back end.
One of the structural changes that is very significant and could not have happened if we had not moved to the online world is the ability for sponsors to take a lot lower investment size because again this goes back to the education when CrowdStreet was first working with the sponsors in 2013 and 2014. Typically, sponsors were taking $100,000 or $250,000 checks from their high network investor network in the off line world. When Tore talks to sponsors about bringing their project online, he requests that their minimum investment size be $25,000 which is, well, a 10x difference in many cases to what a sponsors usual minimum investment might be. You can imagine, again going back to that conversation about the customer experience and how much contact would a sponsor have with investors, because now they are looking for $25,000, sponsors are concerned that they cannot be on calls all day with these investors. So, it took a little bit of time for sponsors to understand that this does not happen. Indeed, at a CrowdStreet sponsor conference, someone talked about how he had 30 new investors come in through the CrowdStreet marketplace, and there was a little gasp at the implied additional work this amount of new investors might burden a sponsor with. But their concerns were ameliorated with the sponsor told them that he had conversations directly with only two or three new investors and these were putting in a lot higher than the minimum amount. This sponsor’s personal experience was that he did not have to have one on one conversation with many investors and so adjusting their perception of the impact on their time of crowd funding that sponsors have to get used to. Once they try to fund this way once or twice they realize the huge advantage of growing their investor base, this way, beyond their local markets.
Aspects of Education
Another aspect in the education process is to really let investors and consumers across the country understand, number one, why this way of investing was suddenly available for an industry that for decades they could not get access to. Before, investors had to get a personal invitation to meet the sponsor from somebody who had invested with that sponsor, possibly many times. And then, even if they got invited, they didn't want to put in $250,000 dollars, perhaps having $25,000 or $50000 to put to work or wanting to spread it around to many deals. The second big question from investors is often how do sponsors get on the CrowdStreet platform. So Tore and his team are very up front with their investor community about the vetting process that their investments team employs. They have a team of eight people who come out of the private equity real estate space for a real reason; because they are used to screening sponsors and they are used to screening the deals themselves. CrowdStreet does not underwrite the deal, but they do have a detailed process around the vetting so that investors know more about the sponsors. To be clear, CrowdStreet is not doing due diligence per se in the traditional sense but they are very clear about the vetting and the background checks that go on behind the scenes on the sponsors before they actually show up and they have found that investors appreciate that.
What Tore is seeing is that once someone has invested in one of the projects and they have become accustomed to the process, over 60 percent of investors become repeat investors on the CrowdStreet marketplace. Of that repeat investor base the majority of those have three or more projects in which they have invested. They are starting to realize that they can now create a diversified commercial real estate portfolio through the online channel. Traditionally the only way they could get diversification was either investing locally with a developer they knew or they could go through a REIT get that diversification.
CrowdStreet primarily has single assets in their marketplace but also have funds, special focused funds, that can be in a specific asset type, as well as having full blown REITs that are listed. CrowdStreet likes to offer investors that type of choice because they might want to put some capital into a REIT where they can automatically get diversification even if it is focused on a particular asset class like senior housing or multifamily or office; they are getting some diversification across the assets in that fund. However, sometimes because of the fund structure there might be a higher fees structure and consequently also lower potential returns, but the portfolio is de-risking some of that by buying diversification and that is the tradeoff. With the single asset investment the investor has more exposure to maybe a specific geographic region or specific asset type as well as obviously the specific sponsor who is managing the deal.
For Tore, coming from a tech background and migrating into the real estate world also had its own learning curve. Having worked in many different industries and coming at it from a technology perspective, whether it was health care education publishing world he had worked with many different verticals and industries. Figuring out where their biggest frustrations are and what are the biggest obstacles that industry participants are facing was the first step because it is always unique across the industries. Dealing with investor and sponsor adoption of and trepidation with leveraging the Internet there was this early concern that the offline consumer is not going to take online. Initially, Tore took things for granted and had to back up a little bit and understand better about the world that sponsors come from, learning about their pain points on investor relationship management and in the fund raising processes. He also spent time with Darren and with customers understanding more about their world and how CrowdStreet could solve problems for them because at the end of the day the ultimate objective is to help both the investors as well as the sponsors and to do better for both of them.
The policy at CrowdStreet is that anybody who is qualified can invest in any of the projects on the marketplace. There is no special treatment given because it is the open internet out there, and people can register so the company does not want to say no to an employee – but there is no special treatment given and they make sure that there is nothing extra that they get.
To date, most of the sponsors have not asked CrowdStreet to prefund a deal. The company took a different approach from other platforms some who did go that Special Purpose Vehicle model where investors are pooled into an SPV, usually an LLC., and take balance sheet capital to supplement that fund raising. CrowdStreet took a very much a road less traveled approach. It is also a road that takes longer until there is investor base that has thousands of investors. You cannot stand up straight with a sponsor and say that there is a high degree of confidence of selling the equity portion without that investor base. In many cases, sponsors will explain that they are listing a sliver of the equity because they have their own current base of investors. That said, CrowdStreet did take a pretty significant pivot as a company back in early 2015. They learned from those sponsors that were using the marketplaces that not only did they love the capability to instantly get in front of thousands of investors across the country but they also saw the capability of the technology platform.
In response to this, in 2015, CrowdStreet launched a software as a service product. It is a white label version of the same software they use to run their our marketplace. As of today’s podcast, CrowdStreet has 85 customers using the software on their own Web site under their own brand to manage their own investors and to create a more online innovative way of fund raising and investor relationship management. Of these 85 companies, fully two thirds of them solely license the software, called Sponsor Direct, and they are going it on their own; they are perhaps not quite ready to try a marketplace and, for the time being, want to keep their deals private. But a third of our SaaS clients today do put select deals of theirs on the CrowdStreet marketplace in order to grow their distribution. These clients are open to more general advertising and they are seeing the benefit of adopting both approaches. They are using the software on their website and are running their investors through it. They have one dashboard and they can see their fundraising process both how it is running on CrowdStreet marketplaces as well as how they are doing with their own investors.
Back to the Future
When Darren and Tore got together in 2013, the passion, the vision of democratizing access to commercial real estate investing was baked into their idea of how they could transform real estate investing to make it accessible to make it transparent to make it efficient. Right now they are just scratching the surface and one thing that particularly excites Tore, is the that the market has not opened up yet for the non-accredited investors to participate. This is a stair step thing; it does not happen overnight but one sees a lot more sponsors being receptive to doing a Reg A plus filing, or a Tier II where they can raise up to $50 million and they can do it through a general advertising and they can make it available to non-accredited and accredited investors at the same time. Tore thinks that is one of the one of the phenomena that is going to happen over the next three to five years where people will be able to put in as little as $1,000. You cannot do that without using automation as technology.
Tore also sees another potential major shift in the market. At the end of the day commercial real estate is still an illiquid asset; in many cases there is no current cash flow. You could be in an asset for the next three or five years before realizing gains. Tore thinks it will be interesting to see how taking what has traditionally been an illiquid investment and turning it liquid – and this is why publicly traded REITS have an advantage. But because they also might have a lower return because you have a liquidity premium built into that investment because you can you can trade it on a daily basis. Tore sees things like block chain that might create an ability to securitize commercial real estate holdings and make it easily transferable and mark to market in a way that makes this investment type more liquid.
From Single Family For Sale, to Senior Housing
Global Senior Housing, the company that Nick Walsh co-founded with his father, develops senior living projects in the western United States. Before forming the company and moving to San Diego, they had developed residential subdivisions in Idaho. Despite being relatively new to the to the senior housing space and having only a small company, they currently have projects in Texas, Arizona and Idaho.
Nick’s path brought him from the last downturn when they started looking at what asset classes they could get into to develop projects that was less cyclical than the residential industry – that they had been involved in in Idaho. Through an associate who developed smaller senior housing projects like cottage type products or projects where there are multiple smaller buildings on a site, they were introduced to the space.
They figured that senior housing is a lot like the hotel industry in that it is operations intensive and felt that as long as you get a good site and line up good financing partners, the operations really is what makes and breaks the success of a project. So going into the senior industry they wanted to partner with a successful experienced operator who knew what they were doing and leverage off their experience versus trying to start a new operating team themselves.
Their Idaho based operating partner had a building prototype that they had built before and were confident operating. Nick came on to partner with them to raise the capital and to find and acquire sites so they generated parameters that they use to look at demographics in the supply and demand in certain areas. They started by focusing on Texas and canvassed the whole state looking for the right markets that were underserved for Assisted Living and Memory Care and that had the right demographics for a project to build. That is how they found their first project and that project, which is in Houston, they funded by crowdfunding the finance.
Nick had not done a CFRE deal before having adopted more traditional financing routes in their residential subdivision business in Idaho. There it was really localized and they knew a group of investors that understood the residential market and were happy to finance their deals. Going down to Texas to do senior housing, they knew that they needed to expand their pool of investors and preferred private syndications for projects of this size where they were raising equity under $5 million. Under that level they feel like syndication is the best option and so wanting to expand their investor based, they started looking at the crowdfunding platforms as the quickest way to achieve that goal.
Initially, Nick came across the idea of crowd funding when he was talking to a few attorneys at real estate conferences who were starting to put together PPM Reg D crowdfund deals at the time that the JOBS Act was getting approved and they were formulating the rules for that. There was a lot of buzz in the industry about crowdfunding as a way to raise money.
Selecting the platform that they were to use was a process even back then when there was probably 20 or 30 companies out there already. Nick started his search process by looking at who was doing ground up development. A lot of the platforms were in their infancy and most were doing deals with existing income streams so finding those doing ground up narrowed the field down to just a handful. Adding the extra layer of wanting to do a senior housing deal narrowed things down even further. Nick looked at each platform and who had raised done a successful raise on a senior housing project before, and that is how he landed on the company that they ended up partnering with , CrowdStreet. They had just completed a successful raise for a larger skilled nursing developer that Nick had read about in a senior housing publication and that is what prompted him to call them.
Early discussions addressed the inexperience of Nick and his father in the senior housing space and that is where their joint venture with their operator partner came into play. They were able to leverage off their partner’s experience in the industry and bring land development and construction as their role in the joint venture. At that point in time they already had a project entitled now so they were raising equity for an entitled project and their role for the rest of the project was to manage the financing and manage the construction of that building and rely on their operator’s resume in operations which helped with their approval with CrowdStreet, as well as with the equity investors they reached out to.
Interestingly, when Nick first approached CrowdStreet he approached them with a different project that they turned down because the market was a tertiary market in Texas and they explained investors would not likely be interested in such a location. This allowed Nick to bring another in a major metro; something more attuned to what investors were looking for. Most investors were looking for a city that they knew that they felt comfortable and that is why the project in Houston met the criteria.
The underwriting requirements that CrowdStreet looked at, of course, included the sponsor group; who the operator was and who the developer was. They had a third party market study that justified the demand in the market for the building that they were going to build. Beyond that, one thing that they really liked about CrowdStreet was that they looked at the deal structure and did not really mandate the deal structure like some other platforms do, but instead guided them through what would be successful. Nick had to put up the fees for the raise whether they were successful or not, and they found that CrowdStreet did not want a blemish their reputation with a raise that was unsuccessful. After the upfront fee, there is an annual maintenance fee for use of the software which sits on the Global Senior Housing website under the investor link.
From the investors perspective, they are dealing directly with Nick and his company and not with CrowdStreet. This was a differentiating factor from a lot of platforms that appealed to Nick. Some platforms operate like equity shops where they will actually fund a deal and then backfill all the raise with investors and sell it later on. CrowdStreet is more of a marketplace where they are really just a middleman between developer and investor. They are exposing a project to their pool of investors but when it comes down to it, investors are calling the developer to ask questions that help them decide whether they want to invest or not. It was the direct investor contact that Nick was looking for. He wanted to build his company’s investor pool and build those relationships with the investors direct so that when they went and did the next deal they would be there.
The process with CrowdStreet was as follows. Nick’s company was given a checklist of documents that they needed to submit for the raise before they went live. They were assigned a designated investor relations person as well as customer relations person who checks in from time to time to make sure thes sponsor has everything that they need to communicate with investors effectively and to make sure everybody is happy. If an investor has a question sometimes they contact CrowdStreet and CrowdStreet will connect the sponsor, but sometimes they may just connect with the sponsor directly by either email direct telephone call.
CrowdStreet’s role with Global Senior Housing was solely that of a middleman marketplace that gets paid a fee to broadcast the project to their investor network. They had no input into the agreements or structure of the deal that Global was proposing, and no rights to intervene should the project falter at any point for any reason. The operating agreement, inside a private placement memorandum with a subscription agreement, was one that Global generated and then put out to investors on a take it or leave it basis. Investors dealt solely and directly with Global in this regard. In some cases, investors would say ‘hey, I like this deal if you had a higher preferred return’, or ‘I'd like this deal if you were putting in more sponsored equity,’ and they would still invest, even without modifications, and some would go in a different direction. Most understand that at the point the deal is being syndicated and is posted on the marketplace, it is really a take it or leave it proposition.
Once the deal went live, the total raise took about 75 days before the last dollar was deposited into escrow. Total amount raised was $1.2 million on top of which they had about another $300,000 in sponsor equity that Global principals were placing into the project. The $1.2 million of outside equity came from 44 investors. There was a range of investments sizes and this was one thing that CrowdStreet helped structure. Global initially wanted to come in with a $50,000 minimum but CrowdStreet said that they thought the deal would be a lot more successful if the minimum was set at $25,000. In the end their investors ranged from some at $25,000 and up to $100,000. While Nick did a little marketing on their own primarily to investors in Idaho who wanted to get into the senior living space, the majority of investors came from CrowdStreet's marketplace. There were many investors from Texas since the project was in Houston, but overall there was a wide range of geographical dispersion with most from the West coast or the western states and a few from the northeast and East coast.
Every investor was accredited and CrowdStreet ran all of the accreditation processing for the investors. Of the investor pool, probably half were real estate professionals who understood the background and the real estate industry and who just wanted to diversify into crowdfunding projects. The other half were other professionals and family trusts who were taking their money from stocks and diversifying into real estate through crowdfunding.
The biggest challenge, Nick found, was the way the timing worked on the raise. It started really quickly after launch, with probably half the money they needed raised in the first 20 days or so. Then it slowed down because when a project is placed on the marketplace it comes up first so everybody sees it at the top of the list. Once more projects get posted, Nick found that his project dropped down and he thought that perhaps it took someone a little bit longer to find their deal. He felt that an important consideration when selecting a site to list a deal on was to look at how many deals are posted. If there are none, that might indicate inactivity; but if there are too many there might be a concern that one’s own deal might get caught up in the wash and not really get the attention that it needs to complete the raise.
Another challenge to raising from the crowd was that Nick found himself spending a lot of time on the phone with potential investors; a lot of time answering e-mails; a lot of time with each potential investor so they could vet out the projects. It took up a lot of time and energy and so Nick advises sponsors that that if they do not have someone in their company who is fully devoted to investor relations to the raise to field those calls, then the process could probably bog you down.
One handicap Nick found with the process was due to the compressed timeline from launch to completion of the raise; it was a very condensed period of time. They were unable to post the project until they had entitlements and were ready to start construction – a CrowdStreet requirement. Their traditional methodology on other projects was that they would start talking to folks throughout the entitlement process, giving them six to 12 months to gather the investor group together. CrowdStreet, on the other hand, looks for products that are ready to go because they do not want to post a project and have investors commit, only to have to then wait for the entitlements which could be an extra three to six months down the line. Investors want to place their money immediately; they are not going to be around in six months or have those funds to invest in six months.
Most appealing to Nick about the process was in their ability to increase their investor pool and work directly with investors. They have now talked to some investors who have already told them that they want to invest in more deals together. It was a good way to expand their investor pool and Nick liked the idea of giving people, through crowdfunding, the idea that no matter where they are they have the ability to do their own research and invest in a real estate project. Perhaps they did not have any experience in senior housing but they were still able to own a piece of a project.
While the project did require that Nick devoted considerable time to it, he understands the attraction of going to a private equity fund where there is just one person to deal with who is asking all the questions. Crowdfunding real estate deals may not be for everybody. Global found, however, that for raises of under $5 million in equity, it is hard to catch the private equity fund manager’s attention. Even if they could, another issue with private equity is that the capital is more expensive. With CrowdFunding, the sponsor can get less expensive capital in terms of both the kinds of payouts that investors expect, but also with the deal structures where control remains more firmly in the sponsor’s hands. Remember, there is no negotiation with crowdfund investors; the sponsor can structure the deal however they like, and investors have a choice to invest or not invest. With private equity groups they are going to negotiate with the sponsor, take more of the project through a larger percentage of the backend and in the operating agreement they want certain management controls that the crowd does not demand. These kinds of controls range from more stringent reporting requirements or audited financials for instance, all the way to management decision making controls on certain things like when the sponsor can sell or refinance, or restricted budgetary controls. In short, compared to the crowd, a private equity group takes more of the management out of the sponsor’s hands.
Another difference, Nick found, was that whereas private equity funds will not require distributions until the deal has been completed, with crowd funding Global has to distribute every quarter and preferred interest check. This, CrowdStreet explained to him, was very important and started from the very inception of the project. Indeed, Global had to raise a little bit more money to begin with in order to be able to make these distributions. The strategy on the Houston crowd funded deal is for a a three year recapitalization and a five year sale. The most advantageous exit for Global, however, would be to develop and sell a portfolio of these cottage style product across Texas, way 8 smaller projects versus just trying to go out and sell one-off as each are completed.
Those in the Houston deal may be the only ones crowd funded. Subsequent to the CrowdStreet raise Global Senior Housing partnered with a Dallas based equity group who syndicates their investors. It is a similar situation with where the money is coming from private investors, but their partner did the syndication work and came in as a co-owner. They brought their own money and so the distinction between them and CrowdStreet was that they are syndicating in a similar way but they are also putting some risk equity in the deals as well. The money was more expensive and while the benefit of not having to do the syndication work themselves cost them quite bit in ownership, Nick felt it was worthwhile. This has allowed Global to scale more rapidly. They were able to partner with a group that provides programmatic equity for multiple projects as well as one that understands the local markets they are active in. For example, they have been supportive of the project that Global originally took to Crowdstreet that was not approved because it was in a tertiary market. Their new equity partner is in Texas, understood the market; the manager was able to drive down to take a look at the site and approve the investment.
Going forward, however, Nick does have at least one crowd fund project on the horizon. They are looking at an acquisition, a reposition project in Austin, Texas. They found that when investors looked their other project and/or sign up on CrowdStreet, they indicate which markets they have in interest investing in. Austin popped up on a lot of lists for a lot of investors and so that is one potential deal that has in place cash flow and that is in Austin. Deal size is $1.3 million of equity so maybe that will be the next crowd fund raise that Global decides to do.
Chris Loeffler graduated Cal Poly, San Luis Obispo, and started his career at PricewaterhouseCoopers as an accountant going down the corporate path. An opportunity came to him, during the 2007-2009 economic downturn, to start buying and selling auction properties at trustee sale auctions and basically flipping homes. He would go to auctions on a daily basis and bid on properties every day. Together with his partners, Chris would drive the properties in the mornings from 4:00 or 5:00 o'clock until 10 o'clock when the auction started. They would inspect the properties to make sure that they were not gutted or had cracks in the foundation or other critical deal breakers. And then he bid on them at auctions all day long.
Using his own small remodeling company, he would then do all of his own remodeling in-house and would renovate the properties, before listed them for sale via his in-house retail brokerage.
At the time Chris’s financing came from anybody who would talk him. He did not have any family money or any startup capital or formal venture funding or anything like that. He literally would meet people through the random circumstance of life and tell them what he was doing and ask them if they wanted to flip a home and tell them how it worked and go from there.
Chris tells of a time when he had put a non-refundable, $10,000 check down as a deposit on a property at auction. He had 24 hours to pay for the property in full, in cash, or lose the deposit. As he had bought two or three homes already, and only had enough money to fund two, he found himself in a bind with $10,000 on the line. That afternoon, he met somebody at a Starbucks at 4:00 o'clock, told him the story, and the next day had a new investor who wrote a $50,000 check that helped close on the third home.
Fast forward nine years later and Chris’s company, Caliber, has become a sophisticated real estate private equity company. They are consistently raising capital into different funds with different profiles; long term for growth, short term for a fixed income, or for the mid-term for a little bit of combination of both. The funds operate independently of the deals so they are always raising capital in the funds because they know that they can deploy it eventually.
Caliber is also a company doing real estate deals across the board. They do hotels, apartments, office buildings, commercial properties, self-storage facilities, single family homes, and all middle market. The company has built itself up to about $300 million in assets under management and has learned sophisticated ways to raise capital from accredited high net worth investors and their wealth advisers.
One aspect of that is that they are conducting a Regulation A+ listing where they are permitted to raise up to $50 million per year while being, in contrast to Regulation D offerings, not restricted to accredited investors only. Indeed, Caliber has found that non-accredited investors are typically a little easier to work with and offer better deal because they have a lower level of expectation for a return on a $5,000 investment than a deeper pocketed, accredited investor.
What makes Caliber especially different in the crowd fund real estate space is that they are operating in many ways like one of the market place platforms, but are actually the sponsor also. Caliber is the real estate manager, is actively the developer, actively buys the deal and conducts the deal making structure and finance, the do the construction and construction management; everything. They are not an intermediary, and not a platform. Caliber is a developer with truly vertically integrated platform. By taking this broad role, Chris finds that they can get very close to the deals and that sometimes that can give them a competitive advantage in the marketplace.
Caliber has a $100 million commercial asset fund that is a bigger fund than they could do under Reg A, in addition to a Reg A for the parent company. They are seeing competitors who have started to create child funds for $100 million, $200 million, $billion funds and for which they will create a mini new company. That company will be taken through all the Reg A requirements, which are not that difficult, and they will raise $50 million into that offering.
The only purpose of that company is to buy a piece of the larger accredited investor fund and so in essence provides the non-accredited investor, for the first time ever, a legal way to invest just like an accredited investor would. They might pay a small spread in fees or something like that versus what the accredited investor spends, but at the end of day individual investors, who otherwise would not get access to these types of wealth building tools, can now get access.
For Caliber, their Reg A+ offering is effectively turning them into being a public company. They will file a 10k at the end of the year and a mid-year report; no need, under Reg A+, to report four times a year. The reporting requirements give investors a lot more transparency into the business in comparison with investing into a private company which is something of a tradeoff. But the cost to maintain that reporting can still be manageable and, either way, running $50 million of other people's money, Chris figures is going to be just the same type of external audits and hard core financial reporting that he would need to do anyway if they remained a private company.
What Caliber is using the Reg A offering for is as a bridge to take the overall company, the parent company and take it public. This entity acts as the general partner and has their equity and their interest and all of the assets that they own. It holds all the control positions they have and all of their funds as well as their operating companies; their real estate company, brokerage, property management, construction, development. All of these businesses are rolled up into a single entity, and that entity is doing the Reg A+ offering to raise up to $50 million to become a public reporting but non-trading company.
As a result, for the first time ever non-accredited investors can own a piece of Caliber. The second phase of this will come at the end of 2018 when they plan to list the stock on the Nasdaq and become a NASDAQ traded company.
Caliber looks only to middle market deals. These are assets that are typically too big or too complex for a handful of doctors to get together, open an LLC and buy. They are not typically $2 million, $3 million deals that are small enough that a couple of people can get together and buy. On the larger side they buy assets that are smaller than $40 or $50 million in check size to do the entire deal which are usually properties that are approaching the size that institutions like a REIT, like a public REIT or insurance company might buy. Caliber does not want to compete with people who have money that costs almost nothing to deploy, and they don't want to compete at too low of a scale with smaller investors who are really scrappy and can afford the time to be able to work the deals at that level.
Chris stays away from asset classes that are hyped up, although that can change over time. For example, there is a lot of hype around assisted living and student housing and apartments currently. Having said that Caliber are doing student housing projects and have looked at assisted living projects, so there are always exceptions that prove the rule.
Caliber has an underwriting model that they think of as being elegant and simple. They want to buy an asset where they are getting better than 20 percent discount to market; for less than they we believe the asset is inherently worth. In addition, they want to see that after completion, the asset can exit at a 10 cap. What that means is that if they buy an asset for $500,000 put $500,000 renovation into it, by the time they are done with the transformation it will make at least $100,000 a year in profit – or a 10 percent cap rate or a 10 percent rate of return. Then, last but not least, they look for properties with a story. Every deal with a story has the ability to transform the property in some way shape or form so it it is a real deal you can you execute on the plan.
The culture of the real estate industry is that a lot of real estate entrepreneurs are pursuing a lifestyle business. If they get good at it and know what they are doing, even in a very small shop they can make a really nice income. And as they build a reputation over years and years with about 20 or 30 investors which is pretty easy to manage, you can build into a multimillion dollar business. It is not as easy as it sounds, but it is not so difficult once you understand what you are doing.
The problem is if you want to build a real company into a real enterprise that is going to be something beyond something that is just there to serve your needs and your lifestyle. It is a path that is very difficult. There are no banks that view you especially as a small real estate investment company as a lendable entity. They might lend you money on your real estate assets but they will not lend you the money to build your business. As you build your business you are going to make bad hires you are going to pick the wrong software, waste money on a strategy that does not work, and will be doing this on a fixed income from fees upfront and along the way, but with most of your money comes from the profit. And you might not see that profit for three to five years.
For Chris, every year for nine years his partners and he have had a look at each other and said, you know, do we want to make money personally or do we want to build the company. Those, for Chris, are mutually exclusive things. As the company goes public that will allows him to be able to get beyond the main hurdles that stop a company like Caliber from being able to function the same way as if they, for example, manufactured toasters where they would be much more supported in the community in terms of lending relationships and equity capital. But for his type of business there is really no clearly defined path for growth and a lot of regulatory risk; a lot of execution risk that goes along the way.
Once the company goes public, Chris is confident that the world will change for Caliber. They will become a lendable company and it will be a lot easier to raise capital. But that has been a 10 year process with a lot of risk along the way
Community – The Impact of Crowd Funding
The real estate industry has been due for change for a long time. If you look at around at our neighborhoods in our communities, there is a reason why you see so many Walgreens in why you see so many strip malls that look relatively the same. And yet when you look at going to these retail outlets where they do look very different is where there are local restaurants and local shops. Why are they these places always packed?
The answer to that, in Chris’s mind, is that everything in real estate at a large scale has been driven by the public capital markets and institutional capital investing into deals. And what does institutional capital like? They like do the same deal the same way the same time a thousand times across the country so that they can put $2 billion into the strategy to keep it efficient for everybody.
But what real estate is local. It is hyper local. It is one thing on one corner on one street that is different from different corner 1,000 feet away. So what people really want is the local coffee shops. They really want the local shopping experience. And they really want that kind of experience in an office space and in retail etc. and because of that, these crowd funding mechanisms are the thing that will bridge that gap. People are going to start investing in their own communities. Indeed, 60 to 70 percent of Caliber investors are Arizona residents and they love investing in projects that they can drive by and see that they own a piece of that hotel or the self-storage facility. And in addition to that developers are going to be able to say “you know what, I want to build this really quirky, weird mixed-use type deal here on this corner. I'm going to put a sign up on my property and offer it out to the community to support my project by voting with their dollars. And so all of those things are changing the real estate business because that capital is cheaper than the normal sources of capital. And it is allowing me to build a project that's frankly more profitable.”
Chris thinks it incredibly useful to have local investors for everything. For finding additional investors, for assistance through entitlements, knowledge and support at neighborhood meeting. When you have somebody who owns another business that is well respected saying that they support the project is fantastic.
Most CEOs of private real estate companies and in the investment business generally avoid talking to their investors pretty much at all costs and when they do they have very structured communications so that they do not have to be in a situation where they said or did something wrong. Chris’s philosophy is the only thing that gets them in trouble with their investors is not having a relationship with them. If something goes wrong and he cannot lean on the fact that they know they are trustworthy people and are just working through a problem because real estate problems occur, then you know that is the big issue.
If you are in the real estate investment business and you think that the most important thing in the business is the deal, Chris thinks you have lost sight of what really matters. It is the relationships; the investors, and it is all about making them happy. If you have good quality equity investors and good relationships Chris Loeffler is confident that the deals will almost always be there.
The 19th Hole
After graduating Penn State, Adam Hooper started his career as, of all things, a class A PGA golf professional. Finding that not quite as glamorous as he had initially anticipated, he followed in his family footsteps and, around the year 2003, took up working a regional commercial brokers firm in central Oregon. It was a really good market and the time and Adam got to ride that wave up, finding that as he was active in a small enough market he was able to gain some experience in little bit of every type of real estate.
In 2008, Adam started his own firm with a partner and focused on single tenant deals nationwide, getting into some of the equity placement transactions, helping developers raise capital for their deals. Realizing that there was a need for helping people capitalize their projects, in late 2011, he moved down to join a firm in the Sacramento area as a partner where he got a lot more experience sourcing joint venture equity. The deals he was working on were sub-institutional size i.e. in the $15 to $20 million range, with $5 million to $7 million of equity.
In one particular deal, he was raising capital for a prolific syndicator with a great track record, great background, and very deep capital relationships. A sister building came up nearby with very similar project metrics, and of a similar acquisition size. It made sense for the sponsor to capture some economies of scale and this other building also. The problem was that the sponsor was tapped out of immediate capital sources and reluctant to dedicate time away from his business and his family to go on a roadshow for a month or so, to syndicate another 4, 5, $6 million of equity.
What Adam was noticing was that this was a fairly consistent issue for sponsors and when in April 2012 the JOBS Act was passed, he had a few deals in the hopper with similar fund-raising limitations. Noticing that sites like Kickstarter and Indiegogo and a lot of other companies were raising capital on a donation basis, it occurred to Adam that there was an opportunity to morph the Kickstarter model to real estate syndication.
What they realized was the single most important impact that the JOBS Act had was that it lifted the ban on advertising private securities and it allows sponsors to openly advertise their deals online. While real estate was ever the intended recipient of the legislation, this fact alone has made it one of the biggest beneficiaries of it.
The way it works is like this. Ever since the Securities Act of 1933, if a sponsor did not have a pre-existing business relationship with someone, he was prohibited from soliciting an investment from that individual. You could only offer the opportunity to invest in your deal to people that you already knew. You could not go to a new group of investors that you did not previously know but the JOBS Act lifted that ban completely.
It was a fundamental shift in how the capital markets can function and access on both sides of the sponsor, investor equation. To be able to use the internet in place of what has always been a one on one conversation, or a meeting over lunch or dinner or playing golf, is a radical shift for real estate syndication.
Adam believes, however, that while the need for the one on one conversation has been removed by regulations, the need for a ‘relationship’ has not. The distinction is that while the law now says that you can simply advertise online to attract investors, the nature of the real estate business mandates that you still have to build that relationship with the investor – just today you have to do it in a different fashion; one dictated by online marketing methodology.
In a real estate transaction of any kind, there is always going to be, always should be, a connection between all the stakeholders; the investors and the manager, the manager and the tenants, the tenants and their customer that they are serving. When Adam and his partners were thinking about how to set up their platform, they were really trying to think of how they can amplify both sides of any real estate relationship.
In practical terms, on RealCrowd, it is a direct relationship. As an investor, when you come in, you communicate directly with the real estate manager. When you choose to invest, you are executing the subscription documents directly from that real estate manager. RealCrowd does not block that connection, they do not aggregate people into our LLC, and they do not try to obfuscate that relationship between the investor and the real estate manager – a process that you see on some other platforms.
RealCrowd’s ethos is to make it as easy as possible for a sponsor to raise capital, and one of the ways to do this is to dispel some of the myths that sponsors have. One of these is the concern that by advertising on the internet, the syndication process will have dramatically changed also. In RealCrowd’s experience, the average investment is around $70,000 per investor per deal. This can range is high as a $120 to $130,000 on some deals. They like to explain that what they do is no different from that which a sponsor would otherwise be doing anyway if they were syndicating their own deals. They are still syndicating, they still get to set whatever minimum investment amount that they want whether it is $25,000, $50,000 or $100,000. They will still follow the same regulatory processes, form the same subscription documents, with the same structures that they are used to. It is just that now they have this new avenue to reach 25,000 plus members. And to address the concern of any sponsor worried about having to deal with too many potential investors; Adam has yet to hear anyone complain that they are getting too much attention and need to dial it back.
RealCrowd functions solely as a marketplace – and one that is completely free for investors. They charge real estate companies a flat fee for using the platform and the technology to distribute their deals. One of the exemptions under the JOBS Act for operating a marketplace such as RealCrowd is that a broker-dealer license is not required provided no performance based commission is charged.
While crowdfunding real estate deals might be seen as a kind of fringe experiment by some, it is, in fact, becoming a meaningful source of capital. In the early days RealCrowd would consider deals that raised $500,000 to $750,000 as a pretty good result. This increased to projects raising upwards of $5 million on a regular basis, and the trend is only upward – including a debt fund that has already raised about $25 million through the platform.
The biggest challenge that the industry currently faces – and likely will face for some time – is one of education. There is little appreciation or understanding within the retail investor based of the idea of a risk adjusted return. What does risk adjusted mean versus just choosing the highest number in terms of total returns. Since the industry’s inception just four years ago, the market has been only on an upward tick. It has been hard to lose money. However, the real estate market is obviously cyclical and we are deep into the current cycle. If the sole decision point that people are basing their investment decision on is what deal has the highest return, without any appreciation for the risk associated with achieving that return, that is setting the whole industry up for a bad time. For example, if the expectation is set for a senior debt position that you are going to get a 12 or 13% coupon and it is being billed as an ultra-secure investment, you have to understand that these hard money loans are hard money loans for a reason – meaning there has to be an explanation of the inherent risks. You must be taking on some risk to get to 12 or 13% coupon into debt instrument. Unfortunately the expectation on what an acceptable return is has become askew from what a traditional healthy real estate return is and should be. RealCrowd has been in a battle from day one that real estate should be viewed on a long-term basis. Consequently, one of the bigger challenge that Adam sees, is how can to help people or give them tools for education.
Another barrier is one of accessibility and the related idea that investors have a certain degree of sophistication. An investor must have a fairly high level of sophistication to be able to look at a portfolio allocation or to choose between 10 or 12 different deals – or more if one is looking across multiple platforms. You must have a high level of sophistication to make good decisions as to what is best for your portfolio. Now that real estate investing has been made available at a scale never before possible, facilitating that level of understanding of the options available is an objective RealCrowd works to meet. Through providing people with the tools to look at risk is to make that more accessible through education and to help make them comfortable lowering the sense of intimidation with choosing deals. RealCrowd works to look at how to take the person that does not really know a lot about this asset class to have some fundamental understanding to enable them to make the right decisions towards putting some percentage of their money and to allocating it to this asset class in a responsible risk adjusted way. This educational function, Adam believes, is going to be the key to see large scale consumer acceptance in this industry.
Tapping into the retail investor base has always been seen as the holy grail of capital raising. If you can efficiently access this phenomenal amount of wealth that is not playing an institutional capital market, and if you have an efficient way to access that, that is a game changer. RealCrowd, and the broader industry, is getting to the point where they are already seen as a viable source of capital and it is only going to grow. The game has not even started yet, to coin a baseball metaphor. In fact, Adam thinks we are still just setting the foundations for what does the industry will look like in 5, 10, 20 years from now. RealCrowd is setting the foundations today so that when the consumer becomes better educated, they can capitalize on capital flows in the hundreds of millions or billions of dollars through the platform.
A Woman’s Voice for Women
AdaPia d’Errico has recently moved into an advisory role with AlphaFlow. She is a special advisor with the company, still working closely with them on influencer marketing and business development and promoting the company and its brand.
That said, AdaPia experienced a big shift driven in part by the #MeToo movement. She found it galvanized her in a way she never could have imagined. It led her to make a decision to dedicate herself to empowering women to develop their inherent leadership traits and to overcome a lot of the barriers that are not only external societal and cultural expectations, but also largely internal: The voice of the inner critic or fears or things that tends to hold women back. She chose to work more closely with a lot of women on empowering them to step into their leadership roles that they have inherently and at the same time to work with companies to help them understand how to bring those leadership traits out in the women in their ranks.
This has been very strong for AdaPia in terms of the direction that she wants to take for herself and for her business. Having been an executive for the past several years in very male-dominated industries, AdaPia really understands the impact that she has had as a person, as a woman, on the company culture, on the direction, on the productivity, on the values and very much on the culture of the company. She finds that effect is prevalent with many women who are in management and leadership positions in companies, and she believes it is important that, as a society, we continue to develop more women and work with management teams, who tend largely to be men, to develop that further.
Why Real Estate is So Male Dominated
We can relate this gender bias to the STEM disciplines: science, technology, engineering and math. There has been some great research done by McKinsey who have noticed that women are underrepresented in STEM disciplines and that as math is a critical skill in real estate finance, you find men disproportionately represented. It goes back all the way to when we raise our children. Girls are told that they should be nurses or teachers or something in the humanities. They are not encouraged to study sciences and they are often told that they are not good at math. Consequently, they are literally directed in other places, in other disciplines.
Women in Fintech
From what AdaPia has seen in real estate crowdfunding and, more broadly, in fintech, there are quite a few women; still underrepresented, but there are more than one sees in real estate development for example. There is Eve Picker at SmallChange, and Jilliene Helman who founded RealtyMogul. Both are real pioneers - not only in the industry, but as women in the space. But this is more centered on entrepreneurship and technology than it is necessarily on real estate per se, and there are a lot of women out there starting companies, who need encouragement.
It is, perhaps, something of a generational shift that is occurring in the sense that real estate crowd funding is a new industry that is emerging during an era of tremendous cultural change in America. For the millennial generation where gender is less of an issue than prior generations, and because crowdfunding real estate is also a new industry, it fits well with a new view of how culture and society should be.
Indeed, there are a lot of societal trends being driven by the millennial generation and they are far more focused on values, and their values are around inclusion, and specifically with real estate crowdfunding, for example, access and abundance of information and sharing and knowledge. Companies that have a social mission or that are mission-driven, that are purpose-driven companies are going to survive the next generation or the next wave of changes in business. Their successes are going to be driven by millennials for whom having a sense of purpose is very important to them.
Goals and Aspirations
AdaPia has been consulting for years and that was how she initially got into the real estate industry when she first discovered Patch of Land – and what drew her to them was that they were purpose-driven. They had a social mission – their slogan was ‘building wealth, growing communities.’ For AdaPia, the heart and soul of the company was built on that and real estate crowdfunding was built on the premise of being an industry that was creating more access; it would increase the flow of money to people and projects who needed it and who were revitalizing neighborhoods.
Now AdaPia has taken step back and has asked herself what does she want to do with the rest of her career, and with her life. She loves working with entrepreneurs. The favorite part of working with them is in helping them actualize their vision. She remains focused on purpose-driven entrepreneurs, and, especially, with female entrepreneurs. She also enjoys working with companies who use her insights and expertise to help them understand how to navigate the gender disparity that is in organizations. She assists them to bridge some of the gaps that have occurred since #MeToo, where sometimes people – men – are a little bit afraid to talk to women now in the workplace. Of course, it should not be this way; it is the opposite of what we want as a society. We do not want any distinction between the genders and AdaPia’s mission is to assist her clients to build inclusive, balanced work environments and cultures.
CFRE – An Educational Challenge
AdaPia D’Errico became involved with real estate crowdfunding around 2013 when she joined the three founders of Patch of Land. It was about three months after they launched and was really the beginning of real estate crowdfunding industry. Patch of Land, a Los Angeles company, was one of the first entrants into the real estate crowdfunding space and, for AdaPia, her industry expertise comes from having been a core part of that team. Their she helped bring not only awareness and demand generation to the platform, but also to raising awareness around the opportunity of real estate crowdfunding to the general public.
Indeed, informing people and really talking about the opportunities they have in crowdfunding real estate is very much an educational process. It really comes down to telling people about it in terms of what it is, what the benefits are, and what value it can bring to them. One must create a good sense of understanding and awareness. Crowdfunding has a complicated regulatory and legal framework. You can wrap it in very technical language with a lot of nuances and it can get they can get really overwhelming quite quickly. It is far better to provide digestible information that helps somebody understand what they are looking at and talking about.
AlphaFlow puts investors side by side with a registered investment advisers (RIAs) simply because they are both looking for the same thing; good risk adjusted returns. The company tries to help them understand what they want and how they can invest to achieve their goals. First, they consider their investment profile and risk tolerance as well as other portfolio goals that one should be looking at if one is a financial adviser before making an investment on behalf of a client. Then it is really about explaining to them the opportunity in the very simplest terms – for example, here is an investment that yields this return. You get X amount based on an investment of this size. At the end of it you receive this yield times the amount of dollars in invested plus you get your principal back.
At AlphaFlow they actually go a little bit further and talk about overall portfolio with investors and RIAs. This is in contrast with non-regulated, non-registered companies that cannot have those kinds of conversations. It allows AdaPia and her team to have a broader conversation with investors which is really fabulous because that allows them to help understand the investor better. Consequently AlphaFlow can fully explain the benefits of their product and how it can fit within a client portfolio.
AlphaFlow purchases loans from lenders; private money and bridge loans that are sometimes called hard money loans. The company talks to lenders who provide these kinds of loans to borrowers. The lender has a direct relationship with the borrowers and knows them well. This pool of lenders has little interest in the technology or the analytics where the algorithms are or the investment management style around which AlphaFlow operates. Rather, they look at AlphaFlow as a partner that is creating a secondary market for the loans they originate. From AdaPia’s perspective, she looks at the lenders from the perspective of how they underwrite, how they manage, how well they know their market, how well they understand their borrowers. Ultimately, if AlphaFlow is purchasing the loans they are taking on the risk. Consequently it is extremely important to understand the process of how a lender underwrites and truly who are they lending to.
The AlphaFlow model involves implementing a complex algorithm on their portfolio to create optimal investment strategies for clients and investors. It can be easy for somebody to mistake what they as robo-advising. Certainly, this is what some of the big guys like Vanguard and Schwab are doing. They take certain principles of rebalancing and asset allocation and even tax loss harvesting and automate investment strategies around them. When you invest in one of these kinds of portfolios, you fill out a questionnaire about your risk tolerances and goals and capital available, amongst other things. This is often a big questionnaire at the beginning of the process. Then, when it comes time to invest your money, the process is basically constructed for you to allocate assets across your portfolio automatically. This is where the ‘robo’ comes in; there is no human interaction in terms of putting the whole thing together. It is not a financial plan. It is a portfolio of investments robotically compiled which is not the way AlphaFlow operates.
AlphFlow has a team of very experienced portfolio managers who are actively working with lenders to identify deals and who also actively manage the selection and purchase of the loans that are purchased. These folk are highly skilled and actively management the real estate portfolio that AlphaFlow acquires. They utilize a suite of data analytics – for which they have attracted venture backing that is used to continue to build out the tools that enable portfolio managers to make better decisions, to better understand the markets, and to better underwrite the loans on properties in their portfolio.
When an investor makes an investment, let us say they put in a minimum amount of ten thousand dollars, within a few days it gets spread across 80 to 100 loans across the AlphaFlow portfolio which is constantly rebalanced on a daily basis. Rebalancing is done with the company’s proprietary algorithm. This is where the idea of a robotic function comes in; on the back end where AlphaFlow has some sophisticated principles at work terms of rebalancing money to optimize the investors’ portfolio according to individual risk tolerance.
At a basic level, AlphaFlow adopts a moderate risk profile portfolio wide where loan to value, being the most recognized indicator of risk, does not exceed 75 percent of the total weighted average. No loans are purchased from borrowers who are first time borrowers because experience is so massively important. Instead, loans are acquired from borrowers who have worked with a lender multiple times, and who has a good track record of paying back
AlphaFlow charges a 1 percent asset-under-management fee (AUM). There are no performance fees but they do have a right to charge other fees which could arise should a loan go into a default scenario. These fees would cover legal proceedings and things like that.
Tech Meets Real Estate
In thinking about real estate and technology, Zillow and Trulia are real estate companies truly centered in technology. There are also leasing technologies, and agent technologies, and then there is this real estate investment technology from which crowdfunding companies emerged as a result of the JOBS Act. This Act made it possible for companies to seek funding from individuals at scale using the Internet.
Currently, AlphaFlow only accepts investments from accredited investors, but they also are seeing some institutional activity, interest from financial advisers and registered investment advisers and from family offices. They even have an endowment investing in the platform. The company does not offer a liquidity option so it is not, as yet, possible to trade invested funds although they are looking at ways to configure the platform to solve that problem. As a result, investors must basically leave their money invested for the duration of the loan which, for the most part, is a 12 month term.
Certainly with housing prices going up, margins for borrowers have been coming down in certain markets but globally, and not every market in the U.S. has peaked. AdaPia sees that some are just getting started. There are still pockets of opportunity having the expertise and the insight and the foresight into those markets becomes really important. AlphaFlow only looks at the markets that they have identified as being risk mitigated. Some of the data that they look at as is really based on historical pricing of the underlying asset. Part of their analytics suite allows them to look at the worst-case scenarios. They stress test markets against the worst housing market downturn – which as everyone knows was the 2008-2010 market.
That said, AlphaFlow looks at a 25 year period to identify the worst the market got and that is where they are basing their comfort level on the loan to value. Ultimately you have to look at every loan from the worst-case scenario which is that they may have to own that property at some point and sell it. That is why they are looking at what the lowest price was in any 12 to 18 month period over the last 25 years. From this they gain a different understanding of in the worst case and what they can sell it for and in order to recover principal.
The company is more interested in protecting the downside than necessarily in maximizing yield at least for their current moderate risk portfolio. Over time they would like to take on higher risk, higher return portfolios but that is a different game and a different investment altogether. For now their focus is on not losing principal.
AlphaFlow has started with the single family private money loans as an asset management platform. There are many opportunities in real estate and different kinds of real estate investment so ultimately the company wants to take the expertise that they are building in the single family residential space and apply that to other segments of the market. For example, looking at multifamily, or small balance commercial loans, or even potentially looking at equity project and are natural extensions of the current model. As the company builds its reputation and its information database and analytics they expect to look at evaluating other property types and other investment opportunities for investors.
Crowd Funding Real Estate – Intersection of Money, Morality and Justice
Amy has always been intrigued by the intersection of money, morality and justice and originally entered the law profession as a human rights attorney. Moving to Los Angeles some years ago, she became general counsel of a fledgling company at the time called 'Patch of Land', which is now one of the leading real estate crowdfunding platforms.
The company was formed at the end of 2013, when the first of the JOBS Act Regulations became effective. The key component of the Act is called Regulation D 506 (c), which allows people to go out and raise capital and tell everyone about it. The legal term is general solicitation, but it is basically advertising. You can raise as much as you want, but only from accredited investors. Patch of Land started doing deals, and at the time Amy joined there were the three founders and one independent contractor.
Amy’s belief in human rights has evolved quite a bit over the last few years and one of the reasons that she joined Patch of Land was because she was looking for something at the intersection of money and morality. The company was democratizing access to capital to a class of people that traditionally struggled to get it. Perhaps they were underbanked, but usually they are fix and flip developers, and banks do not lend to them.
For investors she thought that they were democratizing access to investment opportunities that they had never had before. On a personal level, Amy is aware of being female, Asian and relatively young, and that people did not look at her and think "Oh, there's a real estate investor, let me approach them about the opportunity". The best deals usually go to people in an 'old boys' club' - a certain age, gender and race, and they do not look like Amy.
Her personality has always been geared towards efficiency, and she sees the legal industry as one of extreme inefficiency. One even incentivized by inefficiency. She believes that if technology can be introduced into the legal industry then access to justice can be increased, transactional cost for business will come down, and a lot of good can be done. Today we are in the nascent stage of how tech will affect the real estate industry and Amy sees processes that are inefficient and that could be streamlined and digitized. She has always looked for ways to do things more efficiently, and being a legal counsel and part of a start-up at Patch of Land gave her a lot of license to reinvent the way practice could be.
Crowd Funding Real Estate Platforms
Every real estate crowdfunding platform is different: some are broker dealers, some are sponsors, others are listing aid companies. Some do commercial, some do equity, some do debt. The vast majority of real estate crowdfunding platforms have their own standardized forms that they try not to deviate from, because doing so increases the transactional cost. What usually happens is that the lender will negotiate terms with the borrower, who can then accept them or go to another lender. If they accept the terms, they issue a note and fund the loan, and there is very little negotiation.
On the investor side, when the platform is syndicating the debt out to its investor base there is no negotiation. The first part is about real estate and lending laws, and the second is securities law – you are dealing with investors. Under these laws, all investors have to be treated equally.
Some Platforms Pre-fund Deals
Each of the crowdfunding platforms do things differently. Some, like Patch of Land, will prefund the loan, and they usually have a credit facility and they get paid back when they syndicate it out. Others will not refund the loan, but will put the terms out to the borrower and then put it out to their investor base for funding of the loan. It is riskier from the borrower's perspective, because it might not be funded. Sometimes these platforms will decide to make a contribution of capital if a loan is 50% funded, syndicate the debt and then get paid back.
The platforms are not incentivized to invest in bad loans - they want to invest in good ones so that their investors make good returns. When they have their own money in, that says a lot about their confidence in the deal. We are seeing a trend in crowdfunding as a whole, where if a platform performs a lot of due diligence and is able to curate and choose the good opportunities, the investors start to put their trust in the platforms rather than the sponsors.
An important component of the process today is that now we have the internet and everybody on the Internet talks. For example, real estate crowdfunding investors talk about their investments, and if these are not performing, they warn everybody else. News travels fast online, and people talk when they are unhappy.
From a regulatory perspective, what makes this challenge is that you have got a lot of unsophisticated investors looking at a very sophisticated and complex industry - real estate. Then you are adding the tech layer to it. You may have a great platform with fantastic deals, but if the platform fails, that is another layer of risk that you never had before in real estate.
Real Estate Democratized
An emerging trend is the democratization of real estate crowdfunding platforms, so instead of large, venture capital-backed platforms, we are seeing the rise of tiny real estate companies putting out their own platforms. They are not raising money for other people, but are offering investment options on their existing websites. When someone clicks on this, they are taken to a white label site that has already been built, meaning that the cost of technology to build a platform has decreased. That means that real estate developers are now able to move from getting support from their immediate contacts to involving the local community.
Amy remains focused on economic justice and efficiency. With the cost of legal counsel so high, any wanting to do a small deal meant that hiring an attorney did not make sense for them. Instead, they were downloading random legal documents from Google and trying to draft something useable themselves, which got them into trouble. So much of the USA is powered by small businesses, and they employ a lot of people. And yet there is an injustice when they try to raise capital. They cannot afford to pay for help and when they do it themselves they can structure things incorrectly, which does lasting damage to their business. There are actual cases where start-ups have inadvertently giving away 80% of their company.
Indeed, there is a lot of inefficiency in how law is practiced, and injustice because legal services are priced too high. If we can integrate technology into law, we can bring down the transactional cost of a lot of legal services so more people can afford them, and then grow their businesses and employ people.
Lowering Costs, Speeding Transactions
Starting in the real estate sector, BootStrap Legal is creating software that will automate highly complex legal documents that people need in order to raise capital. These are the legal documents you need for a real estate syndication, real estate private equity fund or a real estate crowdfunding deal. Traditionally, this would have cost anywhere from $10,000 to $25,000, but with Bootstrap Legal the cost is significantly less.
Amy is not only lowering the cost, but is also speeding up the transaction. If you go to an attorney, you would usually wait two to four weeks for the first draft of your documents, but at Bootstrap they are turning them around in 48 hours. This can give real estate investors more time to raise money.
The process Amy is employing at Bootstrap originally was intended to integrate AI (artificial intelligence), but she has found other creative ways to get to where she wants to be. Amy likes to think of it as 'AI-Lite.' There are a lot of rules and it is an expert system, but the idea is that the user goes in, and answers an adaptive questionnaire. The system asks what type of regulation they are trying to use and who they are raising capital from and the type of real estate. Typical clients are real estate syndicators, investors or sponsors - basically anyone who is trying to raise capital for a real estate project.
Legal Counsel for All
Although Bootstrap has started off with real estate, she has her sights set higher. Amy is primarily focused on changing the user experience around how they interact with legal services which currently centers a lot around the attorney. If it could be centered around the client, everyone would be happier. In particular, moving away from the billable hours system would be better for all. You can make things more efficient by decreasing transactional costs, and clients would be happier. In this way, and through Bootstrap legal, Amy wants to have an impact on creating more jobs and levelling the playing field for all.
Jonathan Tate runs a small architectural practice in New Orleans, Louisiana that prides itself on its experimental approach and its contemporary aesthetic. He has been practicing for 20 years now and has always been interested in housing and so that has been the undercurrent of his practice. He focuses on residential projects across the spectrum whether it is private clients or for a single family house or a multi-family project for affordable housing, and integrates his designs while keep an eye on urban scale issues and urban environments.
The last thing Jonathan ever imagined himself to be was as a developer. He often saw friction between what development and architectural agendas. The first thing that gets compromised often in that process is the architectural agenda and he enjoys the challenge of trying to exercise an architectural agenda while also addressing the developer's imperatives. This approach afforded him an appreciation from the consulting side of things of what the pressures were and what the general parameters are around development.
Two to three years before embarking on the first regulation crowd fund deal on the SmallChange website, Jonathan found himself increasingly aware of the conundrum of housing in New Orleans. He saw an increase in housing prices and a sort of inversion that created the consequence where people were, and are continuing to get pushed out basically to the periphery as the cost of housing in the city and adjacent to downtown was getting exorbitantly expensive. Historic parts of New Orleans are simply unattainable at any decent price point. Jonathan saw that nobody was addressing this problem, certainly the cost aspect of housing, but also with by taking a closer look at the type of housing that was available. Mostly what he was seeing was renovations of existing housing stock or, if new, then simply a recreation of existing housing stock by manufacturing new homes to look old. Nobody was really offering sort of middle market custom design or contemporary design housing.
Jonathan saw a gap and that is where it started. In fact, it was by paying attention to gaps in the landscape of New Orleans that the process of finding lots began in earnest.
Developable lots were either priced way out of affordability range and drove the desire to provide housing to potential buyers that was affordable by design. The search for workable lots became largely a land play but cheap land in areas of the city that were desirable were hard to find. What Jonathan noticed, however, was an abundance of parcels of land in the city that most people would not identify as being buildable. These nonconforming or small lots or odd lots were being overlooked because most of the folk that were developing housing in the single-family infill space were not interested in them at least initially because they have models for design and aesthetics that do not fit. Jonathan tasked his team with research to locate all this property in the city in areas of the city that they felt that they wanted to engage in. And then they filtered this list to find the sites that they specifically thought would work for their purposes.
Their target market for end user was housing catering to first time and last time homebuyers in the middle market price range. In other words, not deeply affordable but not high-end market housing that offered entry opportunities into historic neighborhoods. These areas were otherwise quickly closing up due to the escalation of housing costs in that kind of inner city areas. To put that into perspective, a standard housing lot in the neighborhoods that Jonathan was interested in could be $300,000. The cost of the nonconforming lots, on the other hand, averaged between $30,000 and $50,000 a lot which, of course, has a significant impact on the cost of the finished home.
The approach was successful, and Jonathan now has either under development or in construction or constructed some 17 houses that are part of the starter home strategy. The two houses that were crowdfunded are two that belong to this whole index of housing in the portfolio.
There has been one notable exception to the spec home formula that Jonathan’s firm generally engages in. They designed one home specifically for an individual. It was a self-built home i.e. the client built the home himself. The home was designed for a small lot and was designed specifically so the client could understand how to build it on their own. The home stands out because it is the smallest permitted house in the city of New Orleans. It is only around 192 square feet in size, and, although you could squeeze another square foot or two out of it, it is basically the smallest house that code will allow in the City of New Orleans – and at a cost of around $100 per foot probably the least expensive house in the city also.
For the most part, the homes that Jonathan builds under the Starter Home banner are not designed for any one particular individual; they are truly spec housing and the process of developing this direction for the firm was just getting off the ground (or into the ground) at roughly the same time Eve had engaged them about to work with her and SmallChange. At around that time, the city of New Orleans was auctioning off a number of their abandoned and vacant properties throughout the city, and in that mix, as it turned out, was a number of nonconforming lots. NPR ran some coverage on Jonathan’s nonconforming lot Starter Home concept so while people were buying these odd shaped lots at auction, his firm was getting some press coverage. The phone started ringing from people who just bought these funny little lots and did not know what to do with them.
The SmallChange project is actually two parcels that are being developed into two individual houses right next to one another. The lots are about 1,200 to 1,300 square feet apiece so though not so small but they are not enormous either, and definitely not a standard lot. The homes that are being built on these lots are just a hair over fifteen hundred square feet each, two floors, with one parking space each.
Eve was aware of the work that Jonathan was doing and met with him during a visit to New Orleans for a conference. Jonathan became fascinated with the mechanism of financing his projects in this novel crowdfunding way because it embodied the spirit of investigating creative possibilities in everything he was doing through his work. It presented a fascinating possibility and they tracked the opening up of Regulation CF in May of 2016.
The Reg CF Process – Developer’s Perspective
The first thing that needs to be compiled is a package explaining the project that you can present to the world basically. In many respects it is no different than a package you might put together and walk to a bank and say, ‘here let me tell you about our project and why you should invest in it.’ The developer needs to be able to tell a story about your project, why it makes financial sense, and needs to be able to talk about him/herself and what their qualifications are for doing the deal.
The first person that needs to be sold on the project at the funding portal, because you want them interested in you, and, of course, as Jonathan used the SmallChange funding portal, that person was Eve Picker. Once that hurdle is cleared, there is a background check that covers regulatory requirements, but a lot of the vetting actually comes through conversations and mechanisms that the portal has in place that says OK I need to get to know these people and know something about them. Because the funding portal is so heavily regulated, there is an imperative to be able to trust the developer, know who it is, and understand exactly what they are trying to accomplish.
It is the developer’s responsibility to pull the material together that explains the project in all aspects, and it needs to be distilled in some way so that people can understand it in plain English. There are a series forms to fill out that are required by the Act and the developer generally needs guidance in completing, submitting and uploading these, including Form C, to the Securities and Exchange Commission, the SEC. Together with SmallChange, Jonathan found himself completing the first Regulation CF offering completed on the platform, so they approached it as a process for which kinks would need to be ironed out. Naturally along the way they were feeling around in the dark in a few places but were able to get through and consequently, the next time around, no matter who that is, the process will be a lot easier.
Smallchange has a network of investors that they have developed over the last few years; people who have signed up to newsletters and who get announcements about new opportunities. It is a pool of people that the portal can immediately send information for any of the offerings. For the most part, Jonathan relied upon SmallChange’s network but they did put a sign out on the site to let people know that there was an opportunity to engage in funding, and they conducted personal outreach and alerted people to the project and the process.
In total it was a three month raise. The first month when it came out, there was a lot of activity with potential investors immediately, and they had a good burst of folks that jumped on board right away. The majority of these came from Eve's network. In total it was a $95,000 raise, with a minimum of $40,000 which was hit really quickly, perhaps in that first month. Then the next month was fairly quiet and dormant. Actually, during this middle period there was not a whole lot of activity and people were investing but it was not the kind of quick pop that the saw at the beginning. And then the third month was really active where they closed the gap on the funding and and made it all the way to the ultimate $95,000 goal. This final push was largely thanks to an aggressive marketing campaign from SmallChange.
Having a large social media following would likely have helped Jonathan with is raise. If you already have an embedded audience associated with you that you can reach out to then that is probably the best platform you could have starting out with. For sure there are certainly people familiar with his work but it is not like he sends out e-mail blasts to thousands of people every month. If you do, this could be helpful in conducting a Regulation CF raise.
Jonathan has an investor that he works with all the time and with which he really enjoys working, but the opportunity to pursue the crowd funding option was one that allowed him to broaden what he was doing. Furthermore, his own investor network is limited and frankly is not a big pool of investors or friends and family that are willing to give money to him and yet from the SmallChange raise he was able to find an additional 38 investors with whom he can now work.
Smallchange itself is essentially a host to an offering and that is it. When the offering is done they close up and then it is up to the developer to manage the rest of it. The Starter Home investors come from all across the country, with concentrations on the coast and as far out as Australia. There are only three people from New Orleans that participated in the offer.
What Jonathan found most captivating about raising money through SmallChange and Regulation Crowd Funding was watching the process evolve and seeing how people found it and decided to participate. He actually had an investor that was ready and actually had been keen to invest the entire $95,000. He was the person who helped with the first Starter Home project and was interested in anything else Jonathan was doing. He thought Jonathan was crazy to be raising only $95,000 through the crowd funding process rather than just taking a single check from him.
But for Jonathan, the process has not been burdensome at all, and in fact he says that it has been quite pleasurable and intriguing and worth a lot beyond just the capital raise because of some really incredible conversations that have resulted. He feels comfortable recommending Regulation Crowd Funding and SmallChange to people who might be interested in it. What he particularly likes about it is that it raises awareness of his work in and around different scales of communities. If you are doing socially minded or urbanistically minded projects, whatever you name, if there is an agenda around your work then crowd funding is a great platform for people to both to see your work and to be able to contribute and help support it.
The First Regulation Crowd Fund Real Estate Investor
Bill wanted to invest in real estate deal but did not have enough money to do so. That was until he came across the SmallChange website. SmallChange had a list of all their currently ongoing projects and they updated it with what the type of project was, and was it open to accredited investors or non-accredited investors. Not being a millionaire (accredited investor), Bill realized that SmallChange was speaking to him and may give him the opportunity to invest in real estate that he had been looking for. Being tech-savvy, Bill set up an alert so any time the SmallChange website page changed he would know about it. In fact, he was waiting for the first moment a project that was aimed at non-accredited investors went online, so that he could invest.
While Bill was searching for a way to invest in real estate, he was primarily focused on completing his Ph.D. at Cornell in chemical engineering. He was looking at deep biological topics known as ‘systems biology’ and he was approaching the subject more as a theorist trying to understand how the different cells in the body coordinated with each other to grow new blood vessels. His research helps explain how the leopard gets its spots and he had spent about 5 years working on this, engaging in other hobbies and interests. One of these was and remains real estate and urban development and he takes pleasure in understanding how to get things built in society.
Having a family that was involved in real estate back around the time of the dot com bubble in the early 2000s helped acclimatize Bill to the jargon around real estate. His father had acquired a bunch of houses in Portland Oregon and this gave Bill a foundation of education about the financial side of real estate investing – how a mortgage works and what kind of market conditions impact investing. He came to realize that it is a hard thing to find a piece of land that you really, in a neighborhood you like and then to build something of your own because, in Bill’s mind, every place that is cool has already been built up.
This sense of limited supply in areas that interested Bill drew him towards learning more about the infill process and what it takes to change the fabric of a preexisting city as opposed to starting from fresh. His process of discovery brought him to the StrongTowns which is a kind of a think tank about how to balance balanced budgets of municipalities particularly in the smaller cities and smaller towns of the U.S. There is a large infrastructure burden in all these towns because everyone is so automobile dependent and addicted to a low density lifestyle. This creates a financial burden because tax receipts are too low compared to how much these towns have to spend on infrastructure. One of the major remedies for this is to add more infill development. And it was through the StrongTowns website that Bill came to hear about SmallChange and their whole philosophy towards gradual in-fill. SmallChange, and by extension its founder Eve Picker [listen to Eve talking about SmallChange and her path to crowdfunding real estate here]. Bill sees Eve has having a really important piece of the puzzle of how to resolve infill challenge because she provides the financing.
There is a big difference between wanting to buy a house for yourself and to build it or renovate it and investing in somebody else's deal. For Bill, the whole idea of infill whether it is him or someone else doing it is sort of an underappreciated economic opportunity. Bring fresh out of graduate school an in his first job, it is kind of absurd to think that he would be funding his own real estate deals unless he was in the business and was a professional real estate developer. Instead, investing in a deal on the SmallChange website has given Bill a way to make a little bit of money based on what he describes as his ‘armchair understanding of how valuable infill can be’, and it also provides him with a good chance to learn a lot about the infill process itself. The architect developer on the deal Bill invested in, Jonathan Tate, has been very good about filling the investors in on what the plans are, whether there are legal things that need completing, financing mechanisms and so forth. For Bill, it is an interesting educational process as much as it is an investment. A novel take on the oft-cited learn-by-doing approach.
Adding further value to the transaction for Bill is that a primary motivator for him is that the deal has a kind of a social conscience in that it is doing good for the community in which it is located. This is part of the return to Bill that cannot be measured in monetary ways. Had he wanted just a financial profit, he could have just as easily picked up a real estate REIT that went out and built greenfeld houses in Arizona somewhere. If making money were the primary driver there are better ways to do it like, perhaps, investing in the stock market. Bill is expecting around a 10 percent overall and the project will take around a year to complete, maybe a bit longer. For him, the return is comparable to what he would get on the stock market, ‘but way more fun!’
But for socially conscious investors like Bill, the investment was as much about the project and the almost the aesthetics of the kind of building of which he wanted to more built. He has invested in two beautiful little houses that he himself would love to own but cannot afford today. He longs for the day when there are more homes like the ones he has invested in and by helping Jonathan build the models in New Orleans. Bill sees it as being in his own self-interest in a way because, perhaps, a home like that will be available when he can afford to buy one himself.
Researching the Deal
To figure out a market that is thousands of miles away from him, Bill did his homework. He studied all the documents about the deal on the SmallChange website and that are readily available to anyone with an interest in investing. He went on real estate sites like Zillow and looked at what is available on the market right now and what that has to do with proximity to transit and jobs. He likes the neighborhood where the deal is situated. You cannot find a single family home in this area because everything is either a duplex or a mansion so the only way to buy and live in a single family home in the area is if you are willing to spend a few million dollars. So the little ‘starter homes’ that Jonathan Tate is building and that Bill invested in really fits in this niche of being highly desirable detached product in this neighborhood. It is high quality construction and small but still something that a family could afford.
1st Regulation CF Real Estate Investor
The foundation of credibility came from the SmallChange website and from Eve who is a thought leader in the space. Adding to this is that Jonathan Tate has a very established practice. Having been the first person to invest in this deal, Bill Bedell holds the title, unless proven otherwise, of the first Regulation Crowdfund, the first non-millionaire, real estate investor. If he could Bill says that he would invest in every single deal that comes my way as long as it looks as high quality as the first one.
The $2,500 Home
Bill has a novel perspective for what it means to be able to invest in deals like he did on the SmallChange website. He sees it as a way to build wealth. Many people see buying a home as the best way to do that, but, for someone like Bill, coming up with the thousands of dollars necessary for a down payment to be able to do that might simply make entering the real estate market practically impossible. The way Bill sees his $500 investment in the Jonathan Tate house in New Orleans is as though it were the requisite down payment needed to buy a house. If a down payment would usually be 20%, then, the logic goes, his $500 investment just bought him a $2,500 home.
This works well because it means that anyone can have a Harvard educated architect – as is Jonathan Tate – doing the heavy creative and development work and the investor can just get his or her returns from that without having to do the work themselves. Crowdfunding offers a huge opportunity to investors like Bill Bedell, and Eve Picker has realized that there is a space to kick start, to borrow the metaphor from the original big crowdfunding website, to kickstart some projects that were not traditionally attractive to banks. In this way she is using crowdfunding to show that these kinds of deals are viable and as sort of a line of evidence that there is real enthusiasm behind this kind of development.
Eve Picker is an architect by training and fairly early on in her career she was always very interested in cities and took herself off to New York City to Columbia University to do a Masters in Urban Design because she was interested in the design of cities and not of just buildings. After she moved to Pittsburgh she found herself living in an area that was in need of revitalization. She became involved in creating a community development corporation and went about the business of using nonprofit dollars to try and revitalize the neighborhood.
It was a natural step for Eve to move into doing real estate development herself and she started doing projects her own. They were always in neighborhoods where she felt she could make a difference, but, disconcertingly, she found that they were generally really tough to finance. Remarkably, one of her more challenging projects actually 12 different sources of financing on it. And yet Eve felt that these were areas in inner city neighborhoods that were in the greatest need of change and consequently innovation would be important if she was to have an impact. Then came along the bank meltdown of 2007/08 restricting still further her access to capital, and Eve found that banks became even more conservative than already they had been.
She did not have a group of equity investors; her partners were often the city of Pittsburgh who wanted to see grittier areas revitalized, and with the cutting off of finance she was unable to any longer do the kind of socially impactful development work about which she was so passionate. She laments that she was “stopped cold in [her] tracks, and so when she heard about the JOBS Act and crowd funding she found it especially fascinating because she thought she could create a tool, a way for developers like her to raise funds for projects.
Eve saw the JOBS Act and crowdfunding as an opportunity to actually help developers like her raise funds in a different way; to raise a very critical piece of funding for their projects and that is precisely what she is doing. Eve thinks of SmallChange as being a mission driven business that wants to make an impact. She has created a ‘change index’ on the website that keeps her true to this mission, whereby deals are measured by the amount of good that they can bring to a community.
Although Eve formed a crowdfunding portal, she prefers to think of her business more as a financial technology platform. She has moved from being a developer to helping to create a financing tool. She has a real estate equity crowdfunding platform that, at its core, puts investors together with real estate developers online. Registered with the Securities and Exchange Commission and a member of FINRA the financial regulatory agency, Eve’s site is one of only a very few in the real estate space that has gone through a highly regulated process of approval to be able to use the brand new security tool called Regulation Crowdfunding – or Reg. CF for short.
The securities law that allows for this has only being active for just over a year and it is really the first time that unaccredited investors – the average man and woman in America – have been permitted to invest.
On the SmallChange platform, while there are investment limits based on income and net worth, anyone over the age of 18 can invest in a real estate project and that is really a ground breaking difference in the world of real estate finance and development. Developers can set the minimum investment amounts very low and indeed on the first offering [check the podcasts with Jonathan Tate, developer, and Bill Bedell, investor from that deal] the minimum was just five hundred dollars and probably about a third of their investors invested in the minimum for that project.
Eve is passionate about her business and talks of being ‘in love with regulation crowd Crowdfunding [because] it's a way for people who live in cities and neighborhoods to really engage in a meaningful way in the built environment around them. And it's clear that for the first time that they've been given that opportunity.’
Getting Your Deal Funded
To get your deal funded on the SmallChange website you will need to start thinking along the lines of how you would be presenting were you to take the deal to a bank for a loan – only without the bureaucracy and institutional frigidity. Put together a quick high-level summary about the project where it is, why you want to do it, how you think it will work and a set of numbers, a budget an operating budget, a project budget and demonstrate that it all makes sense.
Depending then on precisely what are you requirements, you will review the three potential securities regulations that apply – Regulations D, CF, and A+ – and will be advised which probably makes the most sense for you. Once you have decided which format to go with, you will be guided through the preparation of a disclosure document or an offering packet. This typically involves a restatement of what the deal looks like and includes how you are going to pay investors back, how investors are going to make a return, a review of market comparables that make sense… Basically everything a bank would ask for.
What sets SmallChange apart from any other platform is that no other funding portal offers Reg D and Reg A+ offerings also but Eve went about structuring SmallChange to be able to offer all three. Once you get into the weeds, so to speak, of presenting your deal online via SmallChange, you will see that the use of what can only be described as truly plain English. Eve is particularly fond of this aspect of disclosure. She likes rules that are meant for the lesser sophisticated investors and that is what she has built her platform around.
There are many more people out there who are not even aware of the possibility that they can invest in these incredible deals; not even aware that they are permitted to invest. This is hardly surprising since 97 percent of the population was indeed not able to invest in this way until the middle of 2016. The biggest challenge SmallChange faces – and other similar sites – is probably getting enough eyes on them so that they can grow quickly enough and offer enough opportunities to people.
One compounding challenge to resolving this is that Regulation Crowdfunding has very strict advertising rules, whereas the other regulations do not. Of course, you can never promise anything in securities any way because there is always a risk to invest so you have to be careful about your language no matter what. But Regulation Crowdfunding is especially strict because the intention is that everyone sees the same information at the same time on the Web site and so how that information is disseminated is very strictly governed.
SmallChange Deal Flow
SmallChange is very active in places where there is a lot of change going on. Like Los Angeles where there are some really big zoning changes and similarly in the Hudson River Valley where there is a lot of movement out of New York and Brooklyn. They are also finding activity in Newark and New Orleans where there are a lot of creative architects. [Of course, SmallChange does not limit it range to just these areas so if you have a deal that you think might make sense, contact me a the link at the top of this page and I will gladly provide feedback for you on your deal]
SmallChange makes money in Reg CF offerings by charging transaction fees to the developer, typically a 5 percent commission on whatever the site raises. [Again, if you process the deal through the NREForum we can probably assist you get a decent discount on this fee]. Although the site can accept it in lieu of the fee, it has not yet been given common stock or anything in exchange for funds, though this may change. In Regulation D because the site is not a broker dealer it is not permitted to charge a commission so instead negotiates a fee with the developer on a case by case basis.
Pursuant to Regulation Crowdfunding rules, SmallChange is not permitted to talk directly to unaccredited investors although communication is permitted through social media. But the unaccredited investor is a group of people who is ready and waiting for this kind of investment opportunity. It is very different talking to an accredited investor who is going to invest a larger amount of money. That kind of investor is used to investing in a more traditional way and, in some ways, the those conversations are actually more difficult because for them it is a very new way to invest and they use to conversations around investment that may not happen in the same way in crowdfunding.
The Unaccredited Investor
Eve is finding that unaccredited investors are coming to crowdfunding real estate joyfully. SmallChange’s first investor, Bill Bedell wanted to be the first one to invest in a Regulation Crowdfunding deal. [listen in to the next podcast episode to hear Bill talk of his motivations for investing]. The accredited investor is often motivated by things that go far beyond money and, so far, it appears that there are geographical variations in how the accredited versus the unaccredited investor thinks and acts. Talking first of the Regulation D deals, the accredited investor only. There it seems that think the tendency is more to invest in your own city, whereas the unaccredited investor looks to influence change in neighborhoods anywhere that they can. In fact, the first Regulation Crowdfunding offering, which was in New Orleans, attracted investors from all across the country. It was a first-time opportunity for people to invest in real estate and they were interested in the project and they invested from places as from Indianapolis to Florida, from Boston to Los Angeles.
The Change Index
If you want to raise a million dollars from both accredited and unaccredited investors it might make sense to do a side by side Reg CF and a Reg D offering, which SmallChange is alone set up to do. The smaller deals are very difficult to make money but, says Eve, ‘boy, I still want to keep doing them because some of those deals just matter so much.’ Whether it is a tiny deal, or a larger one, as long as it is consistent with the change index, SmallChange will take a look. The Index is essentially a tool that is used to measure the impact that a project can make on a community.
It looks at features such as the walk score where the project is located or is it close to transit or is there a business corridor nearby. If there is a sustainability play, are they using green building practices or is it in a principal city or is it close to a park or plaza. If it is a residential project does it activate the street with a porch or low chair and table; are jobs created? Is it an underserved community.
Eve is frustrated with the real estate crowdfunding industry because she sees that they really use buildings as a way to make money and do not think about buildings as a way to make places better. She believes the industry can do both and that because of crowdfunding and the influence that investors will have on the motivations of developers, in 10 years from now people will have started to build investment portfolios out of businesses and buildings about which they care and not solely for the money.
CONSPIRACY AGAINST THE LADY
Real estate is not just a financial services play but it is the largest asset class pretty much in the world, and just everything involving a transaction for real estate is subject to change. Most particularly it is the intermediary person who has, in most industries, been removed. The same thing is happening for real estate as well though real estate is probably the hardest one to change partially because the frequency, at least for residential real estate.
Every industry is a conspiracy against the lady. In the case of real estate, your average consumer might buy a house every seven to ten years so transactions are not so frequent where consumers are up in arms about getting better service or better functionality. Plus there are entrenched forces within real estate where you have this idea of concentrated benefit and diffuse harm. This apparent when you ponder why it is that real estate fees and commissions on residential real estate transactions are still stable at between 5 and 6 percent. That seems odd when there's so much competition and when there are so many different technology platforms that would drive that potentially lower.
But part of it is this idea that there is very concentrated advantage to real estate agents who benefit from that fee enormously and that that is their livelihood, and where there is somewhat diffuse harm in terms of consumers who would prefer not to pay such high fees. But if it is a once every 10 year transaction and then once every 10 year fee consumers do not actually care enough to drive change in any way themselves. It is harder to affect change in industries that have those concentrated benefits, diffuse harm and very episodic transactions as opposed to very high frequency transactions.
Fintech is the merger between finance and technology, though the skeptical view of fintech would be that it is much more Fin than it is Tech. In general, fintech is just technology enabled businesses that are trying to do something around finance. We have to think about solutions where banks, for example have branches that we no longer need, and a lot of old fashioned in-person communication that is also anachronistic for mundane transactions. We look to the types of businesses that we can build, because of these things. Essentially, fintech is creating a marketplace for all things around money and for which there are four different categories.
While today we might apply the epithet ‘fintech’ to a company, in 20 years you are not going to think of it this way, but rather you will think about it as your bank or as your insurance company or your retirement account. Only it will look very different than those types of companies look today.
Similarly, you might think of Point or PeerStreet as being technology enabled investment platforms. At their core they are simply technology businesses; there is no branch, there's no retail establishment. It is just a website where you go and it is a marketplace where transactions happen. You can think of PeerStreet as being like eBay for hard money loans, and of Point as the eBay for equity shares in residential real estate.
WHAT MAKES FOR A GOOD VC DEAL
As venture capitalists, when we look at opportunities what we think about is the team, it is very, very good, and is the opportunity enormous. In the case of Point it is about rethinking this idea of how does residential real estate work and that it does not make sense to only have two methods for dwelling. The first method is where one rents and is where one owns zero percent of the residence. The second is called owning in which case one will eventually own 100 percent of the residence by using a bank as a 30 year crutch. But why is that? Why can someone not own 92 percent and sell the other 8 percent to somebody else. We invested in Point because we thought it presented a very interesting opportunity where technology had come a long way and could resolve this anachronism.
So figuring out how to finance the loans or the equity slugs that you do get to homeowners is a good question for kind of the broader use case of a fintech.
The venture capitalist does not buy the assets that these fintech firms originate. This is an important distinction because the assets that are originated look more like credit instruments that might yield 10 to 15 percent or some cases even more. Getting a 20 percent annual return secured by a real asset might be pretty compelling, but ironically it is not very compelling for venture capital. The venture capitalist is betting on managers like those at Point and PeerStreet to yield, every once in a while, a thousand times return on equity.
PeerStreet is about people that buy old properties fix them up and then sell them typically within a short term time horizon. So for PeerStreet it could be described as being speculative but in supply constrained markets with low loan to value ratios a strong case can be made that it is not that speculative of an investment.
The main characteristics that make PeerStreet compelling is that they have a very unique model. A local private lender may make loans to real estate developers in his vicinity and over time comes to understand what kinds of loans and which borrowers pay back as promised. Once they are paid back, they can make loans again. The problem for the local lender is that they cannot scale their model, but they can scale much more quickly if they could go sell part of the loans that they are originating to a third party – and that is what PeerStreet does.
Very important for PeerStreet, of course, is to avoid adverse selection so the company actually does its own underwriting on top of the underwriting that the local lender has done. In fact, they scaled to over half a billion dollars of loans with no defaults in just their first couple of years.
A compelling aspect of their model is that, normally, intelligence is trapped in humans heads and PeerStreet is kind of the opposite in the sense that they have identified this and are using it to their advantage. They recognize that the local lender understands their market intimately and has their own network of borrowers that they go to. So by utilizing this network of lenders, they are able to force multiply the market.
This is very appealing because your average venture firm might give seven to ten million dollars as an initial investment where it can be very difficult to get the customers and the cool thing about PeerStreet is that they actually they do not have to spend any money getting the end customers because of the relationships they are leveraging with local lenders.
Apart from the product type, the main difference between Point and PeerStreet is the duration of the investment. Point presents a much longer duration product. Point is also an equity product that can lose money if the value of the home decreases, as can PeerStreet, but it is a secured form of equity, backed by a lien on the property.
Alex is one of nine general partners at venture capital firm Andreesen Horowitz and they are the ones that make the investment decisions, but in addition there are some 120 other people that work at the firm. Unlike other types of VCs Andreesen Horowitz brings added value to portfolio companies beyond capital infusions.
For example, they provide recruiting support because it is very hard to hire engineers. There is a policy and regulatory affairs team, and another team on communications and marketing. Additionally, every single one of their fintech companies needs debt capital, and in some cases accredited investor capital, so these are areas of support that they have been beefing up also.
Transformation of Equity Financing
When the JOBS Act which of course created crowdfunding came on the horizon, I said to myself, one, this is super cool, but two, this is going to transform the American capital formation industry because it's just about bringing the Internet into capital formation. Something that we haven't been allowed to do for 85 years by publicly advertising private investment. I just said this is this is going to be transformative. Disruptive. Awesome.
Crowd funding Dominated by Real Estate
Probably 90 percent of crowdfunding is still real estate. When the JOBS Act was enacted most people actually saw it as kind of a Silicon Valley phenomenon and that we were going to see lots of high tech companies; who's going to be the next Facebook kind of thing. Indeed that is what the first sites were really about. And I actually wrote a blog post way back then and said, well what about real estate. Real estate is perfect for crowdfunding. For one thing unlike a social media startup, investors investing from a thousand miles away can see a picture of an apartment building or a house or whatever the deal may be.
In addition, in real estate equity crowdfunding companies are actually issuing stock and giving people something for their money that is making people investors rather than just donors – in contrast to many crowd funding sites geared to business startups. This is, in part, what makes real estate by far the dominant sector in crowd funding.
Transformative for Real Estate
I don't it's hard to speculate about what impact equity crowd funding is going to have on real estate because it's just the internet and whenever the internet comes to an industry whether the travel or the dating or taxicab or the hotel industry, It is totally disruptive. The internet directly connects buyers and sellers and gets rid of middlemen. So traditionally private real estate transactions are financed through lots of very inefficient and opaque private networks. Who you know, who does your father know, who does your friend know, who does your lawyer know. But this is just a normal thing for the Internet to do.
The internet comes in and says, none of that matters anymore because now you can connect directly with your customers and for real estate developments that means investors. What is happening now and what will continue to happen I'm sure, is that as the word gets out, as the public education process continues, within a few years when a real estate developer wants to raise money the first thing that will come to mind is let me go online. Let me get listed on a crowdfunding site. It just will become the normal way to raise capital. That's what's going to happen.
Impact on Private Equity Funds
The Internet of course first picks the lowest hanging fruit and then it picks a little higher hanging fruit. At the top of the tree there's always fruit that the Internet doesn't pick. In the real estate market the sweet spot now is maybe raising a few million dollars for a developer. That will go up and up, but at some point it won't go up anymore because the efficiencies that the Internet is bringing to bear on the market no longer matter. That is to say, if you're the New York developer who put up the new World Trade Center, if you're raising billions of dollars, that market is already a very efficient market in the sense that everyone has access to the same information and everyone knows who the players are. The Internet doesn't have much to add at that level. In this way private equity firms won't be driven out of business, but they will see their lowest hanging deals disappear and they will move upmarket. That that's just what happens when the internet comes to an industry.
Crowd Fund vs. Private Equity: Better for Sponsors
I'm sure you could find a deal if you looked hard enough where someone paid more in a crowdfunding deal than he or she would have paid to private equity. But by and large crowd funded equity is less expensive for the sponsor than is private equity. The real estate crowdfunding world sort of started with some developers going to a meeting in New York to meet with the private equity folks for the umpteenth time and coming back and saying, we're just not doing that anymore. We're not dealing with those guys. Many of my real estate developer clients have told me that they could get their deal funded by private equity but that they can get a better deal from the crowd.
I think investor education is certainly what I would say is number one. Crowdfunding, particularly the kind of crowdfunding in which ordinary investors can participate, is very new. It will take time for information about the crowdfunding opportunities to penetrate.
Indeed, depending on the geographic area, some people have not heard about crowdfunding at all. It is still something that only at the far edges of public consciousness. People are becoming aware that they can invest outside their ordinary choices they have; mutual funds and pension plans. So that's the biggest impediment. And after that there are other impediments to the growth of the industry. I think all of which are pretty transparent if you start checking around real estate crowdfunding sites. The sites can be better. The consistency can be better. The ability to compare apples to apples can be better. The explanations can be better. I always say we're in crowdfunding we're where the car industry was in 1914 its just right at the beginning with almost all of the innovation yet to come.
These things tend not to go on a linear scale. Once it takes off it will grow extremely rapidly.
The benefits to investors of having standardized contracts I think are clear. There are people who have a hard enough time understanding the differences between two real estate investments without on top of that needing to understand the differences between multiples 100-page legal documents that go with each real estate deal. There is no reason at all for deals to have different document sets. Indeed, as I have said , what the Internet does is it squeezes middlemen. Well, in private real estate transactions among the many other middlemen there are these people called lawyers and securities lawyers. And there's a lot of money that gets spent on lawyers in private real estate transactions but does not have to get spent. Should not be spent. And the Internet just has this way of finding inefficiencies and kind of pointing the finger at you and saying, you're getting paid too much for this. So that's definitely going to happen with legal documentation.
Impact of the Next Downturn
There will certainly be a shake out. I'm concerned as to whether some platforms, good platforms, can survive a downturn in the way they depend on the cash flow from doing deals. There will be definitely a cut to people's cash flow and I hope that all the best platforms can survive. I'm a little bit concerned about it and I think the weaker players probably will not survive. And we're also going to see investor losses as well. And we're probably going to see lawsuits. We're going to get negative press. People are going to say you lost money in these crowdfunded deals and we'll be able to say but you lost money in the Dow also.
There will be a public relations downturn and the public will get a little skeptical, but this is just the normal business cycle. It's inevitable that the Internet is going to you know come to dominate the capital formation industry as it dominates other industries. It will be a temporary down and then the industry will pick itself back up.
PeerStreet - Investing in First Position Debt on Single Family Homes Nationwide
Brew Johnson: [00:00:00] I was in law school from 98 to 2001 during the dotcom boom and did an undergraduate degree at USC here in L.A. and went to law school at UCLA across town and had planned during the dotcom boom obviously like everything was tech and at law school I was planning on getting into when I graduated, you know the whole goal was to do tech work in the tech industry. And so I graduated from law school I went to work for a top 25 international law firm that was the number two kind of largest tech focused firm in the world, a firm called Brobeck, Phleger & Harrison. And when I was in law school I helped my brother found a tech company which was a user generated content travel company. And I planned on kind of doing tech work and obviously from the start from you know from 98, you know 2001, the dot com bubble that exploded kind of. And then in 2001 obviously. So I got out of law school going into this great job with this firm. And when I was in law school was I was working on IPOs and in M&A and just all this exciting stuff and I got out and things had blown up and cratered. So the office that I was going into there was something like 10 or 11 incoming lawyers were coming in. And they fired most of them except me and one or two others and said basically, hey, the tech work had completely dried up.
Brew Johnson: [00:01:21] So we have labor work or real estate. Our labor or real estate departments are busy. So where do want to go. I said real estate and this it was one of those kinds of serendipitous kind of things, I think. So I started practicing real estate law. And I got recruited to go over to what is generally regarded as the top real estate firm on the west coast, a firm called Allen Matkins which you may have heard of. And I started practicing what was by happenstance really, I mean to be totally frank. I kind of started practicing real estate law from 2001 to through 2005. So I kind of came out of the dot.com bubble environment into this real estate market that was starting to go crazy. And when you are working for a firm like Allen Matkins you just get exposure to all every sort of real estate related client from major banks to small banks to developers of all size I mean everybody from the small local developer to you know Toll Brothers and Centex and Lennar and just are just huge breath of experience and things were happening on the market just didn't intuitively make sense to me you know. I'd go out to our clients projects you know or I'd talk to somebody had qualified for a loan that felt like it was dead all the time.
Gower: [00:02:34] This was when exactly what, this was 2005 and six or so...
Brew Johnson: [00:02:38] To be honest earlier than that because the whole thing that was strange is that well my first firm I represented, the client was a master plan developer who was developing Ladero Ranch in southern California this huge master planned community in southern California. Every week they had this project and like prices were just going up as early as 2002 and very early on a weekly basis. And you know the story was like oh it's just the affordability. Interest rates are low. People can afford more. And it's kind of like OK well that makes sense when interest rates are going down. And the reason interest is going down is that the Federal Reserve is driving these prices down. After this dot.com blah. OK what happens if this unwinds. So really very early on in 2003 it just seemed like things like the whole the whole that was driven by this kind of thing was being driven by monetary policy always seems strange to me. And it does seem like, OK well this is not a sustainable kind of thing if that's the only thing that is driving this. You know obviously things revert to the mean and then there's probably like a point where rates are going to be going down or affordability isn't going to continue going up and then so it just it started pretty early and kind of like OK well that makes sense to a certain degree. But is this like a sustainable thing or like why that affordability is driving things. And then just as years went on it just like it went from that affordability thing and the interest rate thing to just like this excess liquidity.
Brew Johnson: [00:03:58] So it was like a lot of things built on it and you know a day like what was happening in the market just didn't make sense intuitively to me and I became obsessed with what was driving everything. So the first signs were in 2002 2003 something like OK the thing is this affordability argument is a complete, it's not forever and then as thing got later in the cycle it was just like I mean it was just almost without doubt like across the board of stuff going on there was insane. I mean you know we had clients were buying properties you know for 5x with, you know industrial properties for five x what they traded for year before because there were going to put up 10,000 condos in that city that it sold a thousand condos over the previous decade. And there were 150,000 condos going in the next city. You know there's one of these things and you hear people rationalizing things like oh they're not making anymore like Las Vegas is all land constrained and it's like. Well no it's not. If you've ever been to Vegas you know there's no constraint on land and like you all these kind of stories that seem like these justifying them you know just your saw this kind of that classic behavior of people you know like people I'm friends with who were buying properties to sit on and hold for six months or sell you know like that.
Gower: [00:05:10] Right exactly with that. No added value. Exactly.
Brew Johnson: [00:05:13] Yeah. Yeah. You know it's almost like a story of you know who it gets attributed to like whether it's Baruck or Joseph Kennedy or like pre-crash in the 1920s the shoeshine boy you know like giving him stock tips. Yes you know it was like a similar environment I mean I think my haircut is like a Supercuts and the hairdresser was giving me advice...
Gower: [00:05:37] Right.
Brew Johnson: [00:05:37] Buying condos in Vegas and that's a great way to get in early to make all this money. It was insane. So you know so I just became obsessed with it. I became obsessed with the securitization market, everything was driving it and it was just like such an obvious house of cards. I mean in 2004 I convinced my fiance to sell our condo that she'd own for two to two years in Brentwood and doubled in price right. So like I was very it was too early on the side, so I started shorting Fannie Mae and the banks because it was just to me it was like it was it was based on this crazy leverage. I mean you know people that have 50 homes that were financed by 100 percent financing by banks just you know holding so they appreciate value. Like if you have no if you're getting 100% financing from financing to buy a product you don't own property you're renting that property, so you have no skin in the game so anything if interest rates spike up a little bit that's going back to the bank so to say that idea of excessive leverage and risk taking in the system which was just so apparent to me pretty early on,
Gower: [00:06:35] Well listen you know what. I think this is probably amongst the most valuable experience anybody could have in this space. Right. When we talk about crowdfunding and the JOBS Act and the way the industry is developing just to pivot to the bigger picture. Briefly before you continue one of the issues is the JOBS Act was enacted in 2012. Right. So nothing that has happened yet in the crowd spacing real estate arena has seen a downturn in the cycle. It's only been up-tick so far. So having the insight that you have in what happens when the market has a downturn I think is absolutely critical. And as we get a little deeper into Peerstreet, there's actually something that I've seen you do that I'd love to talk to you about. But before we get, you know I have written it down so I won't forget it, but let's continue with how you got to Peerstreet and how you managed to bring these two worlds together. Tech and real estate.
Brew Johnson: [00:07:37] Yes. You know and I can to I sort of go on for hours but I think it's important like that sort of perspective and so for me like on that side of the table like I identified some early in it being a 100 percent certainty that it was like a house of cards and just I mean my brother would always comment what was the worst cocktail party host because everyone was like talking about how much money were made on these condos in Vegas and I would just telling everyone that the world would end constantly what are you. It was one of those really frustrating things. The fallout effect of it was be so massively negative so many people. Right. It was like really this was this frustrating thing and to me it was just like the system the base of the kind of this mortgage finance system seemed broken to me. And I mean I try cut this out but it's like it's really instructive of how we structured PeerStreet. Like today it was I want to talk about a little bit you know and the other part that was frustrating me is like I knew this was coming. And I'd go into my like my 401k account or my wife's 401K account and they like the safest option that you can choose,
Brew Johnson: [00:08:43] the favorite option was like a U.S. government bond fund like there's one of those classic back in like 2000 and my wife worked for a major pharmaceutical company limited choices of what you could invest in for the safe option was the Goldman Sachs something like the U.S. government bond fund and if you went into that thing it was about 1 percent or 2 percent treasuries and the rest would be like CDOs and all these like crazy leveraged vehicles like or not. So it's like right here right. This like the securitization finance machine driving this thing and just putting the average person at risk. So it was just incredibly frustrated with me. So by the end of 2005 and I I had this idea that OK the world is definitely going to end, I don't know if it's going to end next year or in three years, but it's a 100% certainty that it's going to happen, in the kind of financial market. And so I was planning on doing like a you know waiting for the things to fall out and then doing some sort of like a real estate vulture fund or something. But my brother had this tech company that I helped him found when I was in law school and it was growing and he needed help.
Brew Johnson: [00:09:45] So I went to work for him as his general counsel and Director of Business Development. And that was like in 2006 and you know helped to build that business but you know as well as anybody that like the cracks in the system were happening in 2006 and 2007 and you know Lehman was kind of like the final straw but like it's not happening much earlier than that. And you know people were kind of deluded by the fact that it was happening. And I persuaded my brother into selling his company because I was like look at this is bad things are happening. But the key feature is I think like coming out of the real estate world like which you identified as like so just you know it's antiquated and old school for reasons because it's like this physical you know market where things are very unique and you know you need to know there's a reason why it hasn't been transformed by technology and it's the kind of last major asset classes do it. But then they go into day to day operations of the tech company and seeing the power of it. At that point I thought wow when the banking sector a huge portion the banking sector goes away there's going to be a need to fill the void.
Brew Johnson: [00:10:48] And I saw with companies like Lending Club and Prosper were doing in consumer credit and I thought wow if we could do something like this in real estate it can be incredibly powerful. So I actually kind of started incubating this idea in 2008. I actually worked up a business plan but it wasn't the right time for a lot of reasons. A lot of it had to do with the legal and regulatory environment right. But I put the idea on hold. You ended up selling my brother's company to Tripadvisor which at the time was wholly owned by Expedia. Stayed on there for a while. But during the crisis you know did a lot of things,bought foreclosures, bought distressed notes from banks made a lot of hard money loans to other people who were buying foreclosure. And had this really interesting experience. Now fast forward to 2013. A lot of things had changed in the market that made this business that had been very passionate about them going back four or five years, very very, a a lot more viable. Right. One is the JOBS Act and I think the passage of the JOBS Act itself was kind of like OK this is big, but when the SEC promulgated the original rules of how they would like enact it it was like OK now is a good time to do this.
Brew Johnson: [00:11:50] But in addition to that like LendingClub had hit critical mass in the consumer credit space things were going on in Europe in terms with crowdfunding and peer to peer lending and markets place lender. The market acceptance of it had kind of hit that. And so at that point it was like a bunch of different real estate stuff I was working on. I had put everything on hold and then I reached out to my co-founder Brett Crosby to raise some money for the idea and then we started building the business. And so that's kind of the background of it and the reason I can of got long at it is that that long kind of background of the real estate legal this kind of securitization, this knowledge of how at least large big picture of how that system works and the kind of tech aspect of things and how to create like a stable tech platform. We kind of pieced it together in a way that we think is very unique and different than anybody else is out there doing any sort of like you know what is crowdfunding or marketplace lending in real estate and the end of the day is sort of a pause there for a second.
Gower: [00:12:51] Well I was just going to say yes tell me in what way is it unique. Why is it unique and you picked a particular asset class to pursue. So tell me about the asset class that you're looking at why you like it's a particular, Brew in the context of your experience having seen a major downturn.
Brew Johnson: [00:13:11] Yeah that's a great question. So just in general I mean I am a firm believer that I mean the transacting through an online platform and the idea of crowdfunding and allowing people to access investments but access it, you know, in smaller amounts more transparently, I think it's just clearly the way the future goes. You're looking at types of assets invested, and obviously in real estate investing which you know as well as anybody. There is a million flavors to real estate investing right from equity investing to preferred equity to mezz debt to you know all sorts of things. And so if you if you look at it from the outside. OK. Where is the most appropriate place to do a real estate investment on line. Right. And so if you you are looking in, the second piece is like okay if you're going to be exposing investors around the world creating like a platform there's things you want. You want to kind of grow a large online platform you need, it's imperative that you establish credibility right. And it's imperative that you do your best to establish some level of safety or security for investors right. And then you need something that can scale because like if you're not going to be scaling down large numbers a technology platform doesn't really work and it doesn't provide that much value to the to the users, the participants right.
Brew Johnson: [00:14:34] And so I guess one example to look at there's like you know in the back in like the dot com days, it would be the difference of like you know they like the field and it's like eBay or Amazon versus somebody that has a shop and puts up a Web site where they can sell their goods. Right. There is power in that in that scale because scale creates network effects. It's like OK I'm so kind of this idea that scale is important. Credibility and safety for safety for investors and credibility for that platform to help loosen up scale that feels important and what the class of the most appropriate to do this and to me you know. And then the other fact on my side of mine and Brett my co-founder considered is like we think the long term ramifications of a platform like de-leverage is like a marketplace where you know we're more of the marketplace lending, or in a market place for investing in real estate. We actually think of the long term ramifications of like are very very massive it could potentially transform that securitization market I was talking about. So for us it was like OK. The most appropriate asset for most investors to invest in is real estate debt. And specifically first position lien debt. The reasons are obviously very simple; it's the safest part of the capital stack. Right. It cash flows so that throws off cash for people.
Brew Johnson: [00:15:56] And it's also just a lot more consistent in terms of like the idea of like you know if you're doing an equity investment in real estate that's an independent kind of deal that almost every single deal is unique and there's not that much consistency. So the idea of being able to create a sustainable platform that provides value for both investors, you know let's start with investors, you need that consistency you need that homogenization and really something that you know in our opinion where you know put them in a safer position than other options out there so we specifically from day one we're saying we're going to focus on first position lien debt, because it's safer than other types of kinds of real estate investments. We think it's more appropriate and also it's like in the event that there is a downturn and you're kind of trying to create a new industry or a new asset class that is investing online, in the event of a downturn that end investor is much more protected. So that's part of what dictated the idea of all right there's always risk in investing. But if you're the opening of a platform to kind of the masses and investors you want to position from a place that that is that puts them in this in the most consistent and of the options out there, the safer part of capital stack.
Gower: [00:17:05] Ok. So I think that you have actually have a very interesting metric. Your capital is used to take out local lenders. What I would call hard money lenders and you are welcome to correct me if you don't like that term. Who invest in local people local developers who are doing single family home primarily single family home loans for fix and flip typically. You have a minimum loan to value threshold so that's fairly standard but you also, very interestingly, you also have a metric that looks at that particular location's decline relative to its peak over a 20 year period right to measure what your maximum leverage is going to be. Can you explain that to me because that's an interesting thing how you came up with it and why you think it's important.
Brew Johnson: [00:18:00] Sure. So obviously like the number one risk factor in a real estate loan and to acquire a loan is the loan to value. Is the loan to value ratio. So the idea is like OK that's the starting point. But I think the idea of when we look at risk in in a loan in terms of that particular metric. The idea is okay well you know what are the typical risk factors of the loan, like what is the LTV. Who is the borrower, you know, those metrics. But the idea of that kind of looking at data to make informed decisions or investors to make informed decision I think is like a part where that hasn't been available for before. So you know for in our opinion if you're looking at kind of historical cycles of the real estate market, it's like you can have a great LTV but if you're in a market that is declining or you potentially have a huge amount of overhead or a huge amount of inventory your risk factors a lot larger because if things slow down, prices would drop and or there's a lack of liquidity. So the idea of like trying to analyze what is the health of a sub-market where a property is located kind of currently and what we think kind of like the current health of that market, then also letting investors look at the term and like OK what's the worst case scenario in this market. You know is this the type of market that during the financial crisis drops 5 percent.
Brew Johnson: [00:19:19] Or is it the type of market that drops 50 percent. And so I think the idea there is just getting a lot of investors to to make a determination or be able to go serve that information where investors can say can look at it and make informed decisions. So for us it's kind of like when I look at investment I'm kind of like one these cynical guys following people I always start from like OK what's my worst case scenario on this particular investment. So that's really the idea there and like look at you know the classic thing that history doesn't repeat itself kind of thing but of like you know it rise thing. Yeah. We have this recency effect of what happened in 2008. Could there be another financial crisis. Absolutely. Could there not be another financial crisis for another 20 or 30 years yeah that's possible too. But I think the idea is like being able to form a decision and allowing people to look at information is OK here's this loan, the market is currently trending up and oh by the way crunching a lot of data and statistics it looks like it's forecast to continue going up but if for some reason that's wrong in the market turns here's what a potential downside scenario I think is important. Now so I think that's important like looking on a loan by loan basis and investing on a loan by loan basis.
Brew Johnson: [00:20:27] But I think the most important part of why Crowdfunding is such a, or crowdfunding or marketplace investing, or marketplace lending, or however whatever term going there they're all kind of like related to each other but to me the real innovation in that is the ability to allow investors instead of like investing in one loan at a time or one investment at a time and putting a large amount of money in a concentrated position. Have a look at that loan. Analyze the risk for them or whatever, you know whatever the risk is. But spread the risk across a huge broad a broad pool of loans to be able to minimize risk through diversification. And I think the combination of looking at data smartly and looking at data correctly is also the ability to just diversify very very broadly. It's like just a fundamentally different way to invest in real estate. And real estate a little bit but particularly in real estate debt there's never been a vehicle like that. And so the idea is like to be able to kind of create these, a), let's analyze data but be very transparent with it so investors can look at it and it's get their idea of what they think the risk is. But the last piece of it is allowing investors to get broad diversification. We think that combination is very powerful.
Gower: [00:21:38] Right so in your case the broad diversification is instead of putting for argument sake, say $100,000 into one loan with one guy on one house in one town, you could put ten thousand with ten on 10 different properties across a range of locations.
Brew Johnson: [00:21:57] That's right. That's right. And so you know and I think I guess I kind of skipped so I guess I skipped over a little bit the asset class; that a hard money lending.
Gower: [00:22:05] Yes, tell me about that because that's something unique to PeeStreet as far as I can tell at least so far.
Brew Johnson: [00:22:14] Yeah. There's other players playing in it. But the way we the way we've attacked it that you've identified is like partnering or you know or working with these off line hard money lenders is a very unique thing. So yeah I mean like for the focus of the asset class is short you know is short term bridge loan on single family property. To fix and flip and kind of short term bridge or short term buy or rent type loans is the focus. And so yeah you nailed it historically it's been called hard money lending. It's kind of had a negative connotation historically in certain areas because historically you know the kind of use cases like either a real estate investor or entrepreneur has a property or finds a deal that they want to do. They need to move quickly on the deal. So they need they need capital fast so they would historically go to a local hard money lender pay a very high interest rate to get a short term loan to go buy and take down a property and then potentially sell it or refinance it later you know to take out to take out a short term high interest rate loan.
Brew Johnson: [00:23:19] It's a really interesting kind of shadow part of the market in this niche part of the market it's always existed and been there, and it's actually been very important. But historically it's an incredibly localized business. And you know borrowers have borrowed there were very local, the lenders that operated there was very local borrowers typically only had one or two kind of places to go to kind of source that type of short term capital. And then investors most investors, it was just kind of lucrative asset classes almost like this country club thing whereas certain lenders would make these loans and have their own capital or have like a small network of friends and family that they raise capital from to lend wit. So it was this really highly fragmented localized market. But incredible risk adjusted returns. I mean if you look at like you know historically hard money lending you can range from anywhere from 10 to 20 25 percent annual interest rate on a secured loan that is collateralized by real estate. And so this really is just really interesting niche market.
Gower: [00:24:15] So Brew, let me ask you, how did how did this niche market perform during the downturn.
Brew Johnson: [00:24:22] Yeah great great question. Great question. So it really depends on who the lender was and who the originator was. And so this is a key key thing and my love of this asset class, like when I was, my best friend's dad growing up you know he owned a ton of property in our hometown single family rental properties he made up much of his hard money loans or trust deed investments and you know in California. And you know over 30 or over a 30 year period he never took a loss on a property because he lent you know in areas that he owned property understood of the value the value of these properties and where he'd be comfortable owning that property. Right. So and when I became a real estate attorney and was doing these deals are like people making these loans at 3 percent interest or 4 percent interest on a commercial property or something like that, I was like there's another thing where people are making 15 percent return and I know for a fact that these guys have never taken a loss on these properties. It's just an amazing risk adjusted returns; this major asset class right. And but during the crisis guys like my buddy's dad or the experienced lenders who lent in their area and knew it very well and put their own money at risk and knew that they performed OK. They did well. A classic example is one of the largest hard money lenders in the country is Anchor loans in LA and they have been lending for a long long time very experienced.
Brew Johnson: [00:25:42] Through the downturn their investors, you know I think their yields to their investors went down like 1 percent or something during the crisis. And I think they as a fund they may have cut their management fees, but their investors didn't take a loss during the crisis. Now other people lost everything right everything because they were making risky loans and they weren't structuring loans correctly and they were over there were over advancing and giving too much capital. So I think the idea here I think the key thing is like look at people who know what they're doing and have expertise and track records and you know understand their markets are lending it and their borrowers. I think will fare well in almost any and in a variety of different markets. And so in terms of kind of like a regular functioning market I think it's a good asset. And then there's this other kind of interesting thing that in downturns lenders that know what they're doing to lend in downturns actually become have an advantage of countercyclical because downturns' source of capital dry up. So I actually like advance rates can decrease and interest rates would go up but really who makes that loan is really really important in my opinion. So when you asked earlier that we structure things a little differently, is there's a lot of people out there in crowdfunding or marketplace lending that are going and wanting to do the deal or investment directly or make a loan directly to a borrower.
Brew Johnson: [00:27:06] You know in our opinion you know we don't want to be in the lending business and we don't want to do that because in this asset class it's such a localized business we rather rely on we would rather rely on those lenders that are track record and experience to go in the first layer to go make a loan to go underwite a loan, to go service a borrower. And so that's our idea here was like OK let's create this tech platform that that connects those local lenders to the capital markets and to investors. And by doing that and being this kind of intermediary between those, you create value for all parties. So the analogy here is really what we're trying to do is take all the positives from the securitization market that exist in regular lending you know broad diversification you know cash flow, all that stuff but apply it to this more lucrative kind of historically very fragmented market but then learn from all of the issues that created the financial crisis. You know leverage and allow investors to get invested in this asset class, access it, be able to diversify, in a way that they had never been able to do before by investing small amounts across a lot of loans as opposed to putting a lot of eggs in one basket. Right. And then and then make it a hassle free and very very transparent. So my so. So that's the idea. So we try to kind of the idea is like OK we've create a secondary market for these lenders out there. We can drive down capital for their business to go make loans for more borrowers.
Brew Johnson: [00:28:34] And then at the same time providing us this access to these investors we look at it as like a much better asset and so do you if if our opinion that's the proper way for a crowdfunding platform or a marketplace like us to invest is not to be the one out making the loans, it is to be the gatekeeper intermediary between those are the connective tissue between those groups the investor and those kind of the experts. And I actually think this is kind of similar model while we think it's more appropriate in debt because we think debt, the consistency you can apply technology a lot more consistently to debt, I think the same concept applies to equity investing in real estate and Crowdfunding. And so I think the idea there is like look at the experts of real estate are experts; they know their market. They do that. A new entrant that comes in to try to compete with existing experts doesn't make as much sense as opposed to being this this intermediary that aggregates up high quality supply curates it, and then homogenizes it for investors we think that's the proper way to attack it. So that's a fundamental difference of like how we're doing things versus most crowdfunding companies do that. Our goal is actually to be an intermediary in that because we think if we don't find value to both sides of the marketplace and reduces an adverse selection and risk for investors and things like that.
Gower: [00:29:54] So the due diligence that you conduct actually is two layered; one, you do due diligence on the lender. Presumably that's your primary due diligence. You look at their background, their experience, their track record. And then you also screen out their deals and presumably also cherry pick might be the wrong word but you pick the ones that fit your own risk profile. Right. That conform with the your 20 year downturn risk adjusted investment strategy.
Brew Johnson: [00:30:27] Yeah that's right. That's right. That's right. Cherry picking is I mean you know cherry picking. Yeah. That's right. And that's the curation aspect of it I guess is not cherry picking as much as; the goal is to serve as many high-quality assets and the highest quality amount. Right. Right. So the idea is like yeah we have our we have our underwriting kind of overlay that we lay on top of.
Gower: [00:30:49] On top of their overlay. Right so they have their own underwriting standards and then you apply another layer on top of that and whatever screens through from theirs that meets yours as well goes into your pool.
Brew Johnson: [00:31:05] Yeah that's right. And so look at a loan that like you would look at on a loan by loan basis. So our goal with this is like look at that local lender that lender the one who is making that. You're premise is exactly right. We first underwrite them, and that's the first step that is very very key and get comfortable with that sponsor effectively. Right. And a track record in the licensing and their legal and all of that. So once they're onboard them then they bring us these loans and so the idea is right. Yes. You know can you just say you've got the value of that low that local ideally local expert with track record and then we have this overlay. Now our overlay tends to be a little more conservative than if you know our underwriting guidelines like our maximum LTV is generally a little below what the overall market out there is for these loans. And at the end of the day like some local lender, like we have a max loan to value of 75 percent currently. A lot of markets people lend more in certain cases and as we grow and develop more data in terms of what we think of like our high performing borrower loans and market we will adjust that will adjust that LTV and set it up in certain cases right if it's like if it meets a fact pattern or data set that seems to be that to allow that.
Brew Johnson: [00:32:25] And then if investors had wanted more risk they can take that. At the end of the day the person who is mostly right, if one of our local lenders wants to make a loan at a 90 percent or 95 or even 100 percent LTV to a to their best borrower because they know the street they know the borrower, they are comfortable with it and things are going great. Well I think that's fine if that lender wants to take that sort of risk as they know their market really well. But for the average investor who's investing his assets from some or that's probably not the appropriate type of risk right. What was interesting about the platform itself is like we can kind of have the best of all worlds. Those local lenders can still take the risk level and we and so investors invest at a healthy deal level that we're comfortable for. They idea is like you know try to surface those what we think our higher quality assets and higher amount.
Brew Johnson: [00:33:18] This is a combination that we think is powerful. I think over time the more data you collect by analyzing what people are doing and which lenders are having great track record over you know you can then adjust the underwriting criteria to do that. But it should be data driven and it is one thing that most people don't quite understand how important the originator is, or that sponsor is in deals. I mean if you go back to the financial crisis you know if you look at like all loans originated by Wells Fargo IndyMac Washington Mutual that may have been securitized and had a very similar rating on top of them or like look very similar from a third parties view. But after the crisis the default rates on those loans were significantly different. Right. Like what. Wells Fargo outperformed those guys by a pretty significant degree. So there is this important stuff like who was actually that first kind of touch on the loan and the idea is that investors probably want not only more diversity across loans but also diversity across originator, or across the lenders who originate those because you know that potentially reduces risk.
Gower: [00:34:21] So where do you see the future for PeerStreet and for this industry all together. Right. That the real estate and what you might call crowd funding will syndicated finance and the way that regulations allowed. We are right at the beginning of the of this new industry where do you think is headed, Brew?
Brew Johnson: [00:34:41] I think it's a form of bifurcate out you know debt from equity as a starting point and sort of like let's focus on what's, let's talk about PeerStreet because I live and breathe that every day. But like right here we think like technology. I mean we our whole thesis and I truly believe that that technology is going to completely transform real estate debt and the mortgage finance system and I know that if you ask what our long term vision for the businesses we think we think PeerStreet can disrupt the entire mortgage securitization market the finance market is really that's what kind of what we look at is like OK if we're if you can connect investors more directly to loans more efficiently and they get better yields and have a better product by having more transparency and the ability to do. You know it's a fundamentally better way for investors to invest in any sort of real estate debt
Gower: [00:35:38] You're talking about market rate loans as well as hard money loans aren't you. That's a very big picture. That means that I want to go and buy a house and instead of going to the bank for my 4 percent loan I might come to somebody like PeerStreet who is able to offer competitive products. But instead of lending to me through deposits it's actually financed through your network of investors. Is that what you're talking about?
Brew Johnson: [00:36:07] Yeah. That's that. That's absolutely correct. I mean and the reason why I think that's the future and this is I mean big picture of things that I think some people like when I talk about this they look at me like I'm crazy or an alien. But if you think about they if you think about the big picture. I mean most people are saying that almost everybody has exposure to mortgages and real estate debt a traditional type mortgage debt. Right in the in the way the current system works is like a bank or something we'll make a loan. And if a bank is making a loan they're using depositors capital and they're applying leverage to it and they're making a loan for it and they make it. They make they make revenue and then they pay nothing to the depositor for it. Then that same bank sells that loan to Fannie Mae or Freddie Mac and then Freddie Mac brings in you know, spends a lot of money and creates bonds and may sell it off to financial institutions and then they create these mortgage backed securities these bonds and then that that bond, that mortgage backed security makes its way down to things like the Pimco Total Return Fund which is almost,last time I checked which is probably nine or 12 months ago was 47 percent mortgage related assets.
Brew Johnson: [00:37:15] Right. So every pension fund and bond fund is filled with mortgages right. But by the time the interest payment from a borrower goes from that borrower through to that end investor over 50 percent of the of the interest payments are stripped off to these intermediaries. Right. And so here you have this system where the average person is subsidizing the bank on the front end and then subsidizing all these like intermediaries on Wall Street and these other kind of financial firms and managers while it makes its way down to their retirement account. It's kind of perverse if you think about it from that. So like for me like going back to 2007 I would much rather have my money distributed across mortgages that I directly or almost directly owned versus having my money in a bank because banks were highly leveraged and could go out of business. So in the future I could see like you know I think in the future instead of having money actually sitting in deposit people can have money and distribute it across these loans actually earning the interest rate off of that versus that interest rate being able to go distribute it out of the intermediaries. So that's kind of the long term vision of a of a business like this.
Brew Johnson: [00:38:23] And you know we probably don't see that there's any reason why we think that can happen. Now whether somebody comes to PeerStreet directly or comes to some lender I don't know if that really matters directly I think. I think that what matters more is that if you have investment demand from investors on one side of the marketplace you can fund loans either through and through other other lenders or directly. But you can fund way more efficiently because you're not leverage that you're not putting the deposit money at risk. And so there's less there's less regulation for it. But then the other piece is interesting is that you could hypothetically price risk on a loan by loan basis much more accurately. I think that's why I think that's why by Crowdfunding and marketplace lending, however you want to describe it, has such a potential profound effect and just one little anecdote here, not to ramble, I mean definitely if you and I go into a bank to get a loan for the regular mortgage system and you go put 50 percent down and I put 20 percent down; if we go to the regular channel our interest rates are going to look very very similar. Now my guess is with your background and your history and everything you're probably a phenomenal credit.
Brew Johnson: [00:39:30] Right. And if you put a 50 percent down you should be getting a much lower interest rate than I am by putting 20 percent down. But it that doesn't work that way because of the averages which they are based on. Now the irony is there is investment demand it on the through the you know from investors for that really super like that your type of level of credit and it's at a lower rate than you know four percent of the market. So you could actually get the system I believe where like, you're not only are you giving better yields to investors better ways to borrowers. You can create a system where loans are funded really really quickly without having to go through the long onerous process. But more importantly priced accurately, so you go in if you want to get a loan, here's the interest rate you should pay if you put 10 20 30 40 50 percent down to buy a property and that interest rate should accurately reflect the risk the risk for your particular loan. So that's where we think the future goes. I think every type of will go through a platform like this because it's just more transparent, it's a it's a it's more transparent more data driven and it's better for both investors and borrowers.
Gower: [00:40:34] Well it'll be interesting to see how the industry evolves. Let me ask you a quick question actually that I've been thinking of as you've been talking. When you buy a loan and provide a secondary market to these lenders in local markets do you buy the loan with your own funds or investors funds and then backfill with crowdfunded money or do you only fund if you're able to fund it on the platform.
Brew Johnson: [00:41:01] We buy the loan and then we sell it off...
Gower: [00:41:06] And then you backfill. OK.
Brew Johnson: [00:41:08] I mean I think the goal the future would be like to to not. I mean that's just that's more a function of kind of operate. I mean in the current environment I think over time plenty more of that goes away and you just match things directly out. Currently we buy it. So there we have that we have a period where we have effectively a balance sheet and own it.
Gower: [00:41:25] Yeah. So the reason that the reason I asked that was because it sounds like when you start to scale up and do low credit risk market rate loans that you could almost create a fund. I don't know if you can do this under the JOBS Act but where you create a fund. Maybe it's a Reg A type of scenario. Actually it might be Reg A+ where you create a fund that itself, it sits there waiting for borrowers to come along and as long as it meets underwriting you can fund with that.
Brew Johnson: [00:41:54] Yeah yeah. You know that's that's funny actually. So we've had conversations internally for that because it's an interesting thing it's like short term duration there's potential for liquidity from the people. Investors have asked like who are interested in that sort of thing. So there's some potential to do that or that sort of that sort of thing as well.
Gower: [00:42:15] But on the on the same. Right. But on the same side though you also need a secondary market for your loans right because if you putting out money to market rate loans you know on a 30 year basis you know that's that's a long time to be sitting on debt even if it only has a five or six year predicted life. Nevertheless you know it's a long time on on on low interest debt.
Brew Johnson: [00:42:39] Yes you are absolutely right. I guess that's what that's that's one of the reasons that's kind of the last piece of like the ability to move into those longer dated assets like the 30s like the traditional mortgages right 30 right. There's the liquidity issue is massive there, right, like being locked up for that potentially locked up of that time. So that's a you know that's clearly not a place to start but it's a place to work towards in the future.
Gower: [00:43:01] Yeah well that's what we're talking about.
Brew Johnson: [00:43:02] Exactly. Yeah. So I think so to me like that you know the liquidity aspect of it's kind of like a future piece to solve. And so there's either right, the kind of idea on that is either you know I think in the future the reality is there's like some sort of like a platform like ours look from investors side looks more like you can invest in a fractional piece of a loan but trade in and out of it almost like the New York Stock Exchange. You know something like that I think that creating some sort of a liquidity vehicle for investors to be able to like, I think that's I think that's where the future things happen. Potentially not. But I think the other thing is like you know there could be capital markets take out like an institution.
Gower: [00:43:40] Well exactly. Exactly. It's you know securitization if your pool's big enough you can go that kind of route.
Brew Johnson: [00:43:47] Yeah. And so I think the reality is I mean like practically like the reality is is that the securitization market or capital markets take out and then in the future some sort of liquidity thing gets involved. But I I think one thing actually I should probably highlight the idea of the crowdfunding. I think a lot of people think OK this is a bunch of like mom and pops like you know small investors are investing in this but the reality is we have major institutions that invest alongside in individual investors. You know we have institutional take out from I mean mortgage REITs hedge funds. So the idea to this is that the long term goal is clearly give like any investor more direct access and allow them to do that. But you know I think that piece is interesting is that this is the type of asset that institution as well love. And I actually like most sophisticated institutions in the world are investing right alongside individuals and that's think an interesting thing that looks like you know I think we have the same idea that why have money in bank accounts because the reality is like you know it's a long term time before you get there.
Brew Johnson: [00:44:55] And a lot of investors actually rather have an institution invest their money or at least like it right now. So you know we have. And one of the names, you know one of the reasons we named it PeerStreet was the idea is like you know individuals can be peer with Goldman Sachs like the most sophisticated investor and access the same investments of the most sophisticated institutions in the world right. And the idea is like, that everybody should have access to the same type of investment. So they're leveling playing field between Main Street and Wall Street that's really been kind of like an ethos for us and like we say having institutions are important because institutions will help scale. Scale's an important thing for all investors because it means more loans means more data means more diversification. And so the idea is kind of like a lot of those investors of us side by side. We think this is important.
Gower: [00:45:44] Brew. Thank you so very much indeed for your time today. You are an absolute wealth of information.
Brew Johnson: [00:45:51] Well again I'm sorry if I you know I think you probably tell that I like I am very passionate about this. I think this is definitely the future of investing and I think that the future of real estate and I think and I think why it's so powerful that I think it provides a better investments for investors but also provides better and more efficient capital the to borrowers plus real estate sponsors. I clearly think it's the future.
Crowd Fund Capital Advisors Group
Crowdfund Capital Advisors was born with two entrepreneurs, Sherwood Neiss and Jason Best, who, after the market crashed, felt that businesses were really having a tough time raising capital and, having gone through trying to find capital themselves for their own different entities, realized that there had to be a better way to capitalize businesses. Once the JOBS Act was passed, and while it was wending its way through SEC processes, the principals visited and advised entities in over 41 countries on how to develop meaningful legislation and ecosystems that support the financial growth of their own entrepreneurs.
Crowdfunding is actually a way to do something that that has been done forever: It is nothing more than thinking about passing the church hat except that it comes in many forms. It can be through the form of a donation like passing the church hat, it can come in the form of a rewards based prize, or, as in the case of real estate, is can be that you receive a share of something in return for the money that you give. Until the JOBS Act, unaccredited investors, those that did not have high net worth, were not able to access the kinds of deals that typically high net worth individuals were able to. It opened up a pathway for both equity and debt investing, that was not available to the common person.
But what crowdfunding really needs is education because so many people out there think that it is as simple as putting your deal up online and the money will start pouring in, but it is far more complicated and involved than that. Growth of the industry has been steady, which is good because steady healthy growth is a recipe for success. Speeding bullets are a recipe for fraud.
The Funding Portals
To be able to raise Reg CF (Regulation Crowd Funding) money, you must do it through an SEC registered funding portal. The SEC wants to make sure that there is complete transparency and that everything is disclosed to the investing public. It does not take that much time to get to market, depending on which crowdfunding methodology you use, but timing is not the key issue, marketing is, and you have to have probably 30 or 40 percent of your proposed raise earmarked before hitting the market. If you do not know precisely where that part of your capital is going to come from before launching, your campaign is likely going to flop. Even then, you will be raising a lot of money, in smaller amounts from more people than you are used to. To be able to do that and to have people you do not know or who are once removed from who you do know requires a lot more effort before you ever get started.
Establishing a Relationship With Investors is Key
Lisa’s role is to help companies understand these factors and she has, unfortunately, seen very successful real estate brokers and agents, investors and borrowers, go out onto sites, plonk down their hard-earned money, spend fifteen or twenty thousand dollars, who have done real estate deals all day long and screw it all up because they do not understand some basic principles. Going to the same old people that they have previously gone to may or may not work because they may not be interested in sharing the deal with a variety of unaccredited and unknown investors. Think of it this way: If you have a close relationship with somebody that you have in the past raised money from for a real estate deal and then suddenly you try and put the next deal up on line you are going to be distancing yourself from them in some way. Crowdfunding a deal means you are approaching a different market that requires a different approach.
Not only do prior investors need to be acclimatized to the new methodology, but the entire process needs to start way earlier before you ever worry about the portal. This means developing a sophisticated social media presence, promoting your project by through podcasts or live Facebook video, through networking. In short, it involves ensuring that you are out in front of the right people long before you ever need the money in advance, creating a relationship with an audience of people who don't know you and who you don't know. And from who you are about to ask for money.
From the investor perspective, you must do your homework on a deal before investing. You have to thoroughly read the prospectuses, thoroughly read the offering, and have all of your questions answered before signing the check. Investing is a risk, and you can lose all of your money.
Confluence of Three Industries
Crowd funding real estate platforms have to be experts in three industries: They have to function within a strictly regulated framework; they have to be expert in tech and online marketing (not trivial), and, last but not least, they have to be real estate experts. That said, crowdfunding is a modern solution to an old technique that increasingly our world has forgotten which is sharing your knowledge and investing in our community and partnering with people who you know and with their friends.
Regulation CF – Crowd Fund
To issue an offering under Regulation CF, a developer has to work through a portal registered with the SEC, and can decided whether or not they will accept the developer’s deal [Subscribe to the podcast at www.nreforum.org so that you do not miss my guest Eve Picker, Founder and CEO. Eve owns the SmallChange portal, which is of one of the only registered portals doing Reg CF for real estate deals]. Portals charge various levels of fees, all regulated. A lot of times people think that a portal will bring them the investors which they may not. So far, Lisa says, the data has proven that investors typically will invest in a deal or two in a space or a project or that they know really well, and then they will not invest again. Consequently, assuming that the portal will bring you investors, while true, is not the beginning and end of the process of raising capital. You still have to do your own marketing.
Lisa wears another hat. Over the last few years she has been very focused on trying to create jobs and finds that the music industry needs more of them too. Consequently, she has been developing musicians into consultants to sell clarinets – the sales model is very flat with Amazon. Her website is https://www.lisasclarinetshop.com/ and she is working with a few different manufacturers to sell direct manufacture to consumer really high-quality instruments. Check it out and I hope you enjoy the sounds of Lisa playing in today’s episode.
The First Mini IPO and Regulation A+ Origins
It was from a background of being a real estate sponsor, being an operator and having to raise money that the idea of Fundrise was born. Prior to the 2007/2008 downturn, Miller was raising capital from private equity and insurance fund partners, and in 2008 one of his big financial partners, with some $250 billion in assets, went bankrupt. Coming out of the 2008 recession feeling like there had to be a better way, Miller founded Fundrise with the idea that utilizing JOBS Act Regulations he could raise capital online and not be dependent on the institutional players.
Miller’s work, however, and insights to why this methodology could be effective predates the JOBS Act by two years. Together with his partners, he conceived of the idea of raising equity capital online as early as September 2010 and first approached the SEC in 2011 to propose that they permit it.
Before Regulation A was reformed to become Regulation A+, Miller worked with a former general counsel the SEC to figure out a way of raising money for a real estate deal at $100 a share; a process which paved the way to informing the SEC that the idea generally it worked. Initially, it was very difficult to navigate through the SEC because, while these things are now taken for granted, they had not previously been contemplated. Questions that had to be answered included, how does somebody buy a security online, what forms do they fill out, how is SEC staff expected to oversee the applications, what kind of language has to be used? Working with the SEC to take, what was effectively the first online deal through the system, Miller and his team created the initial protocols for what was eventually to become Regulation A+.
It was a painfully slow process and essentially the deal was like a mini-IPO . They raised $320,000 at $100 a share a year and it took us almost two years to put all the components together. In the beginning it was very intensive and slow going but in time they were able to spin it off and scale it, and eventually it became Fundrise – the first company in the industry to be a real estate Crowdfunding platform.
Miller’s team concluded just one deal in two years working with the SEC – and this was after they had already bought the real estate. But the deal they worked on was just five six blocks from the SEC's headquarters. The helped, not only the process in some way, but by making it easy for SEC staff to actually see the deal first hand, they became intimately familiar with the concept as a tangible case study. Consequently, the issues were real and immediately apparent to all and this helped to illustrate the concept and flesh out the solutions.
While the first deal took nearly two years to complete, now Fundrise is trying to close a real estate deal a week. Scaling became possible because Congress and the SEC and the President [Obama] recognized this as an opportunity to innovate. And they did. That said, the JOBS Act was oriented primarily to tech companies and the benefits that have accrued to real estate have been, in a way, accidental yet becoming increasingly influential.
Why CrowdFunding Real Estate Works
Looking back at e-Commerce in 1999 everybody thought it was going to change the world and then, when it blew up in the early 2000’s everybody came to think it was overblown and not likely to do anything, or have any kind of major impact on the economy or society. The same is likely true of the crowdfunding space; in the beginning it is having this tremendous impact on the way deals are being financed and, those getting involved are evangelizing future transformational changes. The next downturn will cause people to turn off the idea, and then it will re-emerge to dominate how capital is formed in real estate.
It is similar to the way that people thought about e-commerce in 2001 when the bubble burst. The market predicted that Amazon could not have that big an impact and their shares dropped 94 percent to around $7 a share – trading today at over $1,000 a share. What makes the impact of crowdfunding so difficult to contemplate, is that lots of things, especially in the modern era where you have technology in particular, are non-linear. That is the nature of a lot of technology. People tend to underestimate growth rates and the growth in crowdfunding will likely surprise everybody. Looking out 20 years, it is not inconceivable that all fund raising, all investing, will be, in a way, a form of crowdfunding.
Fundrise has taken to aggregating deals and offering different return profiles and different risk profiles to investors through debt platforms with different characteristics, rather than offering individual equity deals, one by one. In Miller’s eyes, equity investments do not make sense unless you are in a pool vehicle. Investing in a single deal, say an office building, and crowdfunding it is a disaster waiting to happen. In every deal Miller has been involved in – and this is commonplace across the real estate industry – there is always the need for more capital than originally budgeted. In each case, Miller has made zero percent loans personally. Once you pool these kinds of deals, there are more sources of capital, more diversification, and better cash flow streams. In short, in a pool there are more ways that you know you can borrow against it if need be.
The Liquidity Premium
But buying into a REIT is not a prudent move for most investors interested in diversifying into real estate. A share of a public REIT is really just a piece of paper that is a secondary trade. The derivative that is a public REIT is so separate, so different, from the real estate itself it that it does not act like the same asset. In fact, buying a public REIT, the investor is paying t has at least a 20 to 30 percent premium. Consider this: In a public context, buying into a public REIT, you are getting daily liquidity, a wholly liquid asset. That liquidity is not free. The building underpinning the share in the REIT is not liquid. It is not possible to pay the same price for a building that is illiquid and a piece of paper that is liquid. What do investors pay to make an illiquid asset, liquid? Whatever that is is the liquidity premium. The transaction costs on a piece of paper is almost zero, but the cost to sell a building is much higher than the cost to sell a piece of paper. This begs the question, if you are going to buy something and hold it for in retirement or for 5, 7 years i.e. if you are a buy and hold investor, why buy a REIT and pay a liquidity premium for something you have no need for liquidity on?
Eliminating the Liquidity Premium on Fundrise
If you invest a dollar on the Fundrise platform, that dollar goes directly into buying a property. Because Fundrise is closing on real estate transactions on a continuous basis, the process is happening very close to real time. Investors demand certain return profiles, and so Fundrise creates buckets of deals that match the profiles investors are looking for. Ninety nine percent of the population do not know whether, in any particular deal, they would be better off doing mezzanine as an investment in, say, a particular apartment deal, or JV equity, or a whole loan doing 100 percent of stack. What is the right way to do it in this deal in this geography with this real estate operating partner? Fundrise makes these calls navigating based on investor goals.
Quicker to Raise Capital
Prior to the JOBS Act, if you wanted to raise capital, you had to go have coffee and lunch and meetings to raise the money, and to go on a road show for your institutional investors. Or you could go to the country club. A lot of time spent for a normal developer would be consumed just raising capital and it could take on average 15 months to raise a fund.
At Fundrise they do it in days.
Fundrise is Not Institutional
Although Fundrise is beginning to act as institutional investors or private equity funds, they are more efficient because they are acting online with tens of thousands of investors rather than over lunch and golf. And there is also a cultural difference. Generally the financial industry maintains margins. There is not a culture of competing to lower fees among financial industry players. Instead, while fees have remained constant for decades, more or less, an issuer will be sold on other benefits.
That is not the culture of tech where there is a relentless drive for change. They are not motivated to because their institutional clients don't necessarily find it attractive.
The Fundrise Model
The company takes a 0.85 percent as a management fee, instead of 1.5% to 2% as is typical with a private equity fund. They also take an origination fee of 1% to 2% on the close, which is amortized over the normal life of the deal, say five years. So Fundrise’s total fees total around 1.25% a year, which is a flat fee. And they take no carried interest.
Carried interest, Miller says, is an incentive for developers to invest recklessly. The ‘natural’ rate of return on real estate is around 12%, but carried interest structures typically require far higher returns for everyone to be incentivized through their carried interests. In these structures, developers are like a car with only an accelerator because they have such an asymmetric reward system. You have to recognize that even the best of developers will behave in ways that they really should not if it were not for the incentives. And that is why this system blows up.
Fundrise as a Technology Solution
Fundrise basically functions as a marketplace where investors and developers come together to transact. The platform maintains a minimum level of quality where they do not pick winners or losers. That said, unlike the straight venture capital approach which is solely looking for patterns to disrupt, Fundrise has to blend these ideas, as a tech company, with expertise in real estate. In Miller’s words, Fundrise is both a tech company and a real estate company, it has ‘to have a spliced DNA.’
The Next Real Estate Downturn.
Most platforms will blow up unfortunately and Miller worries about how to protect his platform and their investors every day. During the next recession there will be a wave of opinion that the real estate crowdfunding idea categorically did not work. And then there will be a few models, a few companies, that will emerge from it proving that it did work. And by that point the industry will probably be 10 years old, with a billion of equity and three billion in real estate or more and will, basically, be institutional.
And that's when things will really get interesting.
THE JOBS ACT
The JOBS Act – Jump Start Our Business Startups – was passed in April 2012 but it was not until March of 2015 that Title IV Regulation A+ was announced. The intention of the Act was to make it easier for small companies to raise capital. The first effective component of the Act was Title II which went effective in September of 2013, extending Regulation D to allow companies to market themselves to raise money from accredited investors via the internet. The biggest change under Regulation D was that it allowed for public solicitation, whereas before only solicitation from investors with a pre-existing relationship with the sponsor was permitted.
There are some nuances in Reg D that restrict the number of accredited investors depending on the specifics of the structure and approach that a company is taking. A borrower can market an offering broadly on the Internet but can only accept investments from accredited investors. The thing that 506 (C) requires though is that the issuer, the company raising money, must take reasonable steps to verify that the investors are in fact accredited. You cannot take their word for it. In 506 B, the pre-JOBS Act version, borrowers were limited to soliciting from people they knew but there was no accreditation verification requirement. If they say they're accredited that's enough. An investor would have to sign off on it, but that was enough.
Reg A+ took the old Reg A and expanded upon it dramatically. That little plus sign kind of understates how much it changed. With Reg A+ private, companies can raise money privately and raise up to $50 million a year and in some cases, more specifically in real estate cases, more by doing multiple offerings simultaneously for different geographies.
There are two types of Reg A+ offering: Tier 1 and Tier 2. A major issue is that investments can be accepted from investors worldwide at any wealth level. They do not have to be accredited anymore. And when they state their income and net worth, and whether they are accredited or not, the company selling the stock is allowed to take their word for it. They don't have to prove what the investor states.
Investors anywhere in the world can be accepted at any wealth level into a Regulation A+ and the SEC considers the shares sold through the offering to be liquid for the purchasers of them. If the company doesn't lock the shares then the shares can be traded someplace depending on whether the company lists, where it lists, or whether it provides some other form of liquidity. Options for listing include one of the OTC markets like the QB or the OTCQ or the OTCQX. These come with reporting requirements that are considerably less onerous than listing on the Nasdaq. The issuer can also retain the option of not listing at all or even locking the shares and then providing a redemption system. This has been done by some real estate companies raising money using Reg A+.
COSTS ASSOCIATED WITH A REG A+ OFFERING
An attorney providing the legal services required will charge $50,000 and up depending on the complexity of the offering. That is a front-loaded cost. In addition to this, there are marketing preparation expenses, and if it is a Tier 2 offering, the issuer will need to have an audit that goes back as long as the company has existed or two years. So those are the downsides: upfront cost and it is not a certainty that you will be able to raise the money which is basically true in any kind of capital raise. There are no guarantees.
REAL ESTATE A MAJOR USER OF REG A+
Real estate has become a very large segment of Title 2 capital raises. This is probably because investors understand the nature of real estate. Many investors would like to own more real estate but do not have the time or enough capital set aside to do so. Many of the real estate offerings already issued are paying a reasonable dividend rate or a preferred return which is also very appealing in today's low interest environment. Another reason real estate has taken off in Reg A+ offerings is that in regular business offerings under the Act, it is hard to get investors to pay attention unless they absolutely love a company. In the case of real estate, the industry has a critical mass where regular investors feel comfortable with the asset class and so more inclined to invest.
Reg A+ is not for a sole developer who has a deal in town that needs money for it; it is for established, experienced teams that have a track record and that can demonstrate that not only to the market but also to investors, platforms, marketplaces, and broker dealers.
MARKETPLACE UTILIZATION OF REG A+
The marketplace platform, Fundrise, [subscribe to the Podcast to hear Ben Miller next week, Founder and CEO of Fundrise as my guest speaker] is using a Reg A+ as a completely central part of that platform. They have three parallel Reg A+ offerings going on simultaneously because if you can divide territorially like that, and Fundrise has divided the US into three geographic regions, you can raise money simultaneously for each one, raising up to $150 million per 12 month period.
OPTIONS FOR DEVELOPERS RAISING CAPITAL
THE CROWD AS INVESTOR; THE CROWD AS WATCHDOG
Typically, term structures in a Reg A+ offering will resemble those traditionally offered to friends and family, or to private equity, but economic terms may change as will certain key decision-making rights. In a Reg A+ offering, for example, there is no requirements that issuers have skin in the game. In pre-JOBS Act times this was also true, but investors typically expected it of the developer. In the current environment with relatively unsophisticated investors entering the market – no matter how the SEC defines ‘sophisticated’ – sponsors are listing deals where they have no risk equity of their own. Other terms highly favorable to the sponsor are commonplace so it is very important to be watchful of the fine print.
One of the big concerns about the JOBS Act from before the get-go was that there would be rampant fraud. Countering this concern is the idea that the online offering model is so transparent and so public that the likelihood of this is mitigated. When you have thousands of people examining an offering and examining the social media profiles of the principals on the transaction, word will spread quickly if something is skewwhiff. It is like having surveillance cameras in a neighborhood. It puts thieves off because they would rather go somewhere else where they will not be recorded in a similar way. That said, while the transparent access we have through online funding platforms is really good, the crowd will act as a crowd, and people tend to go with the herd, believing that if everyone else is doing it, it must be OK. And sometimes that can lead off a cliff.
INVEST LIKE AN INSTITUTION – BUT THESE ARE NOT INSTITUTIONAL DEALS
Institutional investors take a very detailed look at a sponsor and their capabilities and add multiple layers of not only due diligence but also management oversight on top of that, on an on an ongoing, real time basis for any sponsor. In Reg A these layer has been removed. Now investors are investing directly in the developer itself and so although small investors now have opportunities to invest where before they could not, they also do not have the same skillset that an institutional investor would have.
While it is true that the SEC goes through these offerings with a fine tooth comb to make sure that they are real, that the companies are real and that they are legitimate, it does not validate the merit of an investment in any way. If there's a broker dealer on an offering, or an online marketplace is making the offering, especially a platform which has a good reputation, then maybe this adds some credibility to the offering.
Bottom line: Do not invest anything that you cannot afford to lose.
Regulation CF – Crowd Fund
Reg CF is also known as Title III and is the most recent of these significant JOBS Act announcements. It went effective in June 2016 and is geared to raising capital of sub-$1 million from non-accredited investors. Reg CF issues are made through SEC approved portals that collect fees under various highly regulated formulae. The issuer must undergo background checks via the portal, and submit GAAP level annual audits; a more stringent standard than otherwise might be usual.
[Coming Soon: Listen to the National Real Estate Forum trifecta podcasts – Reg CF Portal Small Change CEO, Eve Picker, a sponsor on her site Jonathan Tate, and an exclusive interview on the Forum, the first ever CF investor Bill Bedell. Coming up soon. Don’t miss it; subscribe now on any one of these platforms]
Manhattan Street Capital
Manhattan Street Capital is essentially two things in one. The company focuses primarily on Reg A+ offerings but will do select Reg D offerings where they feel they can add value. They are also a platform which enables companies to more easily raise money through using advanced technology. The company accepts crypto-currencies as investment methods. This expands the ease with which international investors can participate in a Reg A+ offering. The company is essentially a concierge service where they introduce clients to all the different service providers needed, in order to get an offering out to market.
Crowdfunding is sort of a misnomer. It describes a format by which investors can pool money with other investors and that capital can then be put to work in a group method to take down larger assets than the individuals alone could manage. The concept is better described as a private, technology enabled marketplace and almost like a wealth management platform
RealtyShares specifically is geared towards a high net worth investors and institutions. The company has changed the medium that capital uses to access deal flow from the old family-and-friends sourcing methodology – and that medium is the Web.
Investors, who historically may have had no access to real estate or limited access, now have access to a much broader set of deals located across different markets, different product types, different operators. These marketplaces are accessible for both investors to deploy capital across a broad diversified set of deals as well, as developers to raise capital at record speed through a network of investors they otherwise would not have had access to.
It used to be that either you knew somebody that was doing a deal, or maybe you might have gone to a local mortgage guy to find deals to invest in. Now we have basically taken this process and put it on the web. Before, an investor would have been compelled to put $100,000 to work in a single asset, single market, single operator with a lot of concentrated risk. And this presumes that the investor actually had the personal network to actually know an operator.
Now, with the Web, the investor can take that same 100,000, and with RealtyShares’ minimums being as little as $5,000, put it across a much broader diversified pool of assets.
One thing that is a little unfortunate in real estate is that there is traditionally very little transparency. An investor investing in a country club deal is being charged certain fees to the project that they are investing in. They do not know if they are getting a good deal, a bad deal, what's market what's not market. Online this changes because investors can now see multiple deals alongside each other and compare relative fees. Indeed, RealtyShares has standardized the fees sponsors can charge, and have transparently disclosed those fees and structures to investors.
On the RealtyShares platform, developers go through an online digital application process to request financing – for both debt and equity, which sets RealtyShares apart in the market. Once a developer is prequalified as being eligible for financing they undergo a 20-point underwriting system. This involves data collection on the deal, a financial model, an appraisal if applicable, an environmental report and due diligence on the sponsor. Once the sponsor’s track record has been verified and market and deal numbers crunched, RealtyShares determines if, from a risk adjusted return perspective, it fits the marketplace and the appetite of the marketplace.
RealtyShares only select about 10 percent of deals that come to the marketplace. They seek best in class operators. Sometimes this might be a first-time operator who has done transactions a principal investor or to a larger shop and now who are now breaking away. Typically, underwriting standards require seven years’ minimum, although many have twenty years’ experience.
Deal preferences are for value add in core plus deals with the potential to generate yield quickly if not immediately, and in high growth primary or secondary markets. Tertiary markets are not liked as RealtyShares looks to certain population minimums and employment growth numbers to mitigage potential loss scenarios. So far, 80% of transactions have been in the multi-family sector and 20% have been across different commercial assets including hotel, retail, suburban, office, industrial, and self-storage.
Investors today are yield oriented. This is driven primarily because they are not getting yield anywhere else, not from the stock market, not getting it from the bond market, and certainly not getting it from bank deposits. On the RealtyShares platform, cash on cash returns are typically six to seven percent or higher, and on an IRR basis it can be kind of mid-teens.
To satisfy investor preference for yield, most RealtyShare deals are existing assets with in place cash flow, or fully entitled construction deals where prefs can be paid current, at least in part, and time to market is not going to be delayed by planning issues.
Deals are stress tested to determine what would happen if there was a drop in NOI, or increase in vacancy and a resulting drop in NOI, and benchmarked against the ability to meet debt service coverage. While there are no guarantees, these measures serve to mitigate the risk of technical default in the event that there is a market correction. The platform also ameliorates risk by offering one of the most diverse online marketplaces for real estate Investing, providing debt and equity options, and deals across both commercial and residential multifamily classes.
POST CLOSE ROLE
RealtyShares is a full cycle investment platform. Investors can monitor the performance of their deal portfolio via a dashboard where they can see how rehab is going, get earnings updates, updates on the asset, and robust quarterly updates directly from the developer. Tax and legal documents also are all available through the dashboard.
The platform actively tracks how deals are performing relative to budget and pro forma. The data this kind of analytics produces is valuable because it provides real time feedback on individual markets and asset classes which help with underwriting future deals.
In the event a debt deal goes bad, RealtyShares retains foreclosure or a deed in lieu rights. For equity deals, investors can select from preferred and common equity, there are triggering events like defaults or a failure to pay that will allow RealtyShares to take over the underlying entity. For common equity there is typically a management replacement right built in.
Being a tech company, not a real estate private equity company, RealtyShares does use third party vendors to do workouts when needed. Using third party vendors for these kinds of functions allows the platform to focus on their core strength which is really sourcing deals, underwriting deals and providing a very efficient marketplace to deploy capital in those deals.
The real estate crowd funding industry needs to better educate investors and developers like around what this is and how it actually creates value for both. This is a very nascent market and the concept of online capital formation and investing for real estate is novel to most people.
LONG TERM VIEW
Ultimtaely, Athwal is aiming to build a wealth management platform; an online wealth management platform or digital wealth management platform for the private real estate market. Part of that thesis is in giving investors options to invest in different types of vehicles. This might be through direct access to deals and the ability to pick the exact asset, the exact zip code, the exact sponsor, an investor wants to work with, but also through creating a programmatic access to deal flow through development of an index fund. In this case, instead of having to invest in every individual deal investors can get exposure to a diverse set of deals set by the platform. Strategies might include income or growth, debt versus equity. Ultimately the company’s vision and goal is to provide diversified vehicles for investors to get exposure to different types of investment options and the fund structure is just one kind of part of that evolution.
REAL ESTATE AS ALTERNATIVE TO STOCKS AND BONDS
One of the vision elements of RealtyShares is to build a global stock market for real estate: To put real estate as an asset class on even footing with stocks and bonds. Athwal is committed to bringing more transparency and trust in, and standardization and liquidity to, real estate. A key component in this will be creating a market for third party validation of deals and platforms that does not exist today in private real estate. There is still a lot to do to bring the level of analysis seen in other publicly traded securities like stocks and bonds and third-party validation is just one of those elements.
Professor Syverson looks at what has been going on in retail over the past decade or two. He discovers that, while a lot of the mind share in the industry is focused on the effect of e-retail, more important than e-retail is the rise of the warehouse club and super center format size. While e-retail has, of course, had a great impact on retail, on several dimensions the warehouse club and super center has even more so moved the needle on the way that retail looks, and how stores are configured, since the year 2000.
Economists are reluctant to make predictions, not exactly having a stellar reputation for predicting the future. But having some fun with the data, Syverson looked at the penetration of e-retailing and in various product categories and projected them out into the future. Some that you wouldn't be surprised about are essentially dominated or close to dominated by e-retailing. But some, drugs, health, and beauty, and food and beverages are two that are not. These are both massively large sectors in terms of their share of retail sales – somewhere in the neighborhood of $400 billion dollars of sales for drugs, health, and $700 billion for food and beverages in the U.S. And in both of these sectors there is still a huge chunk of retail sales – there is very little relative penetration of e-commerce in either of those two sectors.
Some factors like regulatory restrictions on prescription drugs distribution is going to set limitations. However, for the typical CVS or Walgreens in terms of revenue share, things that aren't prescription pharma is still a significant proportion for those stores. So while there remains a continuation of the development of bricks and mortar building activity going on, to some the bulk of the warehouse club and Supercenter build out has happened already – and consequently you might expect that to slow down and for e-commerce to pick up some.
Given enough time, there is likely to be the full penetration of e-commerce, with some upper bound, for example in prescription drugs that might never become fully e-commerce, and there might be other reasons in other product classes where it is never going to get to one hundred percent. The predictions in the paper are, therefore, quite bold in saying that various categories could possibly even get to ninety, ninety-five, or one hundred percent.
WHEN EVEN BIG BOXES VANISH, WILL WE THE CROWD BE FINANCING THE LOCAL NICHE STORE?
In the long run, e-commerce will likely replace the base currently supplied by a lot of the big boxes, and what will be left will be a throwback to the small niche type retail operations that used to be the typical thing several decades ago. To survive in a retail world where most retail is e-commerce stores are going to have to be specialized in something obviously that e-commerce cannot deliver. It will either be some particular product category that has attributes that do not work well with e-commerce, perhaps something where tactility is hugely important and where the customer actually needs to hold the thing in their hand or look at it physically before they are willing to purchase. Or maybe it is simply this need for personal service from someone you know, where not only do you want a salesperson there to walk you through how the product works, but also because you simply want to support their business. Maybe you invested $1,000 in the business directly; maybe you invested $10,000 in building the store is situated in.
And the future of the high street? Retail will be dominated by small, niche shops that provide a social and highly localized service or product. This requires that demand will be sufficient to support the local niche store once again as it did in the past. But how will this be financed; how will these kinds of stores, or the developers that build the buildings in which the reside, finance their existence? Well, that is precisely where crowd funded real estate will facilitate this change. Real estate is fundamentally a local phenomenon. The reason we have the large box stores and chains is because institutional underwriting likes the copy and paste efficiencies of scale. Not so the crowd. The crowd as a gathering of neighbors wants to support itself, locally and financially, and it is the crowd that will fund the next generation of retail – the small, niche, local product, owned by people who live locally and who support their community by sitting on local associations and councils. As institutional capital has institutionalized our lives in every aspect, it will be we the people, we the crowd that will fund the next generation of retail. And it will look a lot like it did a generation or two ago when you knew the shopkeeper and patronized the store because her kids went to the same school as do yours.
COMMISSIONS AND STEERING: THE AGENCY PROBLEM AND INEVITABILITY OF DISRUPTION
Today’s podcast was a discussion about three papers, all of which can be found in the shownotes for today’s episode. The papers illustrate another facet of the principal agent conflict that I have been covering in this series 1 of the National Real Estate Forum dot org podcast series. The issues that presented themselves in today’s episode are as follows.
Non-discount brokers steer clients away from listings that have lower commissions or that are presented by discount brokers. This conflict may be eroded as the availability of information becomes more ubiquitous and buyers insist on seeing all listed properties irrespective of commission factors.
Steering also occurs at the company level; maybe not as a course of policy, but certainly as a matter of fact. Education and ethics training at the industry or regulatory level does not influence this kind of steering. The responsibility lies, therefore, at the company level.
Agent productivity varies depending on level of experience, but reputation is the driving force behind how individuals and companies behave. But how reputation measured? A seller cannot know that an agent sold their house for less than they could have sold it for had they worked a little harder, for a little longer. This might not be relevant, however, if the experience was positive to the Seller, that might be a sufficient factor driving their satisfaction and hence in the way they project the agent’s reputation to the market.
This does not tally, however, with the fact that in Europe and other markets where commission rates are significantly lower than they are in the United States, presumably there are similar levels of consumer satisfaction as there are in the States. Something is artificially supporting these higher commission rates and one indicator of this is the behavior of agents as the market ebbs and flows. As the market strengthens, there is an influx of new agents to the market because the barriers to entry are low. As supply (of agents) goes up, why is it that price (commission) does not go down? In any normal economic model this is what you would see.
What actually happens is that commission rates remains static and sales volume for experienced brokers is negatively impacted as novices enter the market and capture market share. The consumer, of course, does not benefit but is a passive spectator to increasingly frenzied competition between brokers without any resulting reduction in commission rates and, hence, sales prices of homes.
As technology bridges the information asymmetry between buyers and agents conflict issues will become eroded because buyers will start to circumvent agents and go to sites such as Zillow where they can view homes and make offers all on the same platform without the need for an agent at all.
CROWD FUND TEASER
Gower: The JOBS Act changed regulations enabling crowdsourcing sites to emerge to finance real estate deals. These sites are intermediaries that go out and find developers who want finance for deals. They search for local sponsors, on the other hand, and at the same time they advertise to Joe Public that for the first time in history you are going to be able to invest an amount that you can afford to lose in a deal that previously only institutional investors would have had access to.
So if you are a professional without enough capital to do bigger deals yourself, or simply were not in the network of the guys doing the deals, and you want to buy a hotel at the airport until the JOBS Act you just could not. But now because we are able to crowd fund these things if you've got $25,000 or even $5,000 or even less, you can actually invest in that hotel and get the same kind of returns as the institutional investor.
Wentland: Absolutely. And it is better known outside of real estate where you are basically opening up your business opportunity for anybody to invest in however small. And so you can imagine that this could just be a natural analog here where you have this kind of financing set up where you could buy a piece of development in the same ways you could buy a piece of Apple or Google, whether it's an equity stake or whether it's a debt stake in a bond market. In effect it sounds like a similar thing, as you know, these new forms of public offerings are revolutionizing the way deals are financed. You open up this whole new stream of financing to the public in a way that just really changes everything.
Gower: Yes but… look at how banks behaved in the early part of the 20th century; an era during which, incidentally, income tax was considered unconstitutional. The financiers of the day made huge amounts of money and paid no income tax. They became known as the Robber Barons. The one thing to watch for today is, and I don't want to be too glib about this, is what happened in the early 20th century could happen again here and it will be the fool who will be hurt at the end of the day.
In the early parts of the 20th century regulations had absolutely no requirement for any kind of corporate disclosure. Banks could issue a stock or a bond and you would know nothing about it. Nothing. And one of the primary reasons people invested was the reputation of the intermediary – the banker who sat between them and the issuer. This was the key factor because you had nothing else to rely upon. So if it was a reputable bank like J.P. Morgan or Kuhn Loeb, who became Lehman Brothers, people would invest. But there was zero disclosure. And then of course, as you know, a lot of power ended up in a few people's hands, and the so-called ‘money trust’ was broken up and eventually disclosure requirements were brought into law to protect the public.
Well hey guess what; the current state of the crowdfunded real estate environment requires no disclosures at all. The intermediary has to disclose nothing material about the deals or their own performance. How do you know what they are doing? They sit in the middle. They take a commission and it's up to you to do your own due diligence. So at the end of the day my suspicion is that we will see this industry flushed out big time and a lot of pain during the next downturn.
Wentland: That's fascinating. I think for the reasons that you just stated I recall reading something that Adam Smith in The Wealth of Nations had predicted; that the joint stock company wasn't really going to amount to much because of exactly the kinds of reasons that you are just talking about. Because in those days there was little disclosure and it was very much buyer beware and people didn't really know much about what they were investing in. And there had to be a lot of trust in who you were investing in. And that was more or less what it was based on. And then, as a result, you know the folks who are managing and running it have all these perverse incentives. And so you can imagine there's going to be some ups and downs with it. But my prediction would is probably somewhat similar to yours. There might be a sort of gold rush mentality at first and then it'll get pulled back because people will lose a lot of money and then and then there'll be some reforms to it and tweaking with it and then it will evolve.
The finding that agents sell their homes for more than they do when they sell for clients has been established in multiple studies. While it may not be entirely surprising to see a professional outperform in their own industry, the issue for agents is the fiduciary responsibility that they owe to their clients to act in their best interest. If agents are performing better on their own account than they are when acting for themselves, there appears to be an inherent conflict of interest when representing clients.
The study being discussed in today’s podcast examines the ability of agents to negotiate when buying a home, rather than when selling their own home. When selling their own home, the agent is control of the process, but when buying they are competing against the entire corpus of other agents. If agents are truly representing themselves with greater discipline than they do when they represent their clients, we would expect them to perform better when buying for their own account and, indeed, this is what is found in this study.
Taking the examination of this issue beyond simply the role of the agent and looking also at how other actors in the real estate market perform, such as companies, or trusts, or the government for example, it is found that while agents outperform when acting on their own behalf, companies demonstrate even stronger bargaining skills than the individual agents.
Approaching the problem from a different angle and applying an additional layer of statistical analysis to around 200,000 home sale transactions in Dallas from 2002 to 2013, the study adds a degree of refinement to this idea that agents have unique expertise that is not shared when applied to their clients. Specifically, agents sell their homes for 1.7% more than they do when selling for their clients and also buy for a 1.7% discount relative to how they perform when representing clients. This equates to an overall bargaining advantage of 3.4% that they use on their own account but not for clients.
The study also found that companies, when acting to buy or to sell, outperform agents by about 3.4% on both the buy and the sell side for a total bargaining advantage of 6.8% over agents. Companies are tending to purchase properties that are lower priced, however, than the average purchased by individuals or by agents.
That said, those agents that have extensive experience in a market and are highly knowledgeable about a specific market can and do bring value to clients. They might notice an error in a listing that can bring tremendous value to a client, such as seeing a basement wrongly categorized, or the total square footage of a property incorrectly calculated. These errors might only be picked up by an agent with the expertise to recognize them and in those circumstances, they may justify a higher share of their commission. That said, for every error picked up by an experienced agent and passed on in savings to a client, there is a seller who was badly represented and who lost money as a result of an agent getting a fundamental fact wrong on the listing.
Dr. Wentland is a senior economist at the Bureau of Economic Analysis (BEA), a division of the Department of Commerce, a federal government agency. The BEA produces statistics about the performance of the U.S. economy that are closely watched and influences decisions by government, businesses, and the public. The opinions expressed in today’s podcast and in these shownotes are his own and do not reflect those of the federal government.
THREE PRACTICAL OUTCOMES
In introducing today’s podcast, here are three practical lessons for homeowners looking to sell their home.
DON'T BURDEN YOUR AGENT
It is intuitive to expect that by hiring an agent across town that it may be particularly burdensome for that agent to conduct open houses or to do private showings. The inconvenience of travelling adds to the transactional cost to that agent and so their incentive to market your home is reduced. Dr. Wentland’s research shows that the impact of this is to extend the amount of time it might take to sell your home, or even reduce the chance of selling at all.
In a separate study, using data on homes sales in Virginia between 1998 and 2010, it was found that agents who sell their own homes sell for around 4% more than they do when they sell their clients’ homes. This is consistent with the findings in the study conducted by Chad Syverson and Steve Levitt of Freakonomics fame, and contained in NREF podcast #22. The study went on to examine how to mitigate this breakdown in fiduciary responsibility of the agent to the client and found that working with the principal broker in an agency, and not with an agent, could help resolve this problem.
Not unsurprising, perhaps, is that the driving force behind this discovery is the matter of incentives – principal brokers who own or co-own their agencies are more likely to market a client’s home as they would their own. Their incentive to preserve their reputation, and by extension that of their agency, is enhanced because their compensation is dependent not only on their own performance, but on that of their hired agents also.
EDUCATION & TRAINING DOES NOT MITIGATE CONFLICTS OF INTEREST
What is less expected, however, is that education, at least in its current form, does not mitigate the problem. Teaching agents about ethics or adding multiple hours of education to licensing requirements has no impact on ensuring that agents act for their clients as they do when selling their own homes. Only changing the compensation structure for agents makes the difference – and the only time this is seen is when the agent becomes the owner of the brokerage itself. When an agent becomes or is the owner of an office, they now have a stake in the performance of everyone else in the office because they have a share of everyone else’s commissions. This is not true of the sales agent whose only compensation is derived through their own personal sales activity. These agents sell their own properties for around 4% more and keep their homes on the market longer than they do when they sell homes for their clients.
Ethics training is a cornerstone of understanding the agents’ fiduciary responsibility to clients and yet the training currently in place is not solving the issue that agents sell their own homes for more and take longer doing it, than they do for their clients. The only thing that mitigates this failure of fiduciary responsibility is when the compensation structure changes, and the driving factor behind this is the concern that the agency owner has in preserving his own and his company’s reputation.
“Maybe the National Association of Realtors, [the NAR] could think about how could we leverage reputation… to tame the perverse incentives of the real estate agency.”
ARE WE OVERPAYING FOR REAL ESTATE SERVICES?
One of the broader questions is are we overpaying for real estate agent services? From the compensation structure it seems like it might be – 6% for selling a home seems like it is very steep. Basic economics teaches us that in a competitive market pricing is driven down to close to cost – but we are not seeing this in the real estate agency industry. It is baffling that with 2 million agents in the United States there is almost complete uniformity in pricing structure across the industry. Looking at it from a different perspective, selling a home for $400,000 takes no more effort than selling a home for $100,000 and yet the compensation is four times as much. For an economist, this quandary makes no sense; the only conclusion that can be drawn is that there is some kind of price discrimination occurring, where those wealthier homeowners are charged significantly more than the less wealthy – but as, either way, this violates the fiduciary responsibility that the real estate agency industry has to its clients, something appears amiss and should change.
HOT AND COLD MARKETS IN RESIDENTIAL REAL ESTATE
The study originated when one of the co-authors entered the residential real estate market to buy a home and started became aware that there seems to be a regular cycle during which there is more activity in the summer when prices are higher than in the winter months when prices are lower. This is a puzzling scenario because it begs the question: Why would people enter a market during a period when it is known that prices will be higher? Why do they not wait until the winter when they know that prices will be lower. And on the flip side, why do sellers sell during the winter season when they know that prices will be lower?
The pattern of higher prices and more activity in the summer, and lower prices and less activity is so ingrained in the market that In the US the FHFA produces two house price indexes; one that is the actual price and the other that is seasonalized. This means that the FHFA is reporting housing prices as though the cyclicality of the seasons does not exist.
The study looked at how big was this seasonal impact by looking at the raw data and not the seasonalized data to determine what is the difference between the summer and winter months for house prices. They found that the difference between the summer and the winter months is around 4.5% – a significant difference in pricing between the seasons – and that this difference has remained consistent for at least two decades.
The study found international differences in the seasonality with the UK having higher price differences summer over winter, and found that there were regional differences. For example, major California cities experience an 8% variance from winter to summer seasons. This is a very significant price difference, one season over another.
Similarly, the seasonality impacted the transactional volume with summer months experiencing over two and a half times more transactional volume than the winter months i.e. a 150% increase in volume.
The study thus put specific numbers on this known seasonality in the market, and then set out to explain why this was happening – why would anyone buy in the summer when prices were higher, or sell in the winter when prices were demonstrably lower. To answer this question the researchers considered the motivation for participants in the housing market. Typically, these are people who wish to live in the house that they buy – not always, but for the most part this is true. On average in the US and the UK, people tend to live in their homes for around ten years. [This trend is increasing in the US and has been discussed previously by economist Jordan Levine of the California Association of Realtors in a prior podcast].
The process of buying a house is costly on many levels. It is time consuming, stressful, and, of course, costly in financial terms, so when buyers look they tend to pay a lot of attention to the process and to take care in ensuring that the house they choose is one in which they will likely be happy to live for up to a decade. The extent to which a house suits a particular person is very specific to that person – one person might love a house for a number of reasons that another person might not. The result of this differentiation is that for someone who likes a specific home, they may be willing to pay more than the person who likes it less.
This concept that the same home can enjoy different valuations depending on the individual’s perception of that home is what the researchers called the ‘match quality’ of the home. If a person likes the home they will be willing to purchase the home for a price higher than other people might. This is the first building block of the theory underpinning the study.
The second building block of the theory is that where you have a market where the match quality is important – like, perhaps, the jobs market or the marriage market – when things are so specific to the pair, then what you want is that naturally in an environment where there are more choices around it will be more likely that the buyer will find a better match. This is called the ‘thick market effect’ where in a market with more choices you are likely to find something that you really like. In the case of a house, as perhaps with a job or a marriage candidate, when you find the right match you will be willing to pay more for it primarily because you like it that much more.
Likewise, as a seller, if you sell in a market where buyers are going to like your house more, then you will have the expectation that you will get a higher price. This is the second building block of the theory.
When you put everything together, consider the circumstance when there is a small amount of people who want to buy a house in the summer. Perhaps because of the school calendar, or because summer is a better time to look for houses because there is more light, or because people get married in the summer. Whatever the reason, even this small amount of people entering the market triggers other people to come in because it means that there will be more choices for them as well.
So what we see is higher prices in the summer because the quality of the match between buyer and the homes that they find is higher and so they are willing to pay more, and also they are more likely to find that perfect match because the number of available options is also higher. This now brings us back to the question why is it that buyers, knowing that prices are lower in the winter, why do they not buy in the winter? Well, if the buyer cares about the quality of living in the house then they value having more choices. If they wait until the winter they may not have same choices and so may not be able to find the home that best suits their needs.
CONCLUSIONS AND RECOMMENDATIONS
As a buyer, if you are picky about what you are looking for and are looking for something very specific, then you should wait until the summer when there is more choice and be prepared to pay more for that perfect home. If not so picky, then wait until the winter season when you can get a better price on something that may not be quite perfect for you, but that might offer better value for money.
As a seller, if you have a house that has a lot of special features then you should sell in the summer season because there are more people around looking for a home and you are going to be more likely to find someone who values those many features and will be willing to pay for them. If you house is, for example, a new build surrounded by homes that are very similar or otherwise does not have particularly special features, then there is no need to wait.
The central bank of a country is tasked with changing interest rates and changing the money supply to try to smooth out economic fluctuations to prevent runaway inflation and to keep employment at full growth. Their task is to stabilize the national economy and the way that they do that is by moving around short-term interest rates.
Until recently central banks have had a very strong reluctance to have negative interest rates and from an intuitive perspective this would make sense yet during the great recession that started some ten years ago, the federal funds rate were lowered to next to zero. This left very little maneuvering for the Fed as it tried to stimulate the economy. Attention, therefore, started to drift away from short term interest rates which were at close to zero percent, towards how to lower longer term interest rates that you might see on long term treasuries at around four percent or mortgage rates around four to five percent.
That is harder to do because the way that the Fed controls short term rates is it changes the rates that it charges banks trying to get overnight loans from the federal reserve. To influence long term rates, the federal reserve entered the market and became a voracious buyer of long term debt. During QE1 (the first round of quantitative easing), the Fed signaled that it was going to buy long term (30 year) mortgage backed securities. This has the effect of bidding up the price of the bonds which in turn pushes down the yield on the bonds which will be passed through to the corporate sector, and to the household sector. The economy would thus be stimulated by the fed’s acquisition of ten year treasury bonds and Fannie and Freddie mortgage backed securities, because long term investment decisions such as whether to purchase a house or build a multi-family apartment building or a factory will be facilitated as a result of having lower long term interest rates.
But the question is, does this really work and if it does, how does it work exactly because without seeing the full scope of consequences of such monetary policy there may be unexpected consequences that are more damaging than the problem we were originally attempting to solve. At Berkeley university there is a vast database of anonymized data on properties, on mortgages, and on refinances that is used to assess the impact of these policies on the market.
Palmer looked at who was refinancing, who was taking advantage of these lower interest rates, who is purchasing homes, and what kind of refinancing is going on in what volume, and link those behaviors to monetary policy to see what kind of effect the various QEs were and are having on the economy. Palmer looked at the effect of QE1 where the Fed was buying mortgage backed securities, and QE2 where the Fed looked at buying ten-year treasuries, and then at QE3 where there was a return to acquiring mortgage backed securities in addition to treasury debt. This left the question was one of these strategies more effective than another and if so why.
Quick aside. Fannie and Freddie buy and guarantee residential mortgage loans that meet several criteria. The loans must have at least 20% down payment, for example, it has to be below the ‘conforming’ loan limit which is in the neighborhood of around $500,000. If it a loan is higher than the defined conforming limit, it is ineligible for purchase by Fannie or Freddie. The Fed is restricted to buying loans guaranteed by Fannie and Freddie so for those communities where house prices are substantially higher than the conforming limits, then the mortgage amounts will be higher also so the theory is that these communities would not directly benefit from the QEs which were restricted to only buying conforming loans. They would not see interest rates come down nearly as much as those communities where loan sizes fell within the conforming loan limits. This allowed Palmer and his colleagues to compare the behavior of communities directly affected by the QEs, i.e. those communities with a predominance of conforming loans, with those less directly affected, i.e. those communities with higher home prices and consequently non-Fannie and Freddie loans.
What they found was that the reason that QE1 was so effective was that it was able to inject capital into the household sector by enabling people to refinance their homes at lower interest rates. QE2 was not nearly as effective because the Fed was only buying treasury debt and so could not drop liquidity into the household sector with nearly as much effectiveness as when buying Fannie and Freddie debt. When, in QE3, the Fed returned to buying mortgage backed securities it was not nearly as effective as it had been during QE1 because the economy, in some sense, did not need it quite as much as it had.
Going forward there is less likelihood that the Fed will continue with quantitative easing. As mortgages are paid off because someone sells their home or otherwise pays down their debt, the Fed reinvests the principle that is paid back by buying more Fannie and Freddie debt. One way to taper off the QE stimuli to slowly increase long term interest rates is to stop buying back Fannie and Freddie loans with principle that is paid back. As this happens, the long-term end of the yield curve will start to see an uptick in interest rates and consequently pricing will start to soften and cap rates will go up.