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.
The origins of this research came out of personal experience renovating homes and then putting them on the market and wondering what were the dynamics at play when an agent lists a home for sale: What are the agents’ incentives, what kinds of services do they offer, how do they get paid. This led to the question of misalignment of interests between the sales agent and the homeowner. The agent only gets a small percentage of the sales price ‘on the margin’ i.e. the last few thousand dollars of sale price earn the agent a minimal additional fee, and so do they really work for their clients to get the best price possible.
The theory is that the dynamic really changes when there is an offer on the table. At that point the agent has earned 98% of the commission they are going to earn. If they recommend to a seller to hold out and wait for another two, three weeks for a better offer, and consequently have to incur time and money expenses showing the home, advertising etc., the amount of incremental commission is not worth it to the agent – even if the additional sales price is worth it to the seller.
Recognizing that agents also sell their own houses, the study set out to test this theory by looking at how agents perform when they sell their own houses versus how they do when they sell on behalf of clients. This data is readily available because agents are required to report when they are selling their own home as a mandated disclosure. The insight this perspective brings is akin to seeing what physicians a doctor takes her own family to, or what does a car mechanic do when they work on their own car.
In short, the study gives an opportunity to see what the expert does when they serve themselves, versus when they are hired to do it for a client.
The way that agents are currently compensated creates a misalignment between the agent’s incentives and the home seller’s incentives. When a home is sold, there is a commission that is paid to the agent of 5-6% that is split with half of that going to the seller’s agent and half going to the buyer’s agent, and then the agent has to split again with their brokerage which differs from company to company, and from agent to agent, and in all cases reduces the share of the commission to the individual agent. If we assume that the broker split is 50%, then the share that the listing agent gets somewhere between 1.25% and 1.5% of the total sale price.
Now you may think that this is what you want; that as the sale price goes up for the home, the agent is compensated more because they get a percentage of the sale price as their commission. So you might think that the motivations of the agent and of the seller are aligned, but it is the magnitude of the incentives on the margins that creates the misalignment.
SAVINGS ARE SIGNFICANT
Let’s say you get an offer of $637,000 for a home. At that point the agent has earned around $17,500 in commission. To get an additional 4% for the sale of the home would add over $25,000 to the sale price that would go straight into the seller’s pocket, but would earn the agent only an additional $350. That $350 is only 2% more commission for the agent and in nominal dollars. This is just not worth the extra effort working for two or three weeks more, doing more showings and open houses, and continuing to advertise the property. The agent would rather recommend to the seller that they accept the offer, take their commission, and move on to the next deal – but the seller would clearly be better off with the extra $25,000. The problem is, therefore, that the commission rate returns on the margin such a small amount to the agent that gives them such a low incentive to proceed relative go the home seller.
The researchers looked at this typical case and compared it to what happens when an agent sells his or her own house. In this case it is the agent that is getting the lower offer and has the option whether or not to take it or to wait for the higher offer.
When agents sell their own house they keep the house on the market for about 10% longer and they end up selling it for almost 4% more than an otherwise identical house when representing a client.
These findings are amplified where the information available to the seller is less. For example, in an area where all houses are very similar, say in a tract home where the neighbors’ houses are almost identical, sellers see what nearby homes are sold for and are better informed about the value of their own home so they are going to be less inclined to accept a lower price. However, where homes are very different in an area, it is harder for a home owner to predict the value of their house and so they are more dependent on the agent’s advice and likely more inclined to take an early offer that may be lower than they otherwise could get. This is exactly what the study found; that where homes are less similar, agents sold their own homes for proportionally more than when they sold their own homes in areas where homes were very similar.
So what is going on where you have this uniformity of commission structures nationwide that has persevered despite the pressures of a competitive economy? There seems to be something ‘special’ about needing two agents in the transaction; one on the buy side and one on the sell side. This two-agent structure makes the model ‘stickier’ than has been seen in other industries, such as the travel agent industry, or the stockbroker industry where there is only one agent involved.
In the travel industry, once technology allowed for efficient disintermediation of the agent and it became possible to book a flight or a hotel directly, there was nothing to stop consumers from going straight to the airline or hotel. Similarly, with the stock broker; as soon as the consumer could buy stocks directly using their computer or telephone bypassing the agent, the agent role became redundant.
This is harder when there are two agents involved, one on each of the buy and the sell sides of the transaction. In this case while you may have a model that evolves that disintermediates the sales side of the equation, or sharply reduces the cost in some way to the home seller, you still have a buy side agent to contend with. This buy side agent may be reacting to the new model and resisting the changes that they are seeing to their industry by steering their clients away from homes that are put on the market in a way that is unfavorable to their own interests i.e. the reduced commission or full disintermediation model where sellers don’t need a listing agent at all.
Evidence of this is found in other research conducted by the same authors that compared the sales prices of agents who use a flat-fee model with those of agents who use the full commission model. The flat fee agents were able to sell for as much as the full commission agent but it took longer to achieve this result. This indicates steering by buyer agents away from the listings of flat fee agents. That said, this result also shows that although the sales price was not higher, the net return to the home seller was higher because they did not have to pay the full commission of the selling agent – they just paid the lower flat fee.
While steering clients away from a home because an agent does not like the listing agent’s business model is unethical, possibly illegal, its illicit implementation does serve to enforce the existing full commission model on the industry in general and may help explain why the real estate industry has these commission rates nationwide that vary very little.
YOUR (BUYER) AGENT IS NOT FREE
One factor holding up the disruption of the industry is this notion that buyers have that the agent representing them is free: They are not. While the seller does, technically, pay both buy and sell side agents, the seller is using buyer money to pay them. Buyers assign excessive authority to their agent because contractually it is the seller who is paying the buyer agent and so, technically, not a cost to the buyer. However, this is not how the transaction works economically and it is indeed the buyer who must find a larger down payment, and a larger loan to consummate the transaction in order to provide enough funds to pay the buyer agent also.
Syverson and Levitt found that the magnitude of the sales price difference between the commissioned agent selling their own property and the commissioned agent selling a client’s property became smaller over time. It was more pronounced during the early periods of the study’s data set, the early 1990’s, and less so in the later period, the early 2000’s. This indicates an erosion of the commissioned agent’s exclusive ownership of market data and an increasing sophistication on the part home selling public. As the availability of home sales data has become ever greater, the information gap between the agent and the home seller has reduced, and the consumer is now more alert to the value of their own home and less likely to take an offer simply because an agent insists it is likely their best option. Whether this phenomenon has reached the point at which the fee based agents’ rise in the market is imminent remains to be seen.
Professor Siegmann's research examined the role of the real estate agent in the house prices transaction, and compared the for-sale-by-fee agent, the new generation of agent that has risen since the advent of the internet, with the performance of the traditional commissioned agent. In the Netherlands, where the study was conducted, commission rates for an agent selling a home is between 1.5% to 2%. This compares with an average of around 5.5% in the United States.
In fact, commission rates in the United States are among some of the highest in the world at an average of around 5.5%. Unlike the United States, most countries have seen significant drops in real estate commissions in the last 15 years or so. The lowest in the world are in Northern Europe at around 1.7%, and the highest is in Mexico at 7.5%. For those countries that have seen drops in commission rates, the average decline has been 34%. That there has been no significant change in the US gives pause for thought: Why is there such pricing uniformity among ostensibly competing agents?
‘Before the internet everyone needed an agent to buy a house and an agent to sell the house’. Agents maintained exclusive access to the multiple listing service and so were the gatekeepers for sellers to a market of buyers, and to buyers who wanted to see what was available to buy.
However, since the advent of the internet, buyers and sellers now have full access to detailed information about all the houses that are available on the market, and yet sellers are still paying, on average 5.5% to agents who are erstwhile intermediaries. This begs the question that, if information is freely available to everyone, ‘what is the use of an agent?’ The former role of the agent was to match buyers and sellers by providing access to a proprietary data network to each side of the transaction, but now the network itself provides direct access for buyers with seller and vice versa.
FOR SALE BY FEE (FSBF)
The for-sale-by-fee agents in this study involved the Seller in showing their house rather than the agent on the principle that the owner is, presumably, the best person to show the house because they know the house better than anyone else. This model of for-sale-by-fee agent emerged once the availability of information became more widespread on the internet. The for-sale-by-fee agent can offer considerably lower fees than the commissioned agent because, by taking the showings from the agent services, a time consuming component of the agent task is eliminated. In addition, relative to the homeowner, the agent is not as good at showing the home because, simply stated, they do not know as much as the agent.
COMMISSION AGENT – A CASE WHERE YOU DON’T GET WHAT YOU PAY FOR
The researchers’ thesis was that the for sale by fee broker to underperform the high paid commission broker. But what they discovered was that the for-sale-by-fee broker not only sold for a higher price but did it slightly quicker than the commissioned agent.
‘This is really remarkable because it means that they are cheaper and better’. For-sale-by-fee agents do better than commissioned agents irrespective of whether it is a cheap house or an expensive house, it does not depend on whether a home is in a rural area or in the city, does not matter if it is for houses that typically take a long time to sell or a short time to sell. Having a for-sale-by-fee agent, where you do the showings to buyers yourself, will give you a better result – you will sell for more, in less time, and it will cost you considerably less to do it.
Simple Conclusion: For-sale-by-fee brokers, when you do the showings yourself, do better than traditional commissioned brokers. Period.
WHY DO FSBF AGENTS OUTPERFORM COMMISSIONED?
There are two possible reasons. One is that the homeowner knows much more about their house than an agent who may be juggling multiple homes at once. The agent cannot know the details of a house as well as the seller does, and this kind of personal information about a home is of value to a buyer. This information could include things like when it was renovated, which contractor did the job, how is the neighborhood and other similarly intimate insights into the home.
The other reason is that inherent in the commissioned agent’s fee structure is the disincentive to prolong a sale to squeeze out a higher price. If an offer comes in that is lower than asking price it is in the commissioned agent’s best interest to recommend the sale because the incremental commission earned from rejecting such an offer and seeking another, higher priced, buyer is not worth the effort. This is a similar theme as we have seen evidenced in other research. If the open houses and showings are managed by the agent but left to the seller to conduct, that additional layer of time consuming labor is removed enhancing the for-sale-by-fee agent’s willingness to prolong a sale in pursuit of a better result for the seller.
Siegmann and his co-authors pondered whether these results were measuring something that they could not see; something else other than the variables they were considering. What they conclude is that there are ‘smart sellers of houses’ who are very comfortable with showing people around and making sure that their house gets sold. It also shows that the added value of professional agent is not that high; there are enough people who can do it themselves.
FSBF IN THE US MARKET
There are many studies, some covered already in this podcast series, and some coming up, that find similar results here in the US. The overall picture is a puzzle; why is it, other than by tacit collusion, that agents in the US all charge the same commissions and yet claim to compete. This is especially true in the millennial internet age where it is very easy to put pictures up online to show your house and provide direct access to buyers who can search freely and without the need of an agent. Perhaps it is because the agent realizes that as soon as they start competing on price, their business is over.
As a buyer ‘you do want to talk to the seller. Why would you not want to talk to the seller? This seems to be a story told by the agents who say “well, but that’s not good, we are professional sellers”… If I sell something that is really valuable, I would like to tell the buyer what I know about it.’
What is being seen in the European market is that agents are beginning to offer more creative ways to advertise their services and to structure their fees. There are those who charge a flat fee, and who offer a modular service, like photography upgrades, or staging advice. In other words, the market is evolving such that sellers are paying for the actual services they are getting and not just for someone to be in the middle.
It is only a matter of time before these models start to dominate the landscape here in the U.S.
Attitudes to marijuana have changed dramatically over the last 50 years. In the 1950’s only 12% of people interviewed approved of marijuana, but in recent Gallop polls that number has increased to over 60%. Now there is a majority of adults in the U.S. support the legalization of marijuana, and as opinions have shifted over the last couple of generations so, slowly, have regulations especially on the State level. As of time of publication, there are 28 states plus Washington D.C., that have legalized medical marijuana, although on the federal level marijuana is still classified as a Schedule 1 drug and deemed illegal to possess or consume.
As medical marijuana has become legal, some states have begun to legalize recreational marijuana. Currently (as of time of publication) there are eight states plus Washington D.C. that have legalized recreational marijuana, and the first two to do this were Colorado and D.C.
While the standard pros-and-cons arguments have not changed – opponents claiming that marijuana is a gateway drug, proponents arguing that removing it from illicit trade will reduce crime – no-one has really conducted any empirical research yet on the impact of legalization simply because, until recently, there has been no data to analyze.
Effect on Home Prices
The current study adds to the debate by addressing a very specific question: What happens to home values (single family residences) in the neighborhood of a store that converts from being a medical marijuana store to one that is permitted to sell for recreational purposes. What makes this paper’s results so important is that in examining the impact on single family homes values, what the study does is to flatten out the positive and negative effects of having a recreational marijuana store nearby, and to examine the net effect on home prices. In other words, home prices changes likely capitalize the overall impact of bringing a store to the neighborhood by accounting for the impact of both negative and positive effects.
Denver, Colorado provides a good location to examine because, one, it was one of the earliest to legalize recreational marijuana so has the longest history for this that can be studied, and, two, Denver provides a rich source of publicly available data. For other states and cities considering legalizing recreational marijuana, the results of the current study provide a finding that might be of use in making legislative decisions about whether to approve.
The study’s objective, therefore, was to study whether or not there is an impact on a neighborhood’s home values, and, if there is, to what extent is there an impact…
Marijuana in Colorado
Background. In Colorado in 2000 the state legalized medical marijuana but kept the industry very small to limit early growth. This changed a few years later and the state started to relax legislation allowing for the industry to start to flourish, and by 2012 it had become so widely accepted that when Amendment 64 to legalize recreational marijuana in the state’s constitution was put on the ballot, it passed. This allowed for the beginning of recreational sales to start in the beginning of 2014, a little over a year later.
As the state developed a process for managing the expansion it became clearer where these retail marijuana stores were going to be located. By the end of 2013 precise locations that would get licenses to sell recreational marijuana had been identified, and those locations were to be a subset of existing medical marijuana stores.
In December 2013, when the list of approved sales locations was released, the researchers looked at these locations and drew circles starting at a 1/10th mile radius and moving outwards at incrementally greater distances. A tenth of a mile is about a city block – so, at this distance, the impact on a single location would encompass approximately a four-block area (one block in each direction).
House Prices Shoot Up 8%
What the study found was there is a benefit on home values on a very localized basis. Homes within a one tenth mile radius of a newly designated recreational marijuana store go up roughly 8% more relative to homes situated further away; homes situated further away experience neither a negative nor a positive effect.
Why Do Prices Go Up?
From a statistical and methodological perspective, the result shows a strong causal effect: Convert a medical marijuana facility to a recreational one, and home prices within a block radius will shoot up relative to homes situated further away.
What the study does not do is explain why that happens. Why do you think it might happen? Is it:
The researchers had anticipated a negative effect going in to the study, so were surprised results that so confidently show a positive effect on home values. As the debate advances in other states as to whether to legalize recreational marijuana, the results of this study should point to at least one positive impact where, in all likelihood, there is a tendency to erroneously predict a negative one. For those ‘not-in-my-back-yarders’, understanding that their home values could go up substantially might help in taking a different view on the possible impact.
What Value Does the Real Estate Agent Bring?
The question that Jonathan Meer and his co-author Douglas Bernheim set out to answer was, what value does the broker add to a residential real estate transaction? One of the challenges in researching this is that the listing services that an agent provides are generally bundled so it is difficult to separate them out to be able to analyze them independently of each other. These services include listing the property on the MLS, taking photographs, staging advice, listing prices, paperwork, showings, handling other brokers and such like. It is a large bundle of services, but what is strange, when you think about it, is the percentage payment model for the services provided. Why is the value of all these bundled services, that might only total a few hundred or at most a couple thousand dollars, result in a commission cost that could be ten times or more as much as the actual cost of the of the services themselves? Not only is this somewhat strange from a financial perspective, but it sets up a classic case of what is known as the principal-agent problem.*
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*The principal agent problem occurs when one person, the principal, hires another, the agent, to act on their behalf in some manner, but where there is imperfect monitoring of the agent’s performance. This creates a dilemma whereby the agents are motivated to act in their own best interests, which are contrary to those of their principals.
Real Estate Agency Unpacked
The classic example of this is the auto-mechanic who knows a lot more than you do, and where you have to trust them to do the work properly and advise you accordingly, but where the incentives for both agent and principal might not be aligned.
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The same applies to the real estate agent who does not capture a meaningfully significant extra amount of commission for significant amount of additional effort they must put in to extracting the best price for a client. For example, working to get an additional $10,000 from a home sale, might be of significant value to the homeowner, but to the sales agent, the amount of additional commission is too small to warrant the extra effort it would require in getting it. The incentives are not aligned between the principal, who would like the extra $10,000, and the agent, from whom getting the extra money for the principal, is not worth the extra effort it would take.
The objective of the study was to unpack the broker expertise services – showing the home, advising on pricing, negotiations – from the value of listing the home on the MLS, and the paperwork services which can be readily calibrated in terms of their actual costs. The Stanford University faculty staff market provided a ‘usefully unusual’ market in which the unpacking of services could be studied, and served as the foundation upon which the analysis was conducted. The university has an office called ‘The Faculty Staff Housing Office’ which acts as a multiple listing service (MLS) because the university retains ownership of the land and limits who is eligible to purchase homes. So many of the real estate agent’s functions are subsumed by this office. The office lists the homes for sale and provides all necessary paperwork to consummate a transaction in the 800 or so homes on the Stanford campus – the equivalent of about 40 blocks in a typical metropolitan area.
Using an Agent Reduced Sales Price by 6-7%
In the late 1990’s, and though not required, there was a sudden uptick in the number of home sellers in this neighborhood using a broker to sell their home, going from none in some years to up to 60% of sales by the mid-2000’s. This came about because of some aggressive marketing on the part of local agents to use their services.
The study allowed for differences in house characteristics, size, number of bedrooms, features etc. They were also able to identify those homes that were sold multiple times over the course of the 30 years of the study and to compare those that sold with an agent against those that sold without an agent.
Finding: The same home sold with the aid of a real estate agent sold for 6% - 7% less than when sold without the aid of an agent.
This provides ‘evidence of very, very strong agency costs, that is the real estate agents’ incentives are aligned differently. They would like to sell the home relatively quickly and if they sell the home two weeks earlier for ten thousand dollars less that means that they are essentially giving up $200 in order to put in maybe 10-20 fewer hours of work into the sale of the house which when you work out the hourly rate of that is not a crazy decision to be making.’
Listed at Lower Prices, Homes Sold Faster
The researchers also discovered that homes listed by agents were much more likely to sell significantly quicker when listed by an agent, which reinforced the idea that agents were motivated to sell for a lower price in a shorter time. These findings were very similar to another famous study by Chad Syverson and Steve Levitt (of Freakanomics fame), where they looked at the Chicago market and compared sales by an agent of client homes, and compared them to sales by that same agent selling his or her own home. They found that when selling their own home, agents take longer to sell, and sell for more. [AG: I will be covering this study in a future episode]. Syverson and Levitt took this to be evidence of the agent-principal problem and it supports the findings of the Stanford study.
The Stanford study also noticed that homes listed with an agent typically listed at a lower initial asking price than those homes listed without, further pointing to the agent-principal conflict where the agent just wants to sell the home for a good price quickly, but not necessarily for the maximum price and to take the time doing so.
While this study is restricted to a unique real estate market, it is nevertheless of a decent size, being a reasonable equivalent in scale to a city neighborhood, and has been replicated in some regards to far larger, more generic real estate markets by other studies – such as the Syverson and Levitt study in Chicago.
Certainly, the internet has begun to make some of the listing services increasingly obsolete. It is important that the individual decides independently whether the services of an agent are in their best financial interests, and it is important that in making this decision that the homeowner is aware of the principal-agent conflict and that the agent is likely operating from a different set of incentives.
The pressure to unbundle services is likely to become more prevalent: buying an MLS listing, or photography for a home as separate and distinct services versus paying 5-6% of the sales price of a home for those same services for example.
The market forces that are driving this unbundling of services could drive the real estate agent to obsolescence the same way as it did, most notably, with the travel agent.
As the generation that is becoming more comfortable with using technology to do pretty much everything in their lives comes on stream to start buying and selling homes, they are also likely to be increasingly uncomfortable with the current bundled services model that comes with a high commission base pricing structure.
... investing in higher cap rate properties, in less expensive markets nationwide, consistently deliver higher returns on a risk adjusted basis than focusing on quality properties in expensive cities. These results underscore the idea that Value Investing is as valid for real estate as it is for most other asset classes, be they stock, bonds, commodities, etc. and point to alternative real estate investment strategies you may want to consider further.
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The question of whether low cap rate or high cap rate properties are better investments goes back to Warren Buffet’s idea of value investing. The basic tenet of value investing is to invest in assets that are undervalued in some way; those that are not necessarily the most glamorous investments, but that are undervalued for some reason, and to invest in those.
All kinds of academic studies going back to the 1980s that have found that value stocks generally outperform growth stocks. More recently other asset classes – stocks, stock indices, currencies, commodities, bonds – all have been examined to compare how value investments perform relative to growth investments and these too have consistently shown that value investing outperform growth investing. But Geg MacKinnon and his at the Pension Real Estate Association (PREA), and his co-authors, realized that this same effect had not been examined yet in real estate and their study fills this gap.
Typically for most RE investor, when you talk about value you talk about whether the price is high or is it low and the core measure of this is the capitalization (‘cap’) rate. Initial question, then, is ‘do high cap rate properties do better than low cap rate properties’. Though this is a basic starting point, it is one that is very applicable to investors and investment managers as far as how they define their investment strategy – which kind of property, high or low cap properties, to invest in.
The first step in the analysis was to take National Council of Real Estate Investment Fiduciaries (‘NACREIF’) data and categorize the assets in their dbase according to those with high and those with low cap rates. First the researchers controlled for both time – when was a cap rate measured (1970s vs. 1990s for example) – and then for location; where in the U.S. was the property located. Each property in the dbase was then compared to the average at the same time and place for other assets in its class, be it office, apartment, industrial etc. Once that task was completed, the top 30% were defined as having high cap rates, and the bottom 30% were defined as having had low cap rates. Every asset was then analyzed for how it performed over time, and the results were consolidated to see how the assets with different cap rates performed relative to others.
Results show that low cap rate investments are significantly better investments than low cap rate properties. This result holds in absolute terms, in risk adjusted terms, holds across property types, across time.
The (statistically significant) results are, on average:
Of course, the next question is, well, what about risk? Risk was addressed in the study by looking at the frequency by which these results held true over the course of the study period – 1979 - 2010. The upshot was that higher cap rate assets (cheaper properties) consistently outperformed low cap rate (expensive properties) more than 70% of the time across all property types.
Here are the specific results:
Summary: Higher cap rate properties (cheaper ones) consistently yield higher risk adjusted returns.
Is it better to buy a cheap property in an expensive market, or is it better to buy an expensive property in a cheap market? Put another way, are you better off going to Manhattan, which is a high cap rate, expensive market, and buying a cheaper property, or are you better off going to Cleveland or St. Louis or someplace like that, that is a cheap market, and get a relatively expensive property.
What was discovered in the study was that if you look at cheap metropolitan areas, in, say, office for example, i.e. those with the higher cap rates, and you look at properties within those markets with lower relative cap rates, i.e. those that are relatively expensive for the cheap metro areas, what you find is that those types of properties historically enjoy a return of 5.3%. However, if you look at low cap rate markets i.e. expensive market, and you look at the higher i.e. cheaper properties there, the average return there is 4.6%. In short, relatively expensive office properties in cheap markets do better than cheap office properties in expensive markets. For apartments relatively expensive properties in cheap markets do about the same as average properties in
From the value investment standpoint, what applies fairly universally across all property types is that high cap rate investments do better than low cap rate ones. There is a very distinct pattern across the country where cheaper metros do better than more expensive ones on average. If you look within metros, what you find is that the cheaper properties do better than the more expensive ones. So, no matter which way you look at it, high cap rate (cheaper) properties, do better than low cap rate (more expensive) properties.
The typical fund manager will only look at the big major markets, i.e. the higher cost (lower cap rate) markets, and will concentrate on the highest quality properties which, presumably, have the lowest cap rates. But these are not the assets that are going to be delivering the highest risk adjusted returns when applying value investing principles. While some may consider it counter-intuitive for real estate because investing in the ‘highest quality assets’ is the accepted standard, it is, actually, totally intuitive to apply value investing principles to real estate because it works across all other asset classes so why not in real estate also.
The idea of investing in a more expensive property in order to maximize returns is premised on the assumption that these kinds of assets will deliver higher capital appreciation that will compensate for the lower yields. But that is not what this study finds. What the study finds is that not only do expensive properties not experience capital appreciation sufficient to compensate for their lower yields, but, in fact, cheaper properties appreciate at a faster rate than do more expensive ones.
In a sense, therefore, it is a contrarian tale of investing in markets and properties that other people – or at least the larger institutional investors – are not. And it is precisely that lack of attention from the bigger investors, institutional, sovereign wealth fund investors, that drives the result.
AMANDA HITE, PRESIDENT, CEO STR
Amanda Hite joined STR in Jan 2006 when the company had one office in Hendersonville with 65 people. She became president and CEO in 2011 and in that role sets company policy and strategy while overseeing daily operations and implementing initiatives for STR's family of companies: Hotel News Now (HNN), based in Cleveland, Ohio and STR’s international headquarters, in London. She is a member of the boards of directors of the U.S. Travel Association (USTA) and the Hendersonville Chamber of Commerce. Today STR has 300 employees worldwide, with 170 situated at the corporate headquarters in Hendersonville, Tennessee, an international office headquartered in London, a regional office in Singapore, and, in total, 16 offices in 15 countries... and a network of 57,000 contributing hotels worldwide. Hardly any wonder they are the most important voice in the industry.
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THE STR REPORT
The STR Report was originally called, and continues to be called, the “Smith Travel and Accommodation Report”. It is the aggregation of data voluntarily supplied by hotels to STR that describes how a set of competing hotels , the ‘compset’, is performing financially relative to a client hotel. In short the STR report provides a competitive set benchmarking tool to a hotel operator by comparing it against those other hotels that it sees as being competitive to itself. Hotels provide their financial results to STR and in return are given market level data at no cost. Or STR will provide compset data to hotel operators who by such data.
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REVPAR – A MEASURE UPON WHICH BONUSES ARE BASED
The key data points that hotel s look at are occupancy and the average daily rate, but the key metric that drives decisions is what is called ‘Revpar’, or, revenue per available room. This is calculate by looking at total revenue divided by the total number of available rooms. The Revpar index is the metric that most hotels use to evaluate their own performance. Having been in the industry for over 30 years, STR knows that all staff meetings for hotels are usually planned around the delivery of their STR report and in many hotels the general manager’s bonus is tied to performance against the Revpar index.
HOTEL INDUSTRY: NEVER BUILT ITSELF INTO A RECESSION
Unique, perhaps, in commercial real estate, the hotel sector has ‘never sent itself into a downturn through overbuilding.’ Any time the sector has had a downturn it has been brought about by external macro-economic factors, and not through the building of excess supply. And each time there has been a downturn for hotels, the impact has been more dramatic than the last time. This is likely due to the continuing improvement in the availability of data in the industry, both on the consumer side and the operator side. When a consumer wants to book a room, there are countless ways that they can find different rates for that same room. Similarly, when an operator sees a competitor reducing rates next door, they can adjust their rates almost simultaneously and this can lead to a more rapid and precipitous drop in rates and bookings and consequently in the all important Revpar measure.
After the last downturn, the transient demand for rooms came back quickly, but room rates did not climb as quickly as had been expected. Hotels are selling more rooms than ever before in the industry, but there are more rooms to sell than ever before, so the hot topic is the new supply and what will be the impact of that supply as it comes on stream.
GROWTH OF 2% FORECAST FOR 2017
In total STR tracks in-construction, final planning, and planning phase pipeline, which are the ‘under contract’ pipeline. As of June 2017, there are 580,000 rooms under contract, meaning planned to be built… though possibly not all of those will actually end up being built. Of those that are actually in construction and coming out of the ground, there are 189,000 rooms in America currently actually being built – which is an 18% increase over where the industry was a year earlier in 2016. In fact, every year for the last five years the industry has seen that growth increase. The prior peak of under construction in 2007 there were 211,000 rooms under construction – so only about 22,000 off that prior peak of new, under construction rooms.
There are 1.8 billion room nights as of April 2017 to sell, of which 1.2 billion were sold. Growth rate for supply is 1.7% for the 12 months to April 2017, although the total growth rate for 2017 is going to end up around 2% i.e. 2% more rooms in 2017 than in 2016, in the US. In the prior cycle, in 2006, there were a lot of rooms being closed to be used for other, non-hotel, purposes, but this time around this trend is not as pronounced – only around 25,000 or so rooms being closed in a year now, compared with 2006 when some 40,000 rooms were being closed and repurposed.
LIMITED SERVICE DOMINATES GROWTH
Of the rooms being built today, and there are lot, are mainly in the upper-mid scale, and upscale rooms ‘chainscale’ with 65% of all rooms in construction in these two segments. And those are the limited/select service segments, i.e. Courtyard by Marriot, Hampton Inn, Holiday Inn Express… not full service, no restaurant, room service and the like. And so because most of the rooms coming on are of the limited service kind, this may be contributing to the slower than expected growth in revpar despite the increase in number of rooms.
Construction in top 26 markets is showing some very fast growing cities. Nashville, for example, has 13% of the existing market coming on stream, New York has 14% additional to the existing supply in construction – this compared with only 2% nationwide. New York has been top of the list for the last three years. As an operator in New York it has been challenging because so much supply has come into the market – with almost 16,000 additional rooms currently under construction just in New York, which is an additional 14% coming into the market.
IMPACT OF AIRBNB
So how does this considerable growth in hotel rooms tally with the growth in competitive options like Airbnb and the like? Well, a lot of times those folk coming to stay in an Airbnb room in New York, for example, may simply not have been able to come to the city before and stay in a hotel, so to that extent it is expanding the market for travelers, rather than splitting the market. Millennials and the so called ‘experience economy’ are boosting demand in ways not before seen, and hotel rooms are being sold at volumes more than ever before. People are travelling more than ever before – not the group business – but the single traveler traveling either for business or in pursuit of experiences away from home. And the trend is that people are traveling not just during the traditional summer months, but throughout the year which further broadens demand.
Societal changes are being reflected in the supply coming on of limited service hotels where travelers do not necessarily want a full service restaurant to go sit down in in their hotel, they would rather go out and ‘live like a local’ when they go out. They like having an inviting lobby to sit down in and have drink, with perhaps some light food, but are there to experience the people around them. They want free wifi included in the room rate that is provided to them, and this is also a reflection of the way that work habits are changing also. With more employers allowing staff to work from home or remotely, and people becoming more accustomed to working wherever there is free wifi, this has also had an impact on the demand for travel and the kinds of things that such travelers are demanding when they are on the road. And this trend is being seen in the kinds of hotels that are being built i.e. those that accommodate that kind of traveler.
STR is forecasting slowing growth overall, with a negative occupancy growth rate for the end of 2017 because of all the new supply coming into the market – new supply of 2% but negative occupancy growth as demand catches up with the new room supply. Revpar is forecast at around 2.5% for 2017, and average daily rate (ADR) being at around 2.2% increase over 2016. The trend for 2017 and 2018 is that for any kind of revpar growth, the growth is going to have to come from ADR growth because, although the demand is there, occupancy rates are going to decline because of the new supply. So this presents an area to watch: As occupancy rates decline, it is counterintuitive to increase prices in order to maintain the all important revpar. That said, there were two periods during the 1990’s where this phenomena was seen i.e. where there have been declining occupancy but increasing ADR. STR expects that this will be repeated in the current market.
STR is a focusing on shifting from an email delivery system to an online delivery system for the data that they produce, including improvements in intuitive visualizations and presentation of the data for clients. The company is also expanding even more rapidly around the world. Currently they have 57,000 hotels that participate in the STR program internationally, with the largest country outside of the US being China that overtook the United Kingdom in that position two years ago. The Asia focus will continue to grow, as well as a move into South America in 2017/2018.