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.

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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.

SmallChange

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.

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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.

Challenges

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.

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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

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.

1. The first is relatively speaking things that banks do. Banks take deposits, make loans, send money, and there are some things like payments that are an amalgamation of those.
2. The second category is a very broad range of things that banks do not do, for example payday loans or check cashing. In this category also falls Point.com because Point allows you to sell part of the equity in your home which is something banks do not allow you to do.
3. Category 3 is insurance. If you can do it with better underwriting data because everybody is wearing a Fitbit, or you can do it with better underwriting data for cars because you can measure on your cell phone how fast you are driving.
4. The fourth category is just in developing effective investment management. So things like robo advisors and the like.

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

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.

POINT

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.

ANDREESSEN HOROWITZ

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.

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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.   

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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.

Industry Challenges

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.

Standardized Contracts

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

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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.

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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.