Listen to the episode and read the transcript on the shownotes page to today's episode here.

I think the story needs to go back a little bit, right back to the beginning. I grew up as a young boy loving two things: technology, and property real estate. I did my first programming course when I was six years old.

I did my first real estate project when I was 13. I actually led the development ... I was sharing a bedroom with my brother, and I showed my folks how we could knock through the toilet and effectively create a second bedroom or third bedroom.

I've pretty much spent my entire life trying to marry the two industries together. Where did Wealth Migrate come from? First thing that happened was that my father did what we were all taught to do. He went to school; he went to university; he got a good job. He actually became a financial director of a listed company. He invested. He paid his taxes. He trusted the financial industry. Yet, when he passed away at the age of 59, he died broke. That was a really hard lesson for me to learn because I sat back and I was like, "Well, hang on ... He's done everything that we're all taught to do, and it doesn't work."

I, at a very young age, started to look for alternatives. When I did the math, 49 percent of the world's wealth is held in real estate, and yet only 12.9 percent of the world's population actually had access to that real estate.

Then, in the Western world, which is England, Australia, and America,  if you take that 12.9 percent, less than one percent of people actually retire wealthy at the age of 65. Quite frankly, for me, Adam, those stats are disgusting. Yet everyone keeps doing what they've been told to do - not only my father, but 99 percent of other people followed in my father's footsteps.

We decided to do something different. As I said to you already, I did my first project when I was 13; I did my first development when I was 19. I studied construction management, so I got into the building game ... In 1998, I did my dissertation on how technology was going to change the real estate, and construction industry. I then went to London, and I did my masters on the same topic basically 20 years ago.

I tend to joke with people ... People in real estate, and construction industry 20 years ago couldn't spell IT. Nowadays, it makes a lot of sense, but those days, no one ever considered that it would have an impact on those industries.

I basically worked for an Irish developer in London for five years, while I did my full-time masters, and I sort of grew ... On the side, we were already doing houses. We were doing houses in London; we were doing houses in South Africa. We were buying/renovating them.

I had a bunch of friends come to me, and say, "Well, how do we do this?"  At the age of 25, I realized I'd be the world's worst employee and I resigned, and set up my own company, which is called International Property Solutions, or IPS. Effectively, we helped people invest in England, Australia, America, and South Africa. Over the years, we helped about 2500 people invest in those four different countries - primarily houses and apartments.

I noticed three big gaps in the market. Firstly, the majority of people didn't have enough money for a deposit. Secondly, if they had the money for a deposit, quite often, particularly if they were wanting to go internationally, they would consider themselves sophisticated, and so they wanted to go into commercial, but then they didn't have commercial ... They didn't have that money for commercial. The third type of person had enough money and even experience, but then have no idea what country to go, or even how to get started.

That was the first thing that happened. Second thing which happened was, in 2008-2009, we obviously had the global financial crisis, and there was a significant opportunity particularly in London. There was an opportunity everywhere, but I was really in the London market.

You could buy buildings for 50p on the pound, and there was an opportunity in Wimbledon, which is where the tennis is in London, to buy 48 units. I just had one small problem - I had to raise £10 million. Now, what was fascinating to me is I could buy these 48 units at less than 50 percent of what they were sold six months before that, with a 12-percent net cash-on-cash return. It's like an absolute no-brainer. Yet I needed £10 million.

I ran around to my 2500 investors ... I couldn't get people to invest together. People were interested in buying one apartment, but they wouldn't buy the building together. That created enough pain to say, "No, we need to build a platform to allow people to invest like an institutional investor."

In simple terms, the very next year I met my co-founder, Hennie Bezuidenhoudt, who's 20 years my senior. We were in Bondi Beach in Sydney, and him and another US billionaire were buying medical centers. Here's me. I'd helped 2500 people buy houses or apartments. I have a honors degree and a master's degree and, without being arrogant, Cum Laude at both of them, and no one had ever told me to buy a medical center. I asked him, I said why a medical center? He said, "Well, think about it. No matter what happens in the world economy, people will always need doctors." I'm like, "That makes sense."

"Secondly, no matter what happens, doctors stay in their premises for a long time." I thought back to when I was a child and I thought, in my case, the doctors actually passed away, but the medical premises are still going strong. "The third thing is doctors are very good at being doctors but they're not accountants, so they find very good long-term favorable leases."

I literally thought about that. I was like, "That's Real Estate 101." You've got a tenant that is economically resilient; stays a long time, and signs a favorable lease. I couldn't believe it; it was so simple, and yet no one had ever taught me this.

I said to him, "How do I participate?" He said, "No, it's easy. It's just for friends, and family. They invested up to 5 million Australian dollars each." I was like, "Ah, okay, there's the catch." That company, today, has gone on ... It's listed on the Australian Stock Exchange. Today, it's worth over $700 million. When it started 10 years ago, it was $40 million.

I think I did one better. I actually built the platform, and we launched it - the first version of the platform  - in October 2013. Ever since that day, I've been investing alongside partners like that, but allowing people to participate and invest from ...

Originally, we started $100,000 dollars; then we got to $10,000; then we got to $1000. We're about to launch version five, which will allow us to get to $100. Our dream is to eventually get it to a dollar per person per investment, so that truly the 99 percent can invest like the top one percent.

The first one is whether they had an impact, and yes, they had an impact. They definitely had an impact. We were paying lawyers copious amounts of money to figure out how we could invest. We started off  [inaudible] already with the minimum investment of $100,000, because we were only dealing with the sophisticated, accredited investors.

Then, the Jobs Act came out, and it was quite interesting because I was dealing with just a normal lawyer, and what I mean by that is just the normal real estate lawyer. Even in October 2013, after the Jobs Act had already come through, I phoned him up, and I said, "Well, surely this allows us to do all of the different things?" They're like, "No, no, no, you can't.".

Then, Fundrise came on the scene, and then Realty Mogul, and I was like, "Well, hang on, dude. You're telling me that I can't do this, yet other people are already doing it." It had a material impact for us because it got a lot more clarity around what you could, or couldn't do, and things like getting 506(c)s, and broker dealers, et cetera ... It just made it a lot more transparent as to what you could, or couldn't do. Before, though, it was very murky as to what you were, or weren't allowed to do in terms of using technology to help people invest. That answers your first question.

Obviously that clarity is nowhere near as good as countries like England, where they've got a hell of a lot better in terms of explaining what crowdfunding is, and how it works, but it is actually ahead of countries like Australia that haven't even got out of bed yet, in terms of crowdfunding.

I'm talking about equity crowdfunding to put it in simple terms. England is the most progressive regulator in the world, and what was interesting is that they did it differently from everywhere else. In America, the regulator basically [pull out] the Jobs Act. It was quite draconian, and the intention was to sorta get everyone to play by the rules.

What they did in England, but did differently, they went out, and they found five platforms. They did a due diligence on those teams and those platforms, and they said, "Right, we're going to work with you for next year, and we're going to create the regulation with you." Because of that, only after a year or so - don't quote me exactly - 12 to 18 months, they then brought out the regulation, and any new platforms then have to comply with the regulation.

Read the transcript and listen to the episode on the shownotes page here.

My background is I've been in real estate since I graduated, since college. Being at Carlton, this is only my second job I've ever had. My first job, I worked for Prudential, when they had a realty group; when they used to own real estate. I was involved in the principal business of real estate at Prudential, and then I did mortgage loans for Prudential for about four years.

Then I came to Carlton and I've been here almost 20 years. Pretty much what I've been doing at Carlton is really focused on raising JV equity and debt for real estate deals; typically on the larger side of deals. It's hotels, office buildings, recapitalizations, like partner-buyout deals, developments. You pretty much name it, we've done it over the past 20 years. Like I said, typically, on the larger side, that's our thing, but we do do smaller deals also. For us, it's the same amount of work to do a big deal than it is a smaller deal so we really do the bigger deals.

Howard started Carlton. Howard's now passed away but I'm running things now. It originally was started as an auction company in '91.  We're doing a lot with the ROTC, and loan-sales-backed REOs and whatnot for the banks in the early 90s.

Then, in '98, Carlton sort of changed its focus to doing JV equity along with the debt because, at that time, Carlton realized that what the world didn't need was another mortgage broker. We had to figure out a way to make us a little different to everyone else. In '98 is when we changed the focus to JV equity, and it's when I came on board.

Throughout those years, I've been pretty much doing JV equity for trophy deals, like we did the recap of the General Motors Building for Harry Macklowe. We recapitalized Sears Tower, now called Willis Tower, for the owners, who, before they sold it to Blackstone, because Blackstone owns it now.  We brought in equity for our clients to buy the Bank of America Tower, at San Francisco.

Then, 18 months later, we brought in a buyer of the building to buy it from them, who happened to be Trump, along with his Chinese investors. They still own that building, as far as I know. It was a 1031 exchange that they did. We brought them in to recap, or sell that deal, so to speak. That's sort of how I got involved in what we do, but, like I said, our focus is JV equity.

Typically, we bring in an investor who typically invests in 80 to 90 percent, and it usually comes from one investor. It could be some sovereign wealth fund, or someone off the radar ... A high-net-worth guy, family office. It's typically one investor and they put in 80 to 90 percent of the deal.

Investors, typically, usually means you're syndicating it out to a bunch of people, or investors, or you may have one. If you get a hundred million dollars of equity, one guy puts in 10, one guy puts in 30, one guy puts in 50, and one guy puts in five. We don't do that. That's syndicating.

We bring in someone to do all the equity. What they are is they're like the entire LP. They're joint venture partners in a particular deal. They're buying an interest into a real estate deal. Our sponsor puts in 10 to 20 percent of the equity. After certain returns they get a promote. The LP investor is rewarding them for doing a good job and meeting their pro forma and doing all the day-to-day work. Everyone's happy because everyone makes the return that they want.

We do have a crowdfunding platform where it is individual investor equity, where they do put in $250,000 or so, per each. We tend not to focus on the $5,000 to $10,000, or $20,000 per person investors, on the crowdfunding site. Typically, it's 250, and more. That said, though, we probably have done three, or four deals, where we raise for example, I did a $55 million hotel deal/portfolio, in North Carolina, in Charlotte, and the Raleigh area, last year. We brought in investors from the crowdfunding site.

For us, it's still not big enough. Until we can get to a point, where we have to raise substantial amounts of money, we found that it's become too cumbersome unless you're a shop that manufacturers deals every day and you raise the money where it's like a manufacturing line. It's probably easier to do. For us, we focus on each deal and it's hard to raise $5 million for a deal and make any money. That's not our focus. Now, we've sort of gone back to focusing more on raising equity individually. We never stopped with it actually but we focused less on the crowdfunding than we were two years ago for example.

We also bring the debt along with the equity. We still do the debt; people rarely come to us just to do a loan. They come to us; they want the equity and the debt comes along with doing the deal. We basically raise the entire capital stack aside from what the sponsor puts in himself.

We tried crowdfunding because they changed the laws, so, basically when the Jobs Act happened it opened it up for a lot of investors and websites. It was more of a technology aspect to have individuals to invest more into real estate easier. We thought it could've been an opportunity and it is an opportunity for some groups. Some of these crowdfunding groups are very successful in doing this, but that's all they do 100 percent. They don't have it as a side business.

For us it's more of a side business and to really make it successful you had to put a lot of time and effort into it which, for us, as Carlton, didn’t make sense. We were making lots of money doing what we did before. It didn't make sense to put that on hold; stop raising $100 million of equity for a big deal and start raising $2 million for a small deal. Even though you can do it multiple times and maybe a little bit faster it just wasn't enough volume for us, personally, to make the money that we're used to making by doing crowdfunding deals.

That said, in the future it's the way the future technology is gonna be. It's definitely going to be an aspect. It's not there yet. I think there may be one company out there that focuses more on the institutional investors doing it through the crowdfunding type of business or platform or technology-based platform, but right now it's not really there for the bigger deals.

Right now if you have a billion-dollar deal no one's going to invest over the internet. It still takes a bigger personal relationship. We don't have that click, like on Amazon, where you buy something so quickly it's too late. People aren't gonna do that when it's a billion-dollar deal. You still have that personal aspect of it which is what we thrive in and we like that.

Eventually it will become more technology-based but at the end of the day I don't think a huge deal will be getting done through the internet without a lot of relationships and personal interactions with the investors and the sponsors.

On the deal I mentioned in North Carolina, in Charlotte – the hotel deal – we portioned off a small part of the deal to offer to crowd investors. It was a $55 million deal. I'm trying to think of the numbers exactly but it was around $2.5-$3 million was raised through crowdfunding. Then we had a fund from the West Coast do the balance of the equity and the sponsor put in their equity. Then the balance was debt.

In that scenario we did lay off some to crowdfunding and gave some to an institutional investor. We did do that and we will still do that in the future, but I will tell you, it just takes a lot of people. That was a lot of people in the mix. We did it in-house. We were running our crowdfunding site which we still have and we still use it. We're not as active on it as we were, but we did it in-house. We had a few guys here that really focused on trying to find the $250,000 investors to invest. That's what we did. It was all done in-house; we didn't outsource it to someone else.

Expected Returns

Obviously, the safer property types that investors are looking for is multifamily rentals. We're doing a few value-add multifamily rentals now in various parts of the country. Those deals pan out to mid to high teens and they're 14 to 18 percent - the returns they're expected to generate. If it's more of a core-ish type of multifamily you're in the low teens, say 12-percent IRR.

If it's a development deal it's 20+ percent IRR for multifamily. On hotel deals we're still seeing deals that are projected at 20-, to 25-percent returns because people view it as probably more that it's a riskier property type of the group; aside from condos, which are also a riskier aspect.

Some cities’ condo market is still very strong.  We're doing deals in Seattle and in California. It just still makes sense and those deals are making 25-percent IRRs and they're still selling. There's still velocity. The condos that get hurt the most in New York are really just the $10-million-plus condominiums; what they call, I guess, the Billionaire's Row in Manhattan, but there's still plenty of deals which are still happening today..

If you look at the price market, and the price per unit of a condo, today, the $1-, to $2-, to $3-million range, in New York, that's small. In the rest of the world, it's probably expensive, but, in New York, it's a small deal. There's still a lot of velocity for those type of deals. We're still getting deals done where the ultimate unit price is $1 to $3 million per unit because that still sells. $10 million units are harder to sell because it's a different market. That's the ones that are harder to capitalize unless you have a great project. There are some great projects which are gonna have the $10 million and up units but  they're irreplaceable locations and they're one of a kind. The fringey deals; those are the harder ones to capitalize in New York. Outside of New York we're doing other condo deals in Seattle and California which are on the lower end of pricing and there's still buyers for those condos.

Minimum Deal Size 

We do big deals. That's our MO but typically the minimum deal we would do is probably 50 million where we do the equity and debt. We have done lower. If it's an easier deal - we think we can get it done quickly - we could do a lower deal or if it's for an existing client we would do a smaller deal than 50.

Typically, retail people who come to us for equity and debt 50 million is our minimum. That said though it could be 40 if we can still do it but the bigger the better because the way we look at it is it's just as hard to do or the same amount of time to do a small deal than it is a bigger deal, so I really rather do the bigger deal because for us everyone makes more money and that's really what it's all about.

Listen to this podcast in the shownotes page here.

The news of the collapse of the company came as a great shock to the real estate crowdfunding community on the sponsor side, the investor side, and, naturally, to other marketplace platforms operating in the same space.  Not to mention a great shock for the folk who had been working so hard at the company to make it a success and who had no expectation that the company was going to fold.

 In this RealtyShares special episode, there are three key things to learn. 

One, as an investor you are going to hear about how intensely focused the company was on conducting industry leading due diligence on deals they listed on the platform – you are going to want to be sure that any deals you invest are as thoroughly researched.

Two as a sponsor, the obvious lesson is that while using online marketplace platforms is a great way to get going, you also definitely want to have your own independent channels also – if you are interested in learning more about how to do that, please let me know using the contact page on the NREForum.org website and I’ll send you some information about how to do that.

Three, the overriding lesson to be learned is that it is not online real estate syndication itself that is a flawed thesis, but rather the business model upon which RealtyShares was founded that led to its demise.

In today's episode the founder of RealtyShares discusses the four lessons he has learned from the experience of having started the company, built it to nearly a billion dollars in size, and then left a year ago only to watch the company fold.

Listen to the podcast and read the transcript right here!

When I was a kid, my parents were both, probably, middle class, but I just had an issue, I guess, listening. And so, I was kicked out, and I lived on the streets when I was 16 years old. It was definitely a different day back then. Like, now, I can't even imagine that. But back then, it was, "Look, you're not listening. You're not doing what you're told. You've got go out. You've got to get out of here."

And so, literally, from the time I was 16, I never lived with my parents again. I ended up going into a group home. And it really, I think, to some degree, developed the desire and drive in me to prove to everybody that I was worth being there. And I know I'm getting mushy right off the bat, but, really, I think, that was my driver. And I think that has a big driver. And anybody that's truly successful, there's got to be something that's eating a way at you that's making you want to do better, and better, and go for it. Does that make sense?

I ended up -- Because I had nowhere to go, I had no family for support, at that point, I needed going into the military. I was in the Navy for about three - four years. I lived in Hawaii. And it really gave me a good foundation to build upon. And so, when I got out, I got into some electronics. I was doing supervising stuff. And really just trying, It kept me wanting to do more, and more, and more. And I realized I needed to go back to college to do that.

And so, I ended up going to Portland State. I ended getting a --  I almost got a BA, and I ended up starting a sketch comedy group while I was in college. And that really transitioned me for the next four or five years because I was out running around, developing, and really being an entrepreneur at a young age going, "How do we get this comedy group to make money? And how do we live?" And so, we did that. And as we kept going, we tend to hit a block wall of where we couldn't get really any farther. And so, I ended up coming back down to California, and I said, "I've got to make a change. I want to make more out of my life. I know that I'm destined to be something."

And so, as we kept going through, and I was working, I ended up working at a gym and running a gym. And I just kept seeing the same thing over and over every single job I had. And it was always as, I was working at a company, I would shoot for the top, and then I would get frustrated because I was limited. And that's when I realized I needed to be an entrepreneur. And I think, you can identify with that, right?

I started working at a car dealership. And I love this story because I'm working with car dealership, and I hate it. I'm doing very well, and I was the top salesman, but I hated it because in order to work in a car dealership, you got to -- Look, I've got to tell your car's worth less than it is in order for us to make a profit. I didn't like that. So, I started writing down every day, I'm going to meet somebody that is going to change my life. I will meet somebody that is going to take me out of here. I'm going to meet somebody for the change of life. I literally started writing that.

Three months later, I met a gentleman who brought me on to a company called Aquagen, who, at the time, had one distributor that they were selling at. They had done $5000 that whole entire year. And the year that I came on, when I came on, within that year, we had already gotten it to $500,000, we were across the country to Texas, and we were blowing up. And then, my son got brain cancer and shut me down. And that's the point I realized I needed to be an entrepreneur. I needed to be able to control my own destination because I never wanted to be in a situation again where I had to work, and I couldn't take care of my family. I couldn't be there for my family.

And so, at that point, because of everything that I was doing, I ended up traveling two weeks out of the year working for like Robert Allen or Armando Montelongo, these real estate gurus, and I was out every weekend doing this. And the more I was doing that, the more I get that same feeling like when I was at the car dealership where, "Man, all these people talking about what they're doing." They're not really doing. They're just talking about it. I'm selling you on how to repair houses, but I'm not actually repairing houses because I think it's too dangerous right now. And that mentality was insane to me.

And so, at that point, I started a review. And it was really all about, how do we help people? There were two things. And the reason I'm telling you this story is because it leads into where I'm at now. When I was traveling around the country working with all of these different gurus, there were two things that kept coming up with every investor that came in. And the two things were they needed to make money now, but they needed to make money long term. And, really, what these programs would offer them one or the other. Look, you either can get wrinkles. And then, all your money is in this rental. And, now, you're making $700 or $800 a month. Or you can do this split, and, hopefully, this goes well because if it doesn't, you're going to lose everything. But if it does, well, great. Now, you have money, but you've got to do it again. See what I mean?

And so, my thing was, how do we solve that? How do we solve that problem? And that kind of leads me up to Green Zone. Did we talk about that?

Because my thing ever since that was, how do I solve those two problems? How do I solve those two problems for our investors? And what we started to realize was when we looked at what was happening in cannabis, when we looked at what was happening in the country, we started seeing a trend. Colorado was like its own little thing. But then, it was Washington, and it was Washington DC. Then, it was Oregon. And you're having all these other thieves coming online.

And, really, what that was showing was this green rush. It was showing the ability of states to start making their own decision despite what federal government was doing. And a lot of times, people, right now, are going, "What is federal government going to do? What are the repercussions?" And the reality is, well, the repercussions be anything because it's a scheduled one drug. However, if you look at the past, for the last five years, Colorado has been making millions and millions of dollars.

In fact, in 2016. 85% of their income came from the black market. It came from the black market. Meaning the 85% of that money was going anyway. It was being spent on candidates, except it was being put into drug dealers' pockets. It was being sent out of the country. Now, it's staying in the country. And my biggest thing is whether you're four candidates are against it, wouldn't you want to control it to ensure that it's as safe as possible? And really everybody's answer is being yes, right?.

Going back to the Gold Rush, because of a lot of people are really assimilating the California Green Rush with the Gold Rush, right. And when I started thinking about that, I started thinking, "Well, who made money in the Gold Rush?" Very few people making gold or finding gold made money. Who made all the money? The people that were renting the hotels, the people that were selling the shovels.

How do we find the golden shovels? Where the golden shovels in cannabis? And here is where they are. There are two things that you need in order to have a life with to sell cannabis. Cannabis, by the way, by 2022, will be the largest impactor to our economy, period. It will be the largest single contributor to our economy because -- And I know I'm getting sidetracked but this is a really important point.

People think well cannabis is just cannabis, and it isn't. When you look at Desert Hot Springs, it's got 800 hundred acres being developed. These 800 acres are going to be employing a ton of people. Where are they going to stay? What are they going to do? Where are they going to eat? All of that infrastructure needs to be done and all of that infrastructure has nothing to do with cannabis. Cannabis is just the catalyst.

And that's what's happening. So, jumping back now, what do we need? Where are the two golden shovels? Well, the two golden shovels are real estate and testing labs. And here's why. In order to get a license in California, you must have real estate. It doesn't mean you have to own it, but it means that you have to have a location that is approved by the owner, or you have told the state this is what's happening in this location, and they've approved for that to happen in that location. You can't just grow cannabis anywhere. You have to have it in a green zone, which is why we need better company Green Zone.

So, if it has to be in the green zone, and if there's only a limited number, can that now become a shovel? So, we can be a landholder. We can own this property. They're getting two to three times the lease rates. And I mean, we're talking, right now, our current project, we've got calculated at $178 a square foot for sale, and there are already counts at 200.

So, literally, a half mile up the road from our location right now that we're in the middle of environing, they're already selling the properties for $200 a square foot. Our whole entire base is off of low $78. So, we've got another $25, 350,000 square feet that is in there. That's the buffer.

Entitlement can be really weird. You've got, like, for instance, in -- And I know you're not asking me this, but just for comparison's sake. We did high end in Laguna Beach. They meet once a year. I mean, man, talk about trying to get things approved, that it's very, very, very challenging if they're not meeting very often, right? Once or twice a year is not enough. Desert Hot Springs is meeting all the time. Their city almost went bankrupt in 2013 and 2001. And so, when you're looking at a city that's almost gone bankrupt twice now has a $50 million surplus, they're very excited to get cannabis in there because it's making a difference in their community.

This is what we did. We wanted to be really smart about this. The reality is there is a timeline on this. Everything is not going to have -- I mean, it's all about supply and demand. Right now, there's nothing. So, everybody can get a higher dollar amount. But as time goes on, that number is going to go down. And so, what we want to do is mitigate our risk. The way that we did that was to capitalize on both of the things happening right now. So, where we're building 10 buildings out in the desert, we're going to sell eight of them. By us selling eight of them, that puts us at about $11 million profit, and we own the other two buildings free and clear now.

So, not only did we make a great profit, but we, now, have two buildings that we can lease. And this is the whole idea of how I wanted to solve that initial problem with investors. They're able to get a check out right now of like a flip. But at the same time, we're holding two properties that they're now getting cash flow. And when we end up selling those in eight years, they get another big hit. It ends up turning like a $100,000 investment into, I think, 331% over 10 years just because of everything that we're doing in combination.

And again, this is always about how do we solve the investors cash now and cash flow problem. We also made it, so that they can get out after any project where our goal is to do this for about six years, but we know that things come up. I mean, somebody could have a parent that happens the way. Somebody could have a child that needs something. So, we wanted to make it, so that after each project, you can get your initial investment back as well. It was all about, how do we make this as accessible to the masses as possible, which is why we ended up doing the Reg A as well, so that we can not have accredited investors, but we can also create an opportunity and platform for anyone to invest in this cannabis boom.

We're looking at 2019 when we will have pay out. We already have two companies that want to literally buy the entire development from us. If we do that, we're obviously not going to be holding anything, but we will be moving back into another property that we're looking at acquiring just literally right along the freeway. So, if that happens, then that's fine. All that does is turn the $11 million and I think it's like $15 million or something. So, everybody just makes a lot more money right now, which I don't think anybody will have a problem with.

If not, we have about 15 people that want to either buy a building or lease one of the condos. Here's the other thing we did that really make this accessible. The reality is 57% of cultivators are mom-and-pop organizations earning less than $500,000 a year. They don't understand real estate, they don't understand development, and they certainly can't put a large project like this together. So, what we did was we cut. We have a 162,000 square feet and 10 buildings. Well, they're subdivided. In fact, that's one of the process that we're going through right now, getting a track map. As long as we have that, we can pre-cell. We're subdividing those into 50 condos.

Now, the rules are you can either have a 5000, 10,000, or 20,000 square foot license right now. However, you can't just have 5000 square feet. You also need 10% to 20% overage for offices and bathrooms. So, the reason we cut it in the 3000-square-foot increments was because if you buy two, you're in a 5000. If you buy four, you're at 10,000 license. If you buy eight, you're at a 20,000 license. So, we wanted to make it so that it was maneuverable and flexible.

The other thing that is awesome about that, if anybody has ever done developing at all, one of the scariest things with developing is, "What color do we paint the door? What color do we paint the outside? We're doing residential, right?" Look, we know all the money in the kitchen and the bathroom. And so, we've got to make sure we do all this great stuff. We're building vanilla shelf. I'm not even putting an HVAC because I don't know who's going to be a cultivator, who's going to be an edible company, who's going to be a testing lab, who's going to be a manufacturing lab. A manufacturing testing lab and edible company ain't no weighing the same amount of HVAC as a cultivator.

So, by doing this, we allow the build process to be super fast. I mean, we're doing metal buildings. So, either be metal or panel. There will be a step up from green house, a step down from shelf tops. But the reality is where they're where at, we're best for the price points, and that they're going to be up in six to nine weeks, we can literally have a building up. And so, that's why we know as soon as we get through this process, we've already got people lined up. One of the other aspects we want to do is pre-sell the whole development. So, that way, again, we mitigate as much risk. We've got so many different safety factors in from calculating cost to build at $73 dollars versus our actual is $38, so that we have a $4 billion buffer in build just in case there is something that comes up because as we all know, something always comes up, right?

So, we just want to have enough buffers that we cover all those something that comes up, and we're still able to give more returns. It's always about under-promising, over-delivering.

So, the way that it works with cannabis is that in the area, the city has to allot that for cannabis cultivation zone or a cannabis zone. That gives you the CUP, the conditional use permit. The conditional use permit stays with the building. So, whether they stay, they leave, if we're renting it to them, and they leave, the CUP stays. However, you have to have a CUP in order to get a license. So, the license will stay with the business. The CUP stays with the building.

We own the largest real estate group on LinkedIn, and we have a large data base. And we have been doing and raising money for traditional real estate the whole time for other people, and then doing some of our own stuff. I was in a car with somebody talking about how their parents had gotten ripped off, and it just, all of a sudden, dawned on me that, man, California was legalizing things. Let's shift everything we're doing into this opportunity.

We're talking about something that's been illegal for over 18 years, and it's only grown in popularity. We're talking about a product that, literally, we just read this in a law firm that it has, as for the avoidance of any doubt, there is not a single recorded incident of anyone anywhere ever overdosing on marijuana. And that's huge. When we're talking about the opioid crisis and all of the opioids that are used for pain management, they get them and take them that they can overdose on that. They had people do overdose on. And then, you've got marijuana that is a great pain supplement that can help it, and it doesn't have the same effects. It's just crazy.

We went, "Look, we know that there's going to be an uphill battle. We know that there are still going to have to be the people that change their mind that realize that this is not a scheduled one drug like everybody is trying to say, but let's really shift," So, we started pushing all of our content about this project that we're doing. And we've had mixed reviews. Some people have said that they don't like it for this reason or that reason. But, again, a lot of those reasons are stuck from the '50s, from the Nixon era. They're stuck from inaccurate information. And that's the sad part.

That's the kind of push about it, I think. What was the connection between wanting to build a plant, which is one thing, and figuring out how to actually show it to everybody? I mean, was it using Reg B or Regulation A+? How did you come across that option?

I wanted the ability to allow everybody in. The reality is when you look at some of the big players in this, they're mad men. They just spent $$684 million on acquisitions. The largest acquisition, cannabis acquisition, in history so far. But I mean, it hasn't been that long. So, when you look at that, it's like, "What normal person can get into that deal?" They can't. Those guys are going to make a killing off of that acquisition. But, typically, people don't have $600 and something. So, what can we do?

And that's why we put together the Reg A because we wanted to put together a real 420 fund that anybody can get into for only $420. So, that's, on them, a hundred shares at $420,20.

Now, we have a lot of people that buy 1000 or 10,000 shares. I mean, it's not the minimum. But what it does allow is that single mom that is working paycheck to paycheck to be able to make a difference in her future. It allows that 20-something-year-old, that millennial to be able to do something and make an advance towards their future. That's what we wanted to create with the Reg A. We wanted to allow everybody access to the same awesome opportunity that, typically, only very wealthy people get.

In our parallel Reg 506(b) is going to be $50,000 minimum. That's going to be the pay out that we were talking about. On the Reg A, that's going to also be testing labs. So, the Reg B only focuses on real estate. It doesn't touch the plant in any way, shape, or form. The Reg A will focus on the real estate. It will be able to lend to our Reg B to be able to capitalize and see some of those returns. If we're going to have 120% return on our Reg B, why would I not want to put some of the Reg A money in there for all of our investors there to get a piece of that return as well.

In addition to that, the Reg A will also work on testing labs because boosting a huge deficit in testing labs. If you're involved in testing labs, you can't be in any other aspect of the business, so nobody wants to do it because they all want to grow. They all want to have their brands or whatever. They're straying. For us, it was, how do we really make money, and really ensure quality? And by us being in testing labs, we can make sure that everything that everybody is getting is what they think they're getting. We can ensure consistency and ensure the continued safety of the product.

The biggest challenge with the Reg A was just the time it takes to get together, I mean, efficiently. We've been working on this for about 11 months now putting it together because there's just is so much involved and very expensive. But, again, it's the platform that allows anybody to invest in. And then, we wanted to create that opportunity for everyone.

The big costs associated with doing the Reg A could be anywhere from just setting it up. It can be anywhere from $50,000 to $100,000. And then, where do you get an audit? We've not been doing this. So, we had to get an audit of a bank account that wasn't even in existence. They don't like people in. I mean, there was all these miscellaneous things to get it set up, so that it was as transparent and see-through as possible because that's one of the big things is that Reg A, our destination for it is to be a publicly-traded company.

We've just hired a CMO. She is working on our whole plan. And that's part of what are our November launch is, is that we're getting all of the pieces put together to really have a solid marketing plan to go out because this fund is about a $42 million fund. And so, we really want everything together. We're planning on doing a few different states. But the end goal of this Regulation A fund is to be the largest cannabis testing lab in the country, period.

It's funny. We've actually had a lot of our investors that get involve and want to be more involved. They really like the idea of what's happening, and they want to be a part of it. So, I see all kinds of abilities. The thing about it is cannabis, at this point, literally, probably touch 90% of the country lives in some, way whether it'd be their grandma that was using it for this, their child that was using it for this. I mean, one of our newest employees that we brought in, I would have never guessed she knew anything about cannabis but they had breast cancer. And so, they were using cannabis to get through that treatment. And it's like this really does impact every single aspect of our lives and every person. So, we want to create the reality and the opportunity for people to be able to do that. If I can do one one other thing, it would be to create a delivery service because that's absolutely the way it's going.

The reality is there's a lot of testing labs that are starting to shift from food to cannabis because they get paid a higher dollar amount. But some can't because they're on a federal contract, but here's what's going to change. One of the other things that we found that just blew me away was White House will unveil Federal Cannabis Reform very. So, showed Dana Rohrabacher, a Republican from California, is talking about that after the midterm elections, the White House has dedicated itself to re-engineering, I guess, or what did they say specifically? I've been reassured that the president intends on keeping his campaign promise of fixing the marijuana situation.

So, I mean, I honestly believe by 2020, federally, it's not legal, but it's going to be the major -- That's going to be the major point. It's going to be cannabis because you're talking about California. By the end of the year, we'll have the first -- It's the sixth largest economy in the world, and we were looking at doing, what, $2.8 billion without having it legalized. Now that it's was legalized, we're going to jump tremendously.

And look, at the end of day, it's all about money when it comes to politics, when it comes to Washington. And if Washington sees this much money coming in from a product that has zero death on the record. You can only die from cannabis if it's a thousand times your effective level. So, if it takes you, let's just say, if anybody out there has ever seen like 100-milligram bars, it would take you 100,000 milligrams to get a lethal dose. Nobody would be intake that to be passed out. Do you know what I mean? Like-

Yeah, it's just crazy. So, the fact that there's a lot more acceptance is great, but there still needs to be more understanding that, look, here's the biggest thing, me, personally, I lost 100 pounds because I started using cannabis. I started three different companies. Cannabis doesn't make me fat. It doesn't make me lazy. It doesn't make me stupid. It doesn't make you any of those those things. Will you adjust? I mean, I hate to sound like that guy in the corner that told you these lies that we were told as a kids by the government in order to control the situation. And it is what it is. But none of those are true. It's not a gateway drug. It's not a drug that makes a lazy. It's not a drug that makes you stupid. None of it.

There are three other companies that we know with cannabis being the Reg fund. One was approved in 2015 with the intention of leasing real estate to cannabis operators, but nothing ever became of that company. So, they're basically gone. Then, you got two that earlier this year obtained Reg A fund, one with High Times. So, it's a magazine, and it's focused on publishing magazines and trade shows. So, nothing to do with what we're talking about. And then, the other one is all about the development of products with cannabis in them. So, they're focused on the real estate aspect or the lab aspect. We are the only Regulation A company fund that does that.

 And the other really cool part is there's only a handful of regulation funds that have ever been even approved. I mean, maybe 25. right? I mean, it's not like you've got a ton of them. So, they're difficult to get. There's a lot of things you have to jump through, and it's just an amazing opportunity for us to be able to work through it and get it.

Read the transcript and listen to the episode in the shownotes page here.

I've been in a crowdfunding space now for a little over 10 years. So, transitioning to Buy the Block was just a natural transition. I run a crowdfunding platform now for 10 years plus. It is BBnomics. It's available for the community, so they can raise funds for different projects, community causes, businesses, nonprofit, et cetera. So, upon being in the crowdfunding space, always knew that this was something that was going to be able to pass at some point and be available to the community, basically, crowd investing.

So, always, I paid attention to the laws, making sure that I understand what's going on. And when it passed, I wanted to make sure that that this opportunity was available to other communities as well, so they can be able to invest with each other, so they can support each other, so they can develop their community, and having a say. Having a say if they want to leave a neighborhood, or having a say if they don't want to leave it. So, being able to say that, "Okay, if this building is up for sale, we can actually pull our moneys together, and be able to purchase the property, and have it as part of the keepsake of the community." So, having that option is why Buy the Block exists. And this is how I got here.

Pre-JOBS Act, GoFundMe, Kickstarter, that's the pre-JOBS Act. The crowdfunding itself has been around longer than the Regulation CF. So, it basically piggybacked that idea. Back in 2009, that's when crowdfunding online got very popular. The Kickstarters, GoFundMe, Indiegogo of the world started these portals basically where you can raise money to do anything. Basically, you go to these sites, you set up a campaign, and you can allow the crowd to put money in it. So, that's what I've been in. That's the space that I've been in. And I've been in it for a while managing my own platform that allows people to actually raise money using crowdfunding.

The purpose of that, specifically, is to be able to allow people in the community to crowdfund and crowd invest the properties in their community. Gentrification has been a huge issue in predominantly black communities. So, I wanted to be able to provide an avenue for our community to be able to say, "We're either going to play a role in it, or we're actually going to be the ones that are actually building this community, as opposed to watching everyone come in, take the properties, sell them off, and redevelop it, and then relocate the people that live in the neighborhood."

So, the neighborhood that I grew up in has experienced a lot of gentrification. And neighborhoods that I've lived in, I mean, I've seen it, I've been a part of it. So, wanting to be able to provide a resource for our community to be able to have access or be able to actually obtain the money to get those buildings, be able to obtain those properties, and purchase those properties, and be able to keep those buildings in the community, and keep the ownership of those buildings in the community. That's how Buy the Block exists.

Being that I am a woman of color, and I have lived in these neighborhoods, I've seen it firsthand, and being able to actually witness what happens, seeing or being displaced, being moved, being not part of the development process, but just being on the outside looking in. So, this definitely put a sense of urgency for our community or to be able to have a solution for our community.

There's a lot of people that when these things happen, they may not be able to have the -- they don't have the capital. They don't necessarily have the -- They may have the skills, but they don't necessarily have the capital. They don't necessarily have the circle of people around them, or the group of financiers to make sure that their deal can close and be able to develop that specific building or that project.

So, this is what Buy the Block is about, being able to, one, provide access to capital for these developers that, a lot of times, the doors are closed on them. The banks don't really lend to them. VCs don't don't always extend a hand to them. So, we want to make sure that we are there. They have an alternative source to be able to purchase or acquire those buildings, get the funding, and then close on them. And then, of course, keep that in the neighborhood and keep that ownership in the neighborhood because, like I said, a lot of times, we're on the outside looking in, or we're on the inside, and we're getting shut out of these developments.

The reason for Reg CF is because we wanted to be able to open it up to everyone. And that's what Reg CF does for Buy the Block, allow anyone in the community to invest with as little as $100 to be able to actually be a part of a development. Accredited investors opening it up only to accredited investors was a very small pool in the black community. I'm not saying that they don't exist, but it's a very small pool. So, we wanted to make sure that we can open it up to a much larger audience, a much larger group of people.

We are open to everyone, but we do have a niche market. And that niche market is to serve our community. And our community can be of any color. I mean, we're open to anyone. Sponsors can come from any area, and they can also come from any -- They can be any color. We're not closing our doors to anyone. Absolutely not.

There's still a lot of education to go around. We definitely want to make sure that everyone know what they're participating, understand the rules, and the regulations, and so on. But so far so good. It's been very receptive. It's been very receptive. The community has been very receptive. Just as anything, because it's fairly new, it still requires a lot of education for the investors, for the sponsors to make sure that they know that they're following all the rules that are required to be able to do this one. But so far so good, yeah.

The biggest challenge, I think, is the confusion between crowd investing and crowdfunding. Everyone knows what crowdfunding is and how to do that. I mean, I think, right?  Crowdfunding is donation reward-based. So, for example, you put up a campaign, and I donate $100 to it. And for donating $100, I get a t-shirt, and a plaque, or something like that. But part of the proceeds, you still get towards your business, or being able to create a model or a prototype of something because a lot of crowdfunding is used for the prototype. So, I have this great idea for a watch, and here's how I can get it developed. People can pre-purchase it. It's an idea. It's a mock-up, but when it does produce, here are the people that actually get the the actual watch because they were the first people to buy into the concept.

Crowd investing is slightly different. Instead of getting the watch, or the T-shirt, or the plaque, you're actually owning shares in the actual project itself. So, at some point, once the project becomes fruitful, or, actually, it earns a profit, and it generates revenue, you can be an actual shareholder and earn dividends from it. So, that's the difference between crowdfunding and crowd investing. And I think that's where there's a little bit of confusion that people think crowdfunding is still, or you're crowdfunding basically. "I'm putting money, so that means I'm donating." But no, you're not. You're actually investing.

The deals are very community-oriented. So, for example, if it's something that actually solves the problem or, for example, grocery stores solving food desert issues, for example redeveloping land to provide affordable housing. So, these are the type of deals that come to Buy the Block, and these are the type of deals that we actually are supporting through the network.

The screening process is very, very long and tedious. We have to work through all the documents, make sure that it is a legitimate company. We do all the required checks and form that one FINRA requires and the SEC requires us to do. And then, we have an underwriting process where we actually go over every deal and make sure that it can be profitable for the investors as well. And then, from there, once it gets through the underwriting process, then we can determine if it will actually be a deal that we can host or not.

Our deal sizes range from under 100,000 to millions. I mean, it really depends on the project. Some require more capital than others. I mean, building a single-family development, it's in the millions as opposed to in the hundred thousands. So, the range is very, very wide. It really is, but we have some really great sponsors and developers out there that are definitely using this model to be able to acquire properties and be able to develop their communities. So, it's a wide range.

They're coming from all over. There's not a specific geographical location. They're coming from, oh god, I mean, Texas, to Florida, to Washington. I mean, they're coming from all over. So, I mean, I think that's a good thing. Our reach is very, very far and wide.

We've had sponsors that come to us that are not African-American, and they found us through whether they've found us on online, or they found out about us through other networks that either shared our story at some point. But we've managed to get quite a few very ranging, and the Hispanic community, African-American community, everyone. Everyone has been moved. We've been able to get people from all over, all over walks of life.

Marketing is really is up to the sponsor. Honestly, it takes a lot of work from the sponsor to be able to put themselves out there, and talk about what they're doing, and get people excited about what they're doing. So, that's what gets the most attention. So, we really stress to our sponsors to be out there. Get people knowing what you're doing, how you're doing it, and let them know that there is an opportunity available. Just get yourself out there, get what you're doing out there. That seems to work better than anything.

Nobody can explain what you're doing better than you. I mean, I could talk about it, and I can say, but the only person that can really explain what you're doing is the person that actually came up with the idea, the CEO, the president of the company. So, that's something that I really encourage the sponsors to do is get themselves out there and let the community fall in love with them.

They'll put up all whether it'd be -- They talk about it through an interview or any platform that it's open to. There were some sort of shared linked program. And then, they'll point to and they'll say, for more information, like you said, visit Buy the Block. And that's how they drive investors to it because once investors get there, they read the information, they download all the documents, then they get an idea, get a better sense of what's being offered to them.

The good sponsors are not afraid to put themselves out there. They're not afraid to talk about what they're doing. They're not afraid to get people to understand what they're doing. If they are building an office complex, they're not afraid to explain, "Okay. Well, this is the history I have. This is what I've been doing. This is the work that I've done before. And here's the next project I'm taking on." So, that's the difference between a sponsor that really gets the word out there and one that don't. The ones that don't do very well are the ones that don't talk about it at all. They don't really let the people in on what they're doing, or they're not comfortable putting themselves out there and talking openly about what they're doing.

Five years from now, I would hope we are spending millions of dollars worth of development, and being able to make sure that sponsors are holding their end of the bargain, and the investors are actually seeing the reward for taking risk, basically. So, yeah. I mean, that's pretty much what I would like to see five years from now. Just being able to make sure that everything that the sponsors say that they would do, they're holding up their end of the bargain, and investors are seeing the reward for taking the risk on the sponsors.

Right now, the state of the real estate market is a little undetermined. It's hard to say where it's going. I have seen some updates about some slowing down in some areas. But, I think, for the most part, it's still pretty steady. It's hard to tell. It's really hard to determine which way it's going because there's a bit of --What's the word I'm looking for? There's still a lot of hope. There's still a lot of people that are in the market that are that are buying, and selling, and still able to generate revenue, and be able to do what they want to do in the real estate market. But it's hard to determine right now. I think we have to wait and see. I really do. I think we have to wait and see.

Listen to the podcast and read the transcript on the shownotes page here.

My father is in commercial real estate, and when I first got my driver's permit, I was driving around with him, taking pictures of commercial real estate assets, specifically apartments. That was my first sort of intro to the world of commercial real estate. Out of college, I started working for a lender that was primarily focused on Fannie Mae, and Freddie Mac debt. I did that for the bulk of the start of my career, and I learned some very important lessons, but, I was obviously exposed to the intricacies of commercial real estate. With Fannie, and Freddie, you're obviously really focused on multifamily.

One of the things that Fannie Mae did that I thought was really smart is they have a risk loss sharing agreement with all of their lenders, their designated underwriter, and servicing lenders, which gives them a certain amount of rights, and responsibilities, when it comes to who they make loans to, and at what terms. In exchange for having that responsibility, there is a risk loss sharing agreement.

Fannie Mae, to its credit, has created a structure, where these lenders out there that are interacting with borrowers, and dictating terms, and doing the hard work of actually getting money out the door, gave an incentive to these lenders to make sure that it was good money out the door. It was an early lesson that I learned. Essentially, we were underwriting loans with an equity perspective. That's how I got started.

I did that in Chicago before I moved to Boston. In Boston, I continued that. I ultimately moved from Boston to New York. One of the key reasons I moved from Boston to New York was I'm a Midwest kid, so being in New York was a really easy sort of transition, where the diversity is really, really broad. I also had a nice crew of both personal, and professional friends here. I went to work for a company called The Carlton Group, and I got to expand from just doing multifamily debt to doing preferred equity, and mezzanine debt, and all asset classes, not only in the United States, but throughout the world. Having an opportunity to learn about other asset classes, and other positions in the capital stack was kind of the focus.

Now, if you're familiar with Carlton, I was there for four years. To Howard Michael’s credit [CEO at Carlton who has, sadly, since passed away], it's not an easy shop to live on a day-to-day basis. It is, however, an exceptional place to learn a lot. It's a tradeoff that I was certainly willing to make, and I think other people have made. Howard took his professional performance very, very seriously, and expected the same from his team. It was an interesting time, and I was there from 2006 to 2010, which was a time of radical transition for virtually any commercial real estate executive, so, it was interesting.

One of the great things about having a boss like Howard at Carlton is he understands the mandatory evolution that's required. We went from raising capital on fairly straightforward deals to attempting, and successfully, in certain instances, trading distressed paper. Carlton set me up with some expertise in the note-trading space, and I got drafted to Cantor Fitzgerald, which is a large fixed-income trading shop. They trade a lot of different things at Cantor Fitzgerald, but I was brought in, and integrated a loan-trading platform into their fixed income.

I sat next to some muni traders. I sat next to some CMBS traders, high-yield traders. A lot of the clients that were buying the types of fixed-income products from other salespeople within Cantor Fitzgerald were, of course, curious about some of the buy opportunities in commercial real estate, and we had our own universe of buyers, as well. We advised the FDIC on some of those transactions, and Colony [where Gower worked at the time] was such a compelling bidder, for a lot of different reasons. The FDIC put together a really interesting structure, and, at the time, and you've already pointed this out, there's a lot of different reasons to sell, we would call it a piece of paper, or a mortgage instrument to a buyer. There's a relationship there that maybe didn't exist prior. There is yield there that is probably above what currently existed. Interest rates were significantly lower, then, than what some of these loans, when they were originated. Even paying par for a loan still meant a premium yield.

It was a great, great opportunity that forced all of us to learn not just what the value of real estate, and collateral was, but how these positions are structured, and how certain terms, and conditions - whether it's a mortgage, or a preferred equity position - might impact the long-term value, and how it relates to the underlying collateral. It was a very interesting, and compelling time to be in the industry.

It was an exciting time. It was those of us that adapted to the transition in the market and were able to provide a service that was relevant to what was currently happening was a really important lesson. I think it was one of the key lessons for me, in my career, and my willingness to sort of take the step into commercial real estate crowdfunding, because I think this, what's going on in the private placement space on these crowdfunding platforms, is still nascent, but it does have similar characteristics to what has happened from 2008,'09, and '10, and then, as the market stabilized in 2015.

That's how we got here. I was at Cantor Fitzgerald; I made the move to GE Capital, because I thought it would be a nice, long-term, stable place to have a 20-year career, and GE Capital sold everything, so, I was in and out at GE. Despite my move towards something that was maybe a little bit more longer-term, and stable, it ultimately turned to be remarkably short-term. It was a reminder to not be afraid to constantly adapt, and stability isn't necessarily strength, in anyone's career, at any point in time. I had to make the decision, after GE Capital, I had to decide: do I go back, and get a more traditional role, like I had, or do I go get a job that I think I'm going to want to have five years from now?

It was very evident to me, especially people in financial services, how important, and how massive the fintech space not only is, already, but is likely going to become over the next five, and 10 years. With a little bit of time to think about it, it ultimately was a no-brainer. I think you've made a mirror step in establishing the National Real Estate Forum and understanding the potential in this space.

It was an aggregate of the long-term potential. It also happened to be a really great fit for my skill set. I had done a lot of underwriting, for a really long time. At Cantor Fitzgerald, I had to make a lot of phone calls, and I had to establish a lot of relationships. Those two skill sets are actually particularly well-suited to crowdfunding. There's a constant demand for underwriting and reviewing an awful lot of deals. The ability to quickly, and efficiently select the ones that make the most sense, and have a reasonable structure is a skill set that not everybody has. It takes time, and it takes generally seasoned executives to pull that off.

Then, you've also got to not only interact with the sponsors, and borrowers, but there's a lot of investors out there - more than a traditional real estate deal - that are very curious. Some of them very, very sophisticated, that have been doing this for a lot longer than I have. Some of them not so sophisticated that need very complex ideas distilled into relatively short, and efficient answers. It's kind of like the traditional teacher, until you really know something, you can't teach somebody. This is an opportunity to help other people learn about what we're trying to do, and it's an opportunity for me to learn from people that have been doing this for even longer than I have.

I decided that I wanted to get into real estate crowdfunding. I went and looked at the top real estate crowdfunding sites, like a lot of people do, and I went, and tried to get a job, and I ultimately did. Now, unfortunately, it ultimately didn't work out. I had a series of clients, and was given an opportunity. I have a co-founder that had a really remarkable vision that coincided with mine, as well. I had the opportunity to start my own platform, and there were a few key things that we needed to resolve.

One of those is how do we differentiate ourselves in this market? It was a somewhat crowded market, but not terribly crowded, with really qualified, and competent players, but we wanted to distinguish ourselves. It's what you mentioned before: we need to make co-investments. I have a single source of capital that not only understands commercial real estate, and is an active investor throughout the world, not only in the United States, but in Australia, as well. They are willing to, in certain instances, prefund these deals. They're willing to provide capital for co-investments, and they understand real estate.

Having a good co-founder, to people out there considering starting their own business, having a good co-founder that not only understands your vision, but can help you execute it is an irreplaceable asset, when it comes to navigating the world of startups.

It's been a little bit over a year since we started the company. I've been active in private placements, now, for almost two and a half-three years. The biggest challenge is relevant to pretty much any startup, I think, and that is establishing the brand. It is, from a macro perspective, something that is done by just the basic blocking, and tackling, every day. We're going to have our first capital-raise payoff next month. The process of getting that deal funded, keeping regular updates going out, and then, ultimately, making the repayment, that's how you establish the brand. As inquiries come in, providing timely, and accurate responses, that establishes the brand. Doing podcasts like this, making sure that articles go out, all that stuff is the day-to-day responsibilities of First Real Fund, and that's how we established the brand.

Fortunately, our biggest problem is a relatively straightforward solution, and that is keep at it, and do the little things right. I think that's our biggest challenge. One of the great questions, I think, about crowdfunding platforms, in general, is are you a tech firm, or are you a real estate firm? The answer is we're both. From an integration standpoint, and resource standpoint, we are more a real estate platform than we are a tech platform, but all the platforms do a really good job of integrating technology into this.

There are some key avenues out there. Google is a remarkably powerful tool. When you look at the value of Google, it's an impressive thing. Then, when you are managing an online platform, and you see Google Analytics, and their ability to provide specific data feedback on what's happening on your site, you have a whole new respect, and appreciation for the things that Google can accomplish.

 We, like a lot of our competitors, and a lot of people in this space, and, given that we're an online platform, it's obvious that online advertising is a prudent place for us to be spending advertising dollars. Twitter is one place. We've found that Twitter isn't necessarily the best place to attract the most relevant attention, but Facebook is obviously interesting; LinkedIn is obviously interesting. Google Ads are a part of our monthly ad spend. What we have found is that you give one of these platforms a budget, and if you don't limit it, it can take off like a rocket, and you can spend unlimited amount of money in a very short period of time. The challenge is, of course, understanding how those are converting into actual investors. It's a little part of our growing investors, but that, at least, gets attention for the platform.

I think, without revealing too much information, things that move, any type of video, gets more eyeballs. I think that LinkedIn is probably the most efficient social platform to be on, and it's impossible to ignore Google's remarketing capabilities.

Sourcing Deals

Given the 20 years I have in the industry, I have plenty of relationships that ... I have plenty of people asking for First Real Fund to help them raise money, so, if you put ... We also have on our site, "If you're interested in having First Real Fund raise money, submit a deal." We, like a lot of platforms, get to see a lot of deals that way. What do we like is kind of one of the key questions, and this goes back to our initial conversation about handling distress in the market. We like sponsors that have experience, or some sort of demonstrated competitive advantage. There's two things we like to see. One is local expertise, and at least a certain level of track record when it comes to per-unit, or per-square-foot history.

We also love sponsors that are in growth mode, and they've outgrown their current source of capital. That, frequently, is friends, and family, or a small private equity firm, where they're giving up a huge amount of the upside. We would prefer to have either a preferred, or mezzanine position, and limit the upside for us, and for our investors, in exchange for subordinate equity from the sponsor. We love to be in the 60 to 80, even 85-percent loan-to-value, and loan-to-cost, and we're willing to cap our yield, in order for that preferred position.

When you do a stress test, you can have a material change in value, and still have the investment position be sufficiently protected to not only have zero loss on principal, but also still achieve the return. We're comfortable doing mezz debt, or preferred equity. In fact, a lot of our preferred equity looks, and feels like mezz, but it's typically behind senior debt to prohibit a subordinate debt position. In other words, it'll have a fixed rate of return, and it'll have certain triggers, so that there's the equivalent of a maturity date. It'll be directly behind the senior debt, and it'll be superior to the equity from the rest of the sponsor, which is kind of like a mezz loan.

It's got a maturity date; it's got a fixed yield right behind the senior debt, and there's a lot of support, and equity, but it has the benefit of a lien. There's a little bit of a yield differential there. It can be as tight as one or two interest rate points. It can be as wide as four to even six, depending on sort of how high in the capital stack you're going.

Mitigating Risk

What we have done in the past, and I would say what we ... A great deal for us would be 50/50. If it's a $10 million deal, and I think that's a nice middle market sort of a round number, because we're only raising $1 to $2 million dollars per transaction, a 10, or 15, or $20 million deal, we're still a material portion of the capital stack, our raise.

We'd love to see 50/50. If it's a $10 million deal, there's a senior lender that comes in for really cheap, up to 60-percent loan-to-cost. We come in for the six-to-eight tranche, and then, the sponsor comes in for the eight to 10 million, the last piece. That's a homerun deal for us; that's 50/50. The maximum that we would go would be probably 80/20, where we would provide 80 percent of the equity, and the sponsor provides 20.

Our investments are kind of the pref-equity mezz debt, which has similar characteristics. Then, JV equity is a significant part of any of the aggregate commercial real estate universe. It's definitely a product that we like to participate in.  We like to have a transaction, where we're the sole other capital provider. The reality is, is that, in order to have access to some of the biggest, and best deals, we'll make a $2 million contribution, but if it's a $50 million deal, we're just not the only equity partner. We're simply one other limited partner amongst many others.

It's less desirable, because you're not the primary contact. You're one of many people in a larger pool, but sometimes, for larger deals, that's what ... We'd be crazy to ignore investors' potential appetite for a really high-caliber deal that's larger, and has a sponsor that has a tremendous amount of experience. Otherwise, investors wouldn't normally have access to that type of deal. We do do that; I mean, we do both.

Being a majority investor feels better, is one thing, right off the bat. You're really establishing a clear relationship, and it's less complicated to understand every relevant party's interests, if you just have fewer people involved. That's one reason.

It’s also a huge advantage, as majority investor, to be able to negotiate terms. When you're negotiating either a loan doc, or the operating agreement, you're the only party that's involved. If you're one of 50 joint venture equity partners, you're signing the docs, as is, more than likely, 90 percent, 99 percent of the time.

Knowing what to negotiate in the contracts is the level of expertise that you don't get as an analyst; you don't even really get any type ... As just a real estate person, you really have to have entity-level experience, or executive experience, and you have to have access to lawyers.

There's a few key things to look for in the offering documents to negotiate. You always want the control provisions to be favorable for you, and you want to treat your co-investor, your sponsor, with fairness, and you also want them to treat you fair. If they make mistakes, if something happens that's beyond their control, the ability for you to execute your workout plan, and this is relevant ...

Living through 2008 to 2012 was really relevant for me, and certainly, for you, because we learned to address, and how important some of these terms are. The market has evolved since then, and some of the terms have become more clear, and some a little bit less clear.

The best way to summarize it is you want to be able to take control of any property without too much hassle. Sometimes, frankly, being in a preferred position is easier than being in a mezz position, because foreclosure is a terribly long process, and, sometimes, simply the threat of foreclosure is your greatest asset, when it comes to that.

 If you're in a preferred position, and there's a series of provisions that allow the sponsor, or require the sponsor to hand control over to you, as the sole co-investor, that's a really powerful position to be in. That's top of mind, when it comes to what we look for in the offering documents.

Listen to this episode and read the transcript in the shownotes by clicking here.

Education wise I have a master's degree in economics; I completed Harvard's strategic marketing management program and I am a Ph.D. candidate at the Chicago School. I'm about two thirds of the way through or somewhere between a third of the way through my dissertation on organizational leadership. Hopefully by the end of this year early next year I'll be I'll be a doctor; Dr. Steve Kaufman. That's a little bit about my education. I'm a lifelong learner in fact when people ask my number one hobby I always tell them that it is learning and education. And regarding how I ended up as the founder of Zeus, I'm also a CPA. I'm not practicing but I am licensed and in my early days I went to school at night finishing my accounting degree and I worked in public accounting during the day. And this was when Bill Clinton was president. Dating myself just a little bit I'm not that old. Bill Clinton was the first president to recognize that in the United States GDP is sourced 18 to 22 percent from real estate. Said another way; somewhere between 18 and 22 cents of every dollar made in this country is made in the real estate industry. He realized that if there was one segment that he could easily influence it was the real estate industry by making financing a lot more available. He started pressuring Fannie Mae and Freddie Mac to lower their downpayment requirements from the 20 percent down to the 10 percent down to the 5 percent down to zero.

Much of what you think is the mortgage crisis of 2008 really started in the late 90s and that economic experience that we had was so positive was really a part of that. During that time I happened to be a student at night and working in the day in public accounting. The firm where I worked ended up getting mortgage companies and mortgage banks as clients. At the same time I was a real estate investor. I owned three rental properties last time I was 21 years old and I've never inherited anything other than a little bit of medical debt and funeral expenses, so I don't come from money. I grew up incredibly poor. In fact a lot of people who know my true story know that I grew up in a trailer park and for about 80 percent of my life until I was in high school, I did not have electricity. I did not have a telephone. My mother made my clothes and she gave us IOUs for our birthdays and most holidays.

I have four older siblings none of them graduated high school so I figured I would do what they all did which is I dropped out of high school in the ninth grade. I went to work like them because that's what you did where I grew up in a trailer park. Everyone went to work and then sometime around the age 17 I realized that I had to do something different than everyone else around me or I'd end up just like everyone else around me.

I became addicted to drugs. I drug myself to work, I drug myself to school, I drug myself to the bank to save money. I drug myself to volunteering. I started dragging myself to all these places that I know that everyone else in my neighborhood in my trailer park wouldn't do so that I could have a life that they wouldn't have. And I've been doing it ever since. Circa 2000-2001 I was working in public accounting and I decide that maybe I should consult in the mortgage industry or lending industry. During that entire process working for a few clients I decided to start my own firm and I called it Zeus because Zeus is the god of all the gods in Greek mythology and we could simply be the god of all gods in the lending space. That's where it started about 15 years ago and we've had an amazing ride. Lots of great people making a lot of difference for people.

JOBS Act Miracle

The Jobs Act helped in a major way. We were doing hard money lending prior to the JOBS Act and prior to that if you said the word ‘hard money’ even though it was a great tool that a lot of investors loved and used, the JOBS Act did something really miraculous. It's like the war on drugs or making the estate tax the death tax or what global warming is to climate change or in the 80s they had a variable rate mortgages and now they're called ARMs, adjustable rate mortgages. All of these name changes have a dramatic impact on us as consumers as a whole. The JOBS Act took crowdfunding which was basically sourcing investments for real estate from different individuals and opening up the opportunity to do transactions that a traditional bank wouldn't do. Well that's called hard money in the real estate industry and it's been a product for 30 years or more. The change of name transformed our ability to market mainstream a product that we were kind of keeping in the shadows. We launched a few years ago, ZeusCrowdfunding.com which last year was ranked the seventh best site in the country and the number one new site in the country for investors in crowdfunding real estate. A big part of that is because of our commitment to transparency. What it really did was it allowed us to move hard money with a slight name change into the center stage and market it in a way that people were willing to accept it.

Funding of Loans

The changes were significant; small shifts but they've had a major impact in. Prior to the JOBS Act when we funded a loan we funded it with our own capital and then we sought out individual investors that we knew, friends and family and acquaintances that may want to invest in that loan, one at a time to only accredited investors. Very slow tedious process. Then literally overnight we were able, thanks to the JOBS Act, to put that transaction on a Web site ZeusCrowdfunding.com, under our view investment section and then investors all over the globe including Singapore are able to see the deal and invest in it after we've already funded it. It made our job to solicit for funds so much easier. Ironically what used to be our number one problem, which is getting investor capital, now we do not even think about it. It is so overrun that we've raised our minimums we can't handle the amount of people who want to invest with us and that's not a plug. We really cannot.

Discovering Crowdfunding

I didn't even know that the JOBS Act had been passed. I didn't even know about real estate crowdfunding until a friend of mine who was an avid and real estate investor asked me to vet a site where he was going to invest in some transactions online. This is by far without a doubt one of the top 10 sites in the country and when we looked at the deal closely together he asked for my underwriting expertise. We like to say that our firm is good at two things. Number one by far is risk assessment thru underwriting and number two is marketing as in giving our customers borrowers and investors what they really want. Those are the two things we're good at. Well he knew that because of my accounting background and some of the things I've done in my career that I would have a good eye for this and so we looked at the deal. We thought well this is a terrible deal but more importantly I thought how are they able to ask you for money they don't even know you. Prior to that you had to be going to the accreditation process and everything else and so we'd explored their site and we read about the JOBS Act.

I had never learned about it before. I'd never heard it in mainstream media and this was probably four years ago five years ago and I really thought that this is going to be a place to be. With peer to peer business growing dramatically across the globe when you think about Uber or you think about Airbnb, Uber is not going to shut down all car services or taxis but it is taking them and making a meaningful dip. Airbnb is not going to shut down Marriot but it's taking a meaningful dip of their business. I feel the same way about crowdfunding for real estate that we're not going to shut down the banks but we are going to make a meaningful difference a meaningful dip in their market share. The way I tied them together is I saw what another crowdfunding site was doing. I was already doing that but doing it the hard way and I realized that we could create our own platform make it a little bit better and offer the same product but just make a little bit better.

We were in a place that we needed a web presence so we created the Web site and that was just simply from reading the JOBS Act and reading what was permissible. Anybody listening to your podcast or your interviews can read the JOBS Act. It's written in reasonably straightforward terms. We read that and we knew that we needed a Web site that had enough disclaimers that let investors know that they are at a risk of losing their investment if they do a non-guaranteed investment.

Guaranteed Investment

I'd be remiss if I didn't say that we are one of the only sites in the country to offer guaranteed investments through our 15 year corporate guarantee. We very rarely actually make non-guaranteed investments. Almost all of our investments are guaranteed which means if something happens to the asset we still pay the investor. We foreclose, repurpose it and the investor is never negatively impacted at all. We were highly discouraged, we were even mocked once in an interview that we were doing that by another by another platform. But it's worked, it's our model.

We've funded almost $3 billion in mortgages. Our investors’ only complaint is that we're we aren't fast enough or not have we don't have enough deal flow.

We’ve been guaranteeing loans for more than 15 years. Since prior to the existence of the company. When I was making loans prior to the existence of Zeus, I was making loans and if I had to bring in an investor to help me recycle my cash to do it so I could do more loans I would tell them Look my new company will guarantee this.

To describe how we do that, I use this example. If you're going for heart surgery you always ask for a second opinion because you want to know if someone else has a different view of what's happening. But when you get on an airplane you never even ask for the resume or the experience of the pilot and the co-pilot. The reason why is because on the heart surgery if something goes wrong you stay there but he gets up and goes back home to his family that night and nothing impacted him other than he's regretful But the pilot you don't have to ask for their resumes because if the plane goes down you all go down. In our business model we're partners with our investor to the point that we're confident in what we're doing. We want to give them the reassurance that we're pilots with you on this. We're not heart surgeons, you're not taking all the risk and we're just getting a slice and dice where we think is appropriate. We're in it together.

Think of it another way. If you're really confident in your underwriting, why wouldn’t you guarantee it? Then a third element is I'm already putting my own money in the deal upfront anyway. No investor ever sees a deal on our platform ever that we haven't first lent our money unless it's listed as non-guaranteed. I'm so confident in the transaction I've already given my own cash. I've already underwritten it with my team. My underwriter who works here, on of my first two employees from 15 years ago who both still work here, if she says if we're going to do the transaction based on our matrix and our underwriting criteria and we fund it why would we not guarantee it to an investor.

Underwriting a Guarantee

We have a less than 1 percent default rate on our portfolio. We've never had a down year in our portfolio. It's not a matter of if, it's when you take back an asset. If you're in this space that's not the issue. We even do a little bit of thriving through recessionary periods. We like this business during corrections and economic downturns because the industry itself is macro economically countercyclical on a full scale. This industry does better. It does better when banks retract and the economy contracts. People need alternative financing. You could say we were potentially losing business, losing deals because property values were dropping. On the other hand you could say we were gaining market share because of the amount of business we were doing.

I will tell you in 2008 the entire year when we took back five transactions and of those five transactions two of them three of them we sold within probably three to four months and we were made whole or made a profit. Two of them we had to hold for another year and a half. When that happened we gave the investor the option to pay them off and keep the asset, or to keep paying them as we were paying them before.  We ended up when we sold the assets about a year and a half give or take later we made a somewhere in the low 20 IRR in our money net of what we had to pay to the investor. We came out very ahead on the transaction and we were happy to have maintained the investors.

The question is do you have the staying power to do that based on your portfolio and so a small lender who guarantees they're guaranteeing that because they probably can't get the money anywhere else. But our company has no debt. We service and manage all of our own assets and we're perfectly positioned to repurpose based on the foundation of the company. One other thing that we do is invest in assets and so while we're not a home investors franchise, we don't actively buy residential property, but we do do a few commercial projects a year that we redevelop that are more what I call Mom and Pop commercial real estate which is $10 million or less. We understand what it's like to take back the property and to repurpose it. We prefer to only be in the lending business when we do a loan to lend on it. But we understand if a property has to be taken back what to do with it. That’s how we underwrite our guarantee.

Read this transcript and listen to the episode in the shownotes to today's episode, here.

The summary is that my co-founder Nick Bhargava and I were looking into a bunch of ideas that would allow us to test the theory we have about capital markets and in the end we found that real estate was the best arena in which to test those ideas – and as we tested the ideas it became a real business. We both come from a different perspective compared to a lot of other founders in the industry. A lot of people approach this business and ask the question how can we make real estate financing better? Some people have seen an opportunity to cut out middlemen in the financing supply chain, for example. I think all of those are good worthwhile motivating factors. For us because our approach is a little bit different we look at a world in philanthropy, in fields as diverse as wireless and finance and we see a world of people who don't trust intermediaries; who see opportunity to use their connections to others through social media; to see an opportunity to use the information which is newly available courtesy of the Internet. It's a global phenomenon. People believe that they're capable of making their own decisions. In finance what Nick and I found was that 96 percent of us aren't allowed to make our own decisions in real estate because of a combination of the way the industry is structured and how our securities laws are formulated.  We aren't allowed to utilize our independent discretion to access some of the most lucrative investment opportunities out there and those are the ones that are typically known as being in private securities markets. We set out on a mission to open that up. Now it's five and a half years ago after we found ourselves in the first beachhead market in real estate market. That's the broader mission and that's why we started GroundFloor.

I was introduced to Nick because I thought there was an opportunity to invent a financial product that would allow people to participate in private securities offerings spread out amongst thousands of investors. One word that people used at the time was crowdfunding; Nick was actually an expert in that area, it's why I was introduced to him.  He helped to work on Title III of the 2012 JOBS Act. He was in the Rose Garden when President Obama signed the Act into law and was very thoughtful about how to apply securities law to crowdfunding use cases. I was introduced to him because I was interested in creating a financial product that would that would allow lots of people to participate in something that typically only large private financial intermediaries could participate in. We recognized that we needed, if we were to be successful with a mass consumer product we needed a few ingredients. Number one if you look at our product today and that the subsector of real estate needed that we actually delivered on was a high yield product. People are pretty irritated that they only earn 1 percent in their bank account in terms of interest so we wanted to provide something that provides a really high yield.

We also wanted a short term product so that we could test and iterate our own credit. LendingClub and Prosper had terms of three to five years on their loans. We imagined something much shorter where people could get their feet wet and get confident they would be repaid quickly. And then of course as entrepreneurs we needed a profitable sector.  We needed somewhere that the users of the capital that we provided could afford to pay to feed our business model which is based on origination fees. Over time we found ourselves drawn to the residential renovation market. We ended up making some loans in our first loans in February 2014 about a year after we started the company. We funded our first loans on small fix and flip projects that were in developing neighborhoods in Atlanta and we realized that investors snapped them up very quickly. We set a minimum investment of just ten dollars so that it would actually be acceptable to many people and over time we've added many more investors, until now when we have thousands of investors. Our loan sizes are larger but the yields are still very high and the terms are still short term still 12 months or less. Yields are still about 11-12 percent, and it's a very popular product for the mass market investor.

The Grading System

If you're investing $10 you're not going to do hours of due diligence on your investment. What you need is a shortcut as an investor that you can trust to understand the risk of a particular loan and incorporate it into a portfolio of loans.  What's different about Groundfloor is we uniquely allow you to build your own portfolio. There are REIT products out there that use Regulation A as well that are available to non-accredited investors online that will allow you to invest in a fund and then that fund will go out and choose investments and put them in there. Some of the REIT products that are out there have 10 or 20 loans in them for example, whereas we offer a 30 to 40 loans a month and you can pick and choose so the grading system is your shortcut. With an A Grade loan you learn over time for a whole bunch of reasons is a lower risk product than a D or an E or an F grade loan. We go all the way down to G.  Lending Club and Prosper did that same thing when they set out on the same course in consumer debt. And it worked really well for them. So we adapted it to the real estate use case.

The mechanics are important but I think they even more important part of it is the motivating purpose behind it.  We started the company feeling that people are smart enough armed with enough information to choose for themselves. If I told you that you could invest in the stock market but your only mechanism for doing so was a mutual fund index fund or an ETF you'd look at me like I was crazy. It's good that those options exist but we all want to be able to make our own decisions about what stocks we buy and the market lets us. But that's not true in private securities markets. Here at Groundfloor we uniquely created a security that gives you the efficiency of an overall offering like a fund but retains the decision making characteristic that you have with individual investing. Specifically at a mechanical level our investors are making a loan to Groundfloor and we in turn are investing that money as they direct in a series of limited recourse obligations, LROs, that they choose. One of the questions we get from sponsors a lot is, if this is crowdfunding how do I know that my project is going to fund? Well, you don't have to worry about that because we prefund every loan. Like any originator we have access to credit lines and we step in and prefund every loan.

We are one of the few platforms by the way that's out there that actually does originate every loan that we make and that we offer. We go out and we prefund that loan and then we hold it on our books until it's ready to be released for investment. When it's released for investment, people pick and choose which ones they want and we will accept investors until it's fully funded. That usually takes about a week sometimes hours or days; more typically a week and people invest on average somewhere between on average $100 to $500 per loan. On average there are about 20 loans in every investor's portfolio and it means that if you have only $1,000 to invest if you have $100 to invest you can build a portfolio of 10 or 100 loans and be pretty well diversified. Once the loan repays you're repaid exactly what Groundfloor earns. So if a loan is at a 10 percent annual rate of interest and it goes nine months, you get nine months of interest at 10 percent; which is exactly what we earn on the loan. In our agreement with investors and mechanical level is to return exactly what we earn from the underlying loans.

We earn origination fees from the from the borrowers and today Groundfloor doesn't have any fees charged to investors. Investors can put their money in fee free. There's no spread. There are a lot of people out there marketing these investments to accredited investors and I say “caveat investor watch out.” Ask the question, does the platform actually originate its own loans and in several prominent examples the answer is No. They buy loans then sometimes they sell them to Wall Street. One platform out there is backed by Goldman Sachs and then whatever Goldman Sachs doesn't want they float to retail investors. But all along the way they pick a big hefty spread off the top of what the investor earns. They go out and buy a loan that the borrower was willing to take at 12 percent and then the platform goes and buys the loan and then turns around and offers it to investors at 8 percent. Investor beware. The second thing you see out there in do they originate and do they actually pass along the full interest. Those are the two things to watch out for out there and crowdfunding Wild West.

What’s great about our platform is that people can make their own decision what loans to invest in. Some people want to only invest in the most secure stuff where they are willing to accept a lower yield. Other people say you know what I have elsewhere in my portfolio outside of Groundfloor I have secure positions, so I want to roll the dice and go for high yield loans. People who go for the high yield loans typically understand over time that there's greater risk to those in terms of maturity default maybe those loans take longer because it's a more expensive renovation. There's more maturity risk or sometimes loans do experience losses. Fortunately in our case we've only had three out of over 300 that have returned capital that are realized some kind of loss. But that's why we have structured the product to encourage people to diversify. Most people do. Most people put some money into the higher yield loans, some in the middle and some in the conservative end of the range, and over time our investors get the choice. They don't have to wonder what they're buying and whether the fund manager is doing a good job because there is no fund manager, they are the fund manager.

Also we are the only place that people can buy the securities that is fully disclosed publicly with the SEC so people can see everything about how we make our loans how we offer our investments how we handle the portfolio. It's all on file in a publicly disclosed offering circular on the SEC website and we report our performance regularly to the SEC as well. No other issuer that can say that about a direct investment for accredited and non-accredited investors. This is because we're in a Reg A plus and it's because of the way our Reg A Plus is structured. You can you can see those disclosures for REITs but you can't use those disclosures to make your own decisions about what the REIT invests in; you have to rely 100 percent on the on the manager. Not only do you rely on the manager but you're also reliant upon keeping your eye on the store of conflicts of interest that are bundled up in these REITs. There are a lot of fees being passed between the corporate entity and the subsidiary. There's a lot of hide the ball in these products and people know it. With Groundfloor you know exactly what you're getting.

Our business model all starts with the sponsor who is looking for capital. Our theory of this company from the very beginning was that the source and structure of capital matters to the end use the capital. We believe that we can offer the sponsor a product that few others can offer at a lower rate than others can really match. And that's because we're ultimately going to sell this at retail gives us a lot more flexibility to be creative. We make a loan to sponsors by using the criteria that are disclosed in our offering circulars so we have to follow the guidelines for lending that we lay out in our offering circular.  It is very clear to everybody concerned, what kinds of loans we will do, the kinds of loans we will not do, what kind of rates are available and what kinds of rates aren't available. Once we make the loan we go through standard process of diligence. Like any lender would. We look at the experience of the borrower we are looking at the business plan for the project we're looking at the amount of leverage that they're looking for. We're looking at the exit that they're trying to target and questioning whether that's achievable. We do a full business case workup on every loan that we originate. Once we originate we hold it on our balance sheet while we qualify the loan with the SEC. We submit batches of loans; if you go to our EDGAR filings, you'll see we file a batch of loans about every week. Those loans are laid out and amended into our offering.

Once the SEC qualifies that batch which usually takes us about a week, at this point because we've filed over 70 amendments so we've gotten that down to a pretty good efficient process. The SEC qualifies the batch and then we turn around and offer it on our website to investors. They invest via their Groundfloor investor accounts where they have funds as they would at a brokerage, they have funds on account with us and they can direct those funds into the loans that they choose anywhere from $10 minimum. We have people that invest tens of thousands per loan. Everything in between. They choose which loans. And we see people invest on average about every six weeks.

The Reg A+ Offerings

We actually have two Reg A offerings. One is an offering of equity in the company which is quite a bit separate from the Reg A offering that allows people to participate in the loans.  The Reg A offering of debt which is a limited recourse obligations separate from the Reg A offering of equity in the company and here's why it's quite different. One is an investment in these loans which are high yield short term backed by a 1st lien position.  These are technically backed by a loan that we've made that is itself backed by as first lien position on that loan. And then the Reg A offering of equity in the company is an opportunity to participate in the future equity value of the company. That's not a real estate investment that's a fintech start up investment.  When you purchase a limited recourse obligation via our regulation A offering you are technically making a loan to Groundfloor itself. Now the terms of the loan that you're making to us are laid out in an Investor agreement. Our investor agreement with you says you get to pick the series of limited recourse obligation that you're investing in and you get to choose the amount that you invest in each series and by terms of our agreement with our investors we then promise that as we are repaid by the borrower behind a series of limited recourse obligations we're then obligated to return the capital you in the exact same proportion as we receive it on that series called a limited recourse obligation. This is the recourse for our investor who is loaning us the money. It is limited to that series meaning they can't, having not been paid in full for one series of limited recourse obligations, they don't have recourse to then go after other loan or other assets of the company.  It's the same way that Lending Club and Prosper are structured with their payment dependent notes. But in their case there is no there's no real estate underlying those; it's just borrowers promise to pay.

We do it this way because securities law dictates it and has done since 1933 that any offerings of securities offered to the public must be registered or qualify for an exemption. Registering an offering is very costly. That's what companies do when they IPO. There is an enormous burden of reporting. In general companies need to be fairly far along before they can successfully offer and manage a registered offering. So what a lot of early stage companies do, and this was the purpose of much of the JOBS Act of 2012, what younger companies do, and Groundfloor is now five and a half years old, is to use this mechanism which is an easier path, a less onerous path, with less regulatory burden to raise capital. Now a lot of people have done it with equity.  They'll use Reg A in order to sell ownership in their company. We did that. Some people will use regulation A to offer a share of a REIT. There have been a couple of folks out there who have done that and then in our case we actually have invented this very novel and unique mechanism that allows investors to pick and choose the loans that they're going to invest in.

We created a system whereby we could build this mechanism and invent this product that allows people to still retain the power of choice but that gives us an extremely efficient means of operating so that we're able to spread the cost of complying with the regulations across hundreds and thousands of loans and up to $50 million using regulation A.  In short we have unlocked the opportunity to invest for the non-accredited investor. That's the fundamental difference between Groundfloor and other platforms.

Listen to this episode and read the transcript in the shownotes page, right here.

I'm originally from the Canton Cleveland Ohio area. I got started in my entrepreneurial journey when I started a landscaping company in high school and ended up doing a lot of a lot of work for real estate investors and people that were primarily either flipping houses or buying rental properties and fixing them up and then sending them out. These guys would hire me to come in to not only do landscaping but occasionally hire my truck and trailer, and three or four buddies from a football team would come in and also help with the demo of the houses.

I got to see a lot of projects kind of at an early age you go from the ugliest house on the block to one the nicest house on the block and I also saw these guys parading their checks around town about how much money they were making on the flips. It was just totally fascinated with the transformation of the property as well as the opportunity to work for yourself and make a good living. So about that same age I said that's what I want to do when I grow up. I want to be a real estate investor so I sold landscaping business off to pay for college, and studied finance with an idea of getting into real estate development post graduation.   Fortunately or maybe unfortunately I graduated in 2007 right when the real estate world was imploding on itself.

It was not a great time to get into the business with college tuition bills to pay so I took a job with a large commercial property insurance and risk management company that insured about a third of the Fortune 500 companies and Global 500 companies and worked my way up through the ranks to the point where I was running sales and marketing for their middle market group which is about a $900 million company.

I got a lot of great exposure to business and was involved as a subject matter expert on technology development and helped rehang our sales processes and marketing processes and alignment and CRM systems, working on a lot of really cool strategic projects. I had a lot of exposure as well to the executive team of the business at a pretty young age and learned a lot about risk management and insurance management from an underwriting perspective as well. The biggest thing I learned was that I didn't want to be a corporate insurance executive for the rest of my life.

In 2010/2011 the real estate market started to come back around and I thought why don't I get back to my initial passion in the real estate business. I had a little money saved up and started to buy houses to fix and flip and potentially rent out. My exit strategy was to build a large enough business here and retire from corporate America and go run this real estate empire. Through that kind of exercise of flipping a couple of properties I learned of the hard money lending industry which at the time was charging four points and fourteen percent interest without a whole lot of great experience customer experience.

The guy that I borrowed from had 4-6 page application.  It had to be filled out by hand and scanned and faxed and was just an overall bad experience. I thought I could probably be a better lender and at the same time I was doing some investing on Lending Club and Prosper the peer to peer lending sites and they were still pretty new Back in 2010/11 and I was clipping maybe a 9 or 10 percent return on those investments and paying out the 18-20 percent on my hard money. I'm scratching my head saying this makes no sense. Like why am I receiving a 9 percent return on unsecured consumer credit while I'm paying 18 percent or more on a first lien. I've got 20 percent 25 percent equity in a first loss position to this guy, right. Like what's up?! Something was out of whack in terms of the efficiency or how capital is being formed in this hard money lending space. A light bulb went off in my head. Why can't I create a Lending Club or Prosper for real estate investing specifically in the single family space. There seems to be a demand for yield and arguably this asset classes is better because there's a real asset behind it opposed to just the consumer's promise to pay it back and that was where the idea for Fund That Flip came from, all pre Jobs Act.

I had taken the idea to my father in law who was a former SEC attorney and over Thanksgiving in 2012 and he said ‘Great idea but you can't do it legally without a lot of expense; you can't sell securities online, there's this thing called general solicitation. You can't do it.’ Anyway, the idea kept me up at night literally to the point where I eventually did enough research and stumbled across what Regulation D offerings are an then what a regulation A offering is, and bumped across FundRise who was doing some Reg A stuff even before the JOBS Act and followed that rabbit hole down deep enough until finally I stumbled across what at the time was somewhat of an obscure bill called the JOBS Act which is still kind of being debated on the floor of Congress. Read the whole thing in a weekend and said this is going to pass. If I'm reading it right when it does, it will make what I want to do a lot easier.

I took it back to my father in law and he introduced me to some attorneys within the firm that were also tracking the bill and we started more or less to put together a framework that would allow us to do what we wanted to do in terms of having a crowdfunding platform for real estate.

I moved down to New York City from Rhode Island where I was living at the time and started building a team and technology and trying to work toward getting deal number one done figuring that we would learn a lot through that process and then take what we learned in a second and third, working on up from there.

I'm not a lawyer and I'm not by any means the smartest guy in the world. But what I knew from the feedback that I had gotten was that the thing that was prohibiting me from doing what I wanted to do without a whole lot of regulatory burden was with the general solicitation right. So the idea of offering up the opportunity to invest in something without having a preexisting relationship with that person was really the key to why you can't do it.

After reading the Jobs Act it became pretty clear to me that what they were trying to do was to remove that general solicitation ban and allow businesses to offer up investment opportunities to investors so long as you followed a certain set of rules primarily being that you need to take reasonable steps to confirm that any money that you do take comes from an accredited investor.

My father in law helped me focus on some of the details, like was I raising a blind pool or are just going to raise money and then go invest in real estate. There was some precedent in the '80s like how those went really bad with a lot of fraud that was something I was looking at. And then also the registered investment advisory kind of rules around are you going to be making recommendations.  He asked did I want to be a registered investment adviser if so explained how that might work. The pieces that started to fall in place I think were good on all of this because the general solicitation is the big one, and the blind pool goes away because we're not investing on behalf of investors; we’re presenting to them opportunities on the platform that they get to decide which investments they go into. Unlike the RIA, we don't recommend any of our investments we just present them. We present the facts and let the investors come to their own determination on whether or not it's an investment that fits their individual risk return profile based on that set of facts that we produce.

One of the things that I learned about being an operator was that, one, it's very hard to scale it. You've got to have a lot of good people to operate the projects you've got to be able to source products, you've got to understand your market really well. I was flipping in Providence Rhode Island. I knew that market well and I could feel comfortable investing there but if I wanted to go even to Boston, that’s a different market that I have to get smart on. So the idea of being a lender seemed to be more scalable to me.

You're leveraging a lot of local sponsors’ expertise and to the extent that you can align incentives appropriately with them and make sure you're partnering with people that have some experience and can demonstrate some competency around their markets and how to manage a project you leverage other people and their unique ability to find properties manages those properties etc.. And to me that the lending piece was a much more scalable business. One of my tech cofounders likes to say the people who got rich in the gold rush were not the prospectors they were the people making the shovels.

I look at it is like this; we are a shovel manufacturing business as opposed to a prospecting business. Not as sexy maybe but higher probability of scalability and wealth creation by leveraging all the people that do want to go out and actually dig for gold if you will.

I decided that it was probably going to be hard to build this business in Rhode Island. I was also not in a position that I necessarily want I want to quit my day job and go all in on this because there's still so many unknowns around will this work, will borrowers want to borrow from us, will investors want to invest. Can we originate loans etc. etc. Can we raise money. And I thought, I can probably increase my chance of success if I'm in an environment that has other entrepreneurs and Fintech companies etc. New York was right down 95 from Rhode Island and I like to say a lot of a lot of my success and I think probably a lot of entrepreneurs success is a function of timing.

I came up with the idea, the Jobs Act thing was kind of happening around the same time I had enough experience in this space and Lo and behold a job opening within my company opened up in New York City that was a good fit for me.  So I moved down to New York with my current company and really start to build on my idea nights and weekends.  I enrolled in the Founder Institute which is a Don't quit your day job incubator kind of program that walks you through a 13 or 14 week process around how to how to go from an idea that's in your head into something that's a little bit more real so everything from branding and marketing to product market fit to building a financial model, they kind cover all of that 13 weeks.

We had like 40 or 50 people start the class and we finished with 12.  The program does a pretty good job of helping people realize that either their idea sucks or they're not cut out for this type of effort. But what it did for me is it also validated like maybe I really do have something here and ‘post-graduation’ they give you some good advice, like build an advisory team, start to build some tech and some MVP and really press for your first customer. That's what I did. I brought on an advisory board that had a lot of a lot more experience than I did in real estate investing and raising capital. And those guys helped us really push from an idea into something that was real and one of them even then joined as the co-founder and our COO. It helped grow the business once we all determined that we were on to something pretty cool.

The big ‘aha’ moment for me going through that program was, we have a marketplace business, we have sponsors or borrowers on one side and lenders, the guys that are writing the passive checks and the other side.  My initial assumption was that the more important of the two was the money side the investor side we had to build a platform and our main value proposition was geared toward them. On the other side were those who needed the money; they would find us - if we build it they will come kind of a thing. The very quick realization was it like. It's actually the other way and this now makes sense to me and I even understood it as an operator.

But if you have a good deal like the money is out there that will fund it. So the big aha moment for me was with the question Who's your customer? It's obviously both but where we spend most of our marketing dollars and where we spend most of our energy from a sales perspective is actually on the on the borrower side. So getting the good deals in and how do we make their lives easier and what's our unique value proposition for them feed into our ability then to get the other side because if we do have good products and if we have better product relative to our competitors and if we can offer a better risk adjusted return that money that money has naturally has for us to flowed in.

Something that I learned especially in the early days is there's always more to do than time to do it in. You've got to be very good at figuring out like what's the most important thing to get done to advance you to the next stage. There was a lot of time and energy and effort spent on figuring out the borrower dependent note structure and how we were going to put together the legal framework for us to raise money. We got that figured out and felt pretty good about that. And then I needed at least some framework of a technology platform so investors can invest and see deals and borrowers can sign up and submit deals that we hacked together a minimum viable product or MVP from a technology perspective. I spent a lot of time on that.

Once I had the foundational pieces that I needed to do a transaction, I decided to see if we can get a transaction in the pipeline so then it was really sales and marketing to the borrower side of our business to see if I could get a real deal on the hook and have something to fund and kind of simultaneously while I was doing that as I have created a kind of a fake project. I was shopping it around to potential investors on a one on one coffee meeting saying hey if I bring you a deal that looks like this would you be interested in writing a $10,000 check or $15,000 check to finance it at a 10 percent return. Got enough of those to say like okay if I do get one in a hook I probably got $300,000 dollars worth of yesses lined up. Half of them will flake out so as long as my first loan is under $150,000 I should be able to actually deliver to the borrower. And then it is just a matter of doing that. So we got our first borrower on the hook and I had to figure out how do I actually originate a loan. I've never done that before. So finding some good representation from a legal perspective and getting our loan documents drafted and reviewed and then we originated our first loan.

The first deal was in Trumbull Connecticut. The guy bought a property for a great deal he made it. He made a killing on it which was good for us too because it was a good notch in our belt from valuation and underwriting perspective. I got paid off in five or six months as well so it allowed us to return some principle to early investors and wash rinse and repeat that capital into the subsequent deals.

Scaling

In a marketplace business liquidity is very important. You have to have enough deals to attract the capital, you have to have enough capital to be able to actually feel good about funding the deals. So it's like any marketplace business or even eBay; if you have a ton of people listing stuff for sale but no one buying it you will lose, there's no value in the marketplace. That was certainly a challenge for us and we figured out about six or seven months into actually having funded our first loans some ways to find cheap liquidity on the capital side. We got some commitments from some larger funds here in New York to commit to funding a certain percentage of our loans early on which allowed us to just more focus on building the deal flow on the borrower side.

As we got more deals more investors became interested and things started to snowball to the point when we launched a deal this week that sold out in six and a half minutes to our investor base. It has largely grown that side organically through word of mouth and doing podcasts like this and what have you don't pay a lot in marketing dollars for investors. The idea being we're originating a good product. People will talk about us and find us and they'll dip their toe in the water with a couple of thousand dollars let us perform and then grow that or that allocation over time.

Listen to this episode and read the transcript in the Shownotes Page, here.

I am the co-founder and managing director at Arborcrowd. I have been surrounded by real estate my entire life. My entire family works in real estate. My father Ivan Kaufman began working in real estate at 24 years old and now he runs a publicly traded real estate investment trust, Arbor, it's called, and they are a leading commercial lender in space. Arbor has a lot of different arms to it and the newest arm is Arborcrowd where we focus on multifamily investment offerings to this new class of investors that the JOBS Act created in 2012.

We go after accredited investors and we created the company first in 2016 with the simple concept in mind that the industry is evolving and as a company we're always looking to evolve in the industry and this whole new class of investors can now access the same institutional quality deals and transactions that we were looking at on our desk regularly and we thought that the next best step would be to form Arborcrowd within the Arbor Family of Companies. In doing so. We were cautious and we were hesitant. We understood that there were a lot of other companies that jumped to the opportunity with the passage of the JOBS Act and we took our time to really sit back and watch and see how these other companies were forming, the way we thought they were doing things well the way we thought they were doing things not so well.

Ultimately when we came online in 2016 we thought that the direct to investment model of offering one investment opportunity at a time was the right way to do so in the crowd funding vehicle. And it was during an interesting time where a lot of the other crowdfunding platforms were moving to the Reg A plus model that online fund or eREIT type of model. And we didn't think that that was going to be the long-term play in the industry.

So we decided to choose one deal at a time to go with on our platform and marketed to accredited investors to come in and invest in those transactions. Why did we think to do this because we think that this model really offers the most precise and accurate level of transparency into each transaction for investors to really feel equipped and armed to make investment decisions that are based on information that we are making ourselves to invest in these deals. And that's why we chose this model at that time.

Challenges

Where we are with the market today I think that everybody knows it's hard to find good quality deals and you know as a company we are always looking for momentum to post deals in our platform. But what our experience lends to us is that posting quality deals will build a long-term company with happy investors. So we spend a lot of time looking at our relationships that we've cultivated over the past 30 years in the industry finding and securing it really off market transactions that are not available to the public that we are that we have been participating in for many years and doing the diligence that we think is necessary to really offer a quality deal to the crowd.

We're patient and we think that right now finding quality deals has been difficult. We think people are overpaying for their deals. And at the end of the day when the market cycle changes or shifts they're going to be caught like a deer in headlights because there's going to be no value created in these transactions. And we are at an interesting point in the industry because crowdfunding is so new and the market cycle has only been good since crowdfunding has really been enacted.

A lot of the life cycle of a lot of the deals being presented hasn't really come to fruition. So we don't really know what the crowdfunding industry is going to look like in a down market. And that's why experience and transparency matters so much to how investors are looking at deals and how we are at Arborcrowd presenting deals to investors.

You see in the industry phrases like ‘democratizing real estate’, right, making real estate available to everyone. But if everybody is getting in and they don't really know the risks and the downside and they're not really being presented with enough information to understand the risks and downside it's a very dangerous thing that ultimately I think is going to push a lot of the companies that are more technology focused or have less experience in real estate or are trying to show a lot of traction and growth in their own company and focusing less on the investors and the transactions themselves out of the industry altogether.

For us, more is everything. We only present to the crowd a deal that have been closed. We actually front the money for the transaction at closing for the deal to close and then we market and offer the investment to the crowd where the crowd money comes in and replaces our money that we put on the line on day one. Why do I say this? Because it's important for two reasons. One is that you can actually secure the deal and close at funding because a lot of the sponsors wouldn't want to say, Well where is the equity, and all of a sudden you say well hold up let me turn around to the crowd right now and raise that money.

We literally put our money on the line, ensuring that transaction closes and also showing investors that we believe in the transaction so much that we literally invested on day one before passing the equity interest over to them. If the deal doesn't fund we’re in the transaction no matter what. So why that's important is that ultimately when we go to build out the offering materials to present this information over to the crowd because the deal is closed we are able to present the crowd with a detailed business plan an offering overview and a detailed private placement memorandum of the same materials that we looked at to underwrite the transaction and literally invest in to the crowd.

The terms aren't changing. The deals not changing. We present to them you know 30 or 40 pages of an offering overview that outlines everything from you know where their investment is going to what's happening on a property level to increase value to the market demographics and jobs being created that can support the value that we're projecting on a rent level. So we do a lot of work putting together that offering material and really what it is doing is repurposing the material that we looked at to underwrite the transactions and present that to the crowd and we take a lot of time to do so and we go into an enormous amount of detail to present to the crowd so people ultimately feel when they're going to invest that they were able to really understand the transaction in the same way, in a digestible way, that we were looking at it from day one.

We usually have third party reports that we commissioned those costs money and you can't share them but we can share the findings of them you know exactly what was drawn out of those reports and we can cite them. You can't distribute those third party reports but we will share in our offering overview to a great level of detail just why we think a market is the way the market can support the business plan based on facts because we do not we are not investment advisers. We don't advise on the investment we simply present facts based on the facts that we understand and know.

We basically pass on the information on why we thought this deal was good and bad. We present the good and the bad of the deal the risks and the positives. Ultimately we think the transaction is worth investing in and what we do in the offering overview is that really you will not find anywhere else be present even the partnerships so we require that our sponsors other the other equity in the deal who are running the day to day of the deal, co-invest with the crowd so they could invest significant amount of their own dollars so that really the interest is aligned at the end of the day and in our offering overviews you'll see the background presented of these sponsors to the detail of their realized and unrealized investments and their performance there so that investors can really open up the offering overview and say Who am I going into business with, who am I partnering with. What has their track record been like. And we present that information as is so that investors can make a decision on their own whether they would like to invest or not with those with those partners.

We are not the principal on these deals but we're not going out and actually soliciting sponsors because we have these relationships with the sponsors over 30 years who are securing financing or debt from Arbor Realty Trust who we are transacting with every single day that we are all of a sudden offering additional equity to and the crowd coming in to great quality off market transactions that crowd the crowd can't really find as an opportunity anywhere else. We don't have to do much work soliciting sponsors. We're really just opening up our network for the crowd investors to invest alongside the sponsors.

It's an alternate source of equity for many of the borrowers who come to Arbor because if they are constantly participating and buying transactions. Maybe bigger transactions that they're participating in. Now they can secure through Arbor crowd vehicle as a company they can secure additional equity via crowdfunding.

What we'll do is we don't charge anything for the deal we basically say we have a passive equity vehicle namely the crowd to come in to give you additional equity and they're happy with those terms you know they're happy to get more equity they're always looking for more equity they don't have to source it from family and friends or from institutional capital so they're happy to receive the equity. To the crowd we're IRR driven and it basically present to them either or as in our offering overviews net of the fees charged to the deal which we think are common real estate fees.

What type of terms do we look for from sponsors. We really look at each deal individually and look at the strength of each deal and what our focus is we focus on multi-family particularly workforce housing from good sponsors so the terms that we look for and the fees they charge. It really depends on the strength of the deal because we like to present to the crowd you know mid to high teens IRRs in secondary and tertiary markets. If the deals can support you know those returns to the crowd before going on the platform we'll look individually at each deal and look at it differently for what it can support on a sponsor requirement level. One additional thing I'll talk about so we are not, Arborcrowd as a company does not also co-invest in the deal.

However, part of the Arbor family companies includes our private equity shop, eMac. And oftentimes in the transactions that we've posted to the platform they have invested in the transaction and have the same principals as a crowd. So another Arbor family company or entity eMac or private equity shop also invest in some of the transactions alongside the equity and that's outside of Arborcrowd as a company.  Because they have the same principals, Ivan and me or my brother Maurice, people feel generally pretty good about the fact that that vehicle is coming and investing in the equities as well.

How does Arborcrowd make money. We charge fees but we think our standard real estate fees which we present very clearly in our offering overviews. We charge an acquisition of a point to a point to five, a disposition fee of a point and a AUM fee of about a quarter of a point to half a point and a refinance fee of a point, if there is a refinance on the property. Now the returns that we project in the business plan are net of these fees. None of our investors have to go in to do the calculations on their own. We show these calculations in the offering overview and the returns that we project on the deal level are net of these fees.

We tend to just underwrite really conservatively and be careful about the deals we present on the platform which is why we're so selective. You won't go to our platform every day and see a deal posted live to invest in. And that's just because the market right now we do not think is going is so great to buy in and is not going to survive. You know the projections right now are not going to survive a downturn so we're really carefully selective in the deals that we post on the platform and we're really conservative in our underwriting as a whole. And that's really what sets us apart from a lot of the other platforms with they're constantly rolling out new deals for investors to invest in that we've passed up on a lot of transactions they've crossed our desk and we have not decided to invest in them.

I have a background also in advertising technology you know power the power of big brands finding their consumers online and how to do that. I have had some experience there but I think the common mistake that people are making in crowdfunding is actually focusing on the technology because at the end of the day for us the technology really serves as the access point to the product. And if we lose sight of that product by focusing on the technology at the end of the day when the investments do not perform well you lose your investors and nobody cares about the technology.

I think that all investors really want at the end of the day is technology that serves them to access that product they want basic fundamentals to really access manage their portfolio how are they getting the information and once the transaction closes, how is information being delivered to them. And that's really the power of the tech in this industry. It's really servicing the product and the investors to access the product. And that's in our view towards technology overall. And unfortunately I think a lot of other companies have taken the opposite approach and they've invested a lot of money into their technology and now they really don't have the deals to support that. And in a few years from now I think there's going to be a lot of conversation around how much is that technology worth and whoever is left, do they want it even so I think to wrap to really address your question, we look at real estate first in this industry and we look at technology to service the product which is real estate.

We haven't had too many challenges with the sponsors. We're working with.  Ultimately I think it's just about educating them that crowd funding is a means in which to raise capital right now. And they the common response is Well what is that. I've never heard of that or how did you do that. And I think after a brief conversation usually you get a that's very interesting and you've been successful doing that and you know you can raise the capital by doing that. And when I say yes, they say we're interested to see how that happens. And they're really not too involved on the capital raising side other than providing all of their information and track record to us. And once it happens I think you know they're a part of it and they see a little bit of how it happens that they get excited by it but they don't really look to adopt it on their own because they're busy out there finding properties investing managing properties and they really look at the funding side of the fund raising side as a different aspect of the business.

The biggest problem with investors is that there are so many crowdfunding companies out there and they offer a really flashy returns. You know really they have a lot of you know glitzy sexy projected returns and they're not showing their risk so much so when investors come to our platform and we're traditionally more conservative it takes a bit more of time to explain to our investors or potential investors.

You know the diligence and the expertise that we have in the industry that really drives the type of deals that we present to them. It takes that extra conversation especially when you're competing against flashing lights that read You know 25 percent IRR you know that equity multiples 3x.  People are basically looking at those numbers, they're investing today because they're being told you know promise I should say really these returns. And when they come to our site they seem more realistic returns. But you know if you give us the time to explain you are stable a more stable approach towards selecting these deals it's a little bit more time consuming and requires more of a conversation.

We've cultivated a big investor group and potential investor group on the basis of education. So when we don't have a deal live or even when we do we're constantly sending out educational pieces or articles or basically describing you know different aspects of real estate how to understand real estate how to look at how we approach underwriting how we approach different markets even sharing some of our investor stories and you know their backgrounds which investors to really build up the community so that when a deal is ready to invest in a lot of our investors feel like they're equipped with enough of the devices to make the investment decision of whether to invest or not.

We focus an enormous amount on education and the distribution of content. Additionally we do a lot of webinars so when a deal goes live we'll do a sponsor webinar where you'll have me and the sponsor of that deal walk give the investors the chance to see that business hear the business plan I should say walk through my eyes and the sponsors eyes and you know field live Q And A's at the end. We'll do a lot of education related content to even FAQ sessions or infographics and content to really deliver each deal and real estate as a market in general to drive the details home to make investors feel like they're investing something they know how to invest in and that they really feel a part of.  We put a tremendous amount of effort in that community.

In the past couple of years alone you've seen crowdfunding will be a small slice of the overall commercial real estate market in general grow tremendously. And I think as investors become aware that they can now invest in commercial real estate to diversify their investments and their portfolio and or access these investments that were really previously excluded from them exclusive to them. I think it has a tremendous amount of growth that is really going to play a significant amount of of of dollars in the overall commercial real estate landscape and people are going to look at crowdfunding as a legitimate source of capital that is more everyday more regular. So I think that growth is going to be great. And I think particularly on the equity side you know there's so much money that's going to enter the market it will shift actually how people look at sourcing capital whether they go for institutional dollars or not. And the amount of players in the space as a whole. So I think there's a tremendous amount of growth that will be where we are seeing today and we'll continue to grow. I think the dangers and the perils in that growth are that you know it has to be regulated and done effectively and that's on the responsibility of the different platforms out there.

Listen to this episode and read the transcript in today's Shownotes, here.

Harold Hofer is Canadian born and, consequently like me, a subject of the Queen.  He moved to the California when he was a kid and grew up in the Los Angeles area eventually attending UCLA where he received both undergraduate and master's degrees in economics, followed by a law degree, also at UCLA. Harold practiced law for a couple of years when I got out of school and his college roommate was working for a real estate firm in Orange County where he now lives.  He accepted his roommate’s suggestion that they go into business together and putting together little syndications to buy the projects that his firm was building and selling.

In the 1980s they were raising money using Reg D private placement partnerships to buy real estate and raised around $80 million in equity for some $300 million worth of real estate.  In the mid-1990s they sold their company to Koll in Newport Beach, California that was, at the time, run by Ray Wirta, Harold’s current partner. Ray took Koll and merged it with the predecessor to CBRE in 1997, ascending to the CEO role.  Several years later they took the company private and then took it public again, consequently having quite a successful ride.

When Ray retired as active CEO of CBRE in around 2005 he had a checklist of things he wanted to do that he hadn’t been able to do in real estate because of the structural confines of CBRE.  Incidentally, at time of writing, Ray remains chairman of the board of CBRE.

One of the things they had wanted to do was to find a way to use the Internet to aggregate investor capital to buy real estate. They thought real estate in general as an industry was slow to embrace modern technologies and as many industries and companies were effectively using the Internet to create efficiencies and cost savings so the wondered why real estate wasn’t falling lockstep as quickly as it should have been. One of their ideas was to raise capital with an online format versus having to raise capital through brokers as was commonplace.

That was the idea they had in 2005, 2006 and they went ahead in 2007 putting together a public offering in Texas in a REIT format to raise capital from small investors to buy interest in a shopping center that they had purchased, raising about $3 million. Shortly thereafter the economy went off the edge of the cliff and so they mothballed this concept of raising capital online at that time.  But then the JOBS Act came about in 2012.  One of the premises of the JOBS Act was to make the aggregation of capital easier for small businesses. Harold was re-intrigued with the idea of raising capital in an online format to buy real estate, aggregating small investors with an online platform to buy real estate.

Now, in 2005 2006 when had raised money using general solicitation in Texas they had been able to do so because it was a REIT and because it was an instate public offering i.e. they were not under the under the purview of the SEC.  They had used an investment in state offering exemption from SEC registration requirements. As they had been able to get their offering approved by the Texas regulators, this had allowed them to use general solicitation to raise money to buy real estate from non-millionaire, unaccredited investors.

They did all sorts of advertising in Texas trying to get people interested. They put little flyers on the door knobs of people who lived in the area of the shopping center they had purchased. They put a sign out on the street that said, ‘Own a piece of the shopping center, go to the Web site!’

Despite these efforts though, they didn't really gain traction though they believe now that they were simply ahead of their time in terms of the market receptivity to that sort of an idea.  Plus, of course and not trivial, the economy went off the edge of the cliff stemming the enthusiasm with which investors viewed their proposition.  They had, in short, the right idea but bad timing.

It had become well known that the JOBS Act was coming out and that it had many permutations.  The primary initial thing that was intriguing to Harold and Ray was that it allowed for general solicitation under Reg D private placement offerings. Before the JOBS Act if you wanted to put together a Reg D offering you could only present it to people that you knew or believed to be accredited. You couldn't really just stand on a street corner with a sign saying ‘Invest Here!’

The JOBS Act allowed you to have general solicitation for a Reg D offering. They had never done a Reg D offering what intrigued them was the idea of going back out and raising capital from the public using an online platform as it was being reawakened by the JOBS Act. They decided to get back on the bandwagon.

Their premise has always been that they wanted to make offerings open to non-millionaire, non-accredited investors. The JOBS Act introduced the Reg A+ element where it expanded the size of the Reg A offerings to $50 million which was intriguing because it also allowed for general solicitation of both accredited and non-accredited investors alike.  That said, they decided not to avail themselves at least initially of Reg A+, but instead to do another instate public offering, this time in California. They did a non-SEC offering for non-accredited, non-millionaire investors that allowed for general solicitation within California and they launched that around 2013.  Again, they used a the REIT structure they were familiar with from their work in Texas six years or so earlier, working with the exemption from SEC filing responsibilities by operating entirely within one state known as the ‘intrastate offering exemption’, Rule 147.

Under this Rule, as long as they were confining the offering to California residents they were OK. They could tell where by identifying IP addresses when people try to access their platform where they're coming from. This allowed them to preclude access to the platform if someone was trying to come from a state where the offering was not approved at that time. Consequently, if you were in any state other than California you'd be denied access to the platform if the software detected that you were trying to access our platform from outside of California.

Using this public offering in California, they decided to move ahead with a $25 million equity offering that they ended up upsizing twice from $25 to $50 million, and then again to $100 million because they were raising quite a bit of capital using a $2,500 minimum amount from investors who wanted to own real estate. They realized that there is considerable demand from the investors to own real estate but that most investors don't know how to access it, nor would they know how to analyze or underwrite a publicly listed REIT plus are fearful of the liquidity within the unlisted REIT market.

Non-traded REITs had been selling this product type for many years through broker dealers with a 10 percent commission associated with it, but Harold’s business model was to go direct to the consumer and present the same investment opportunity.  They would not charge consumers a 10 percent commission by using the Internet to effectively be the distribution method rather than the broker dealer community to be your distribution method. Their thought was not to necessarily to disintermediate the broker dealer community but rather to expose the sort of investment opportunity to investors who qualified for the offering financially but did not have a broker dealer to begin with.

The financial suitability standards for these sorts of offerings are $75,000 in income or $250,000 of net worth, so it's a much broader base of investors than the accredited investor standard which is $200,000 of sustained income or a $1 million in net worth. A much larger investor base could be participating in these sorts of offerings and Harold could expose products to investors directly rather than through the broker dealer community which is which is how that money had traditionally been raised in the past.

After the JOBS Act was passed, Harold didn't rely upon any particular element of the Act initially. It was just the idea that JOBS Act jarred his and Ray’s thinking.  They realized that the market was pulling out of recession and that this Act will result in people trying to raise money online for real estate investments.  They saw it giving rise to many of their peers in the real estate industry adopting crowdfunding methodologies.  They wanted o expose offering opportunities to smaller non-accredited investors but immediately after the Act was passed, it really just stimulated the idea that while other people were jumping on the bandwagon to raise capital from for real estate investing from a whole disparate group of investors with an online platform, that they should too.

Their initial offering, the on that had doubled twice, closed in the middle of 2016 by which time they had raised over $85 million. It had ramped up slowly and then accelerated.  They started wondering that if this was playing so well in California, could it play on a national scale, so they had a public offering registered with the SEC which became available to sell in mid-2016. They shut down the California offering at that time and opened up with the same investment strategy but this time on a national scale through a new SEC registered but not publicly traded REIT format. 

It was the JOBS Act that allowed them to solicit nationally, where before they had been restricted to instate offerings.  They could have used the REIT structure within a Reg A+ format but chose to do an S11 offering which is a fully registered offering through the SEC.  Recognizing that the Reg A+ offering process with the SEC was much more simplified than the process they actually used, they had not wanted to be limited to raising $50 million per year and, believing that they could raise more money than that had not want to have to shut one down at $50 million and start another one thereafter.

Now, some folk are using Regulation A+ to raise more then $50 million in any given year by creating entities that specialize in different asset classes or geographical regions. While Harold knows of folk doing that, initially he thought that there was a danger that the SEC would integrate those offerings and say Hey, wait a second you're just trying to evade the intent of the Reg A+ 50 million dollar limitation by segregating it, splitting hairs geographically or splitting hairs in terms of product type. Being uncertain how that might eventually play out, Harold and his partner Ray were not 100 percent sure that will ultimately prevail, and concerned that the SEC might say these are one big offering were leery of trying to be the guinea pig trying to test that system.

The whole premise of the Rich Uncles is different than most other crowdfunding platforms. Most other crowdfunding platforms are trying to create a marketplace matching accredited investors on the one hand with real estate sponsors on the other. Harold’s business model has always been to make the product available to non-accredited investors, plus they are the end user of the capital that they raised and not just a matchmaking site. Harold and Ray are real estate people by background not tech people by background. Rather than take your money and give it to some third party real estate sponsor they thought that they could do as good a job or better than any third party sponsor in terms of investing your capital prudently.

Their challenge as a company in terms of customer acquisition was really focusing on finding investors not trying to find real estate – and this did not mean trying to find competent real estate sponsors as they were principals in their own real estate ownership. Their business model differed from most of their peers in the real estate crowdfunding space in that they focused on just aggregating capital from investors and then we would ourselves handle the investment of the product, and because they focused from the get go non-accredited investors.

A couple platforms have morphed over to embrace non accredited investors as well that Harold at Rich Uncles had pioneered in making product available to.

Rich Uncles started with two products.  The first was a single tenant, triple net lease product. If you could look at a spectrum of real estate in terms of risky versus less risky probably perhaps the riskiest might be, say, hotels because the income stream effectively changes daily in a hotel depending on occupancy and what you're charging per hotel room. On the other side of the spectrum is single tenant net lease product types where you've got long term leases with creditworthy tenants on a triple net basis where they pay their taxes, their insurance, and their maintenance, so Harold focused on the less risky side of the spectrum which is single tenant triple net lease.

He also kept leverage, the amount they borrow against the properties, to 50 percent. In short, they opted to buy a conservative investment product type within real estate and cap financial leverage at 50 percent. The idea was that they have a lot of investors that have very limited exposure to real estate investing and they wanted to create a story that was easily comprehensible by a neophyte real estate investor and to lower on the risk spectrum from real estate relative to other investment opportunities that there might be in real estate.

The product is, therefore, focused on current yields. Harold’s thought was that if you try to explain to one of his investors what internal rate of return means they will likely have their eyes glaze over so keeping the product type based on current yield kept it simple and easy to understand.  They have recently launched a second product type on the platform and are, as of time of writing, working on putting a Reg A+ product on the platform also.

What came to intrigue Harold about Reg A+ is as follows.  If you look at the broader landscape of 260 million adults in the United States, with maybe 3 percent or so, 10 million are accredited investors. Included those that would qualify for their single tenant net lease offering having $75,000 in income per year or $250,000 of net worth, that might add another, say, 25 million people.  This encompasses maybe the top 25 percent of the adult US population, with another 25 percent of the population meeting the financial suitability standards of the current offering we have for single tenant net lease. Reg A+ effectively opens up to everyone – as long as an investor represents that the investment they make does not exceed 10 percent of their annual income or 10 percent their net worth. Harold likes that this levels the playing fields entirely by making real estate investing open to everybody. To do this, they have launched a Reg A+ offering that is student housing faced and the minimum investment is $5 so you can get into it for five dollars.

Just $5.00

The idea of this product is that you really make this open to everybody not just accredited investors on the one hand, but to those who they have never pursued before and beyond those who meet the financial suitability standard of their SEC registered public offering.

The $5.00 minimum effectively opens up real estate investing to everybody. The idea is to make it easy for anybody to dip a toe in the real estate investing waters through this Reg A+ product. The current investor Rich Uncles has been able to get so far into the single tenant net lease products is average age 48, with about 40 percent of the money raised so far from retirement accounts.  They have a nice business raising money every month, buying real estate every month, but they haven't got the contagion that they were looking for that they thought they might be able to get through a younger more millennial based audience. That's where they want to head with the first Reg A+ offering with the $5 minimum.

The broader investment thesis for the student housing instrument is not just the yield play, but also a value add component.  The value add in student housing comes from effectively adjusting the rental stream manually as you get a new crop of students into the facility. Student Housing has evolved very rapidly over the last ten years or so. Before that time it was either on campus housing or some apartment near campus that was a bunch of students crammed into a room. There has been a phenomenon called purpose built student housing which is about 10 or 15 years old, at time of writing, where developers have built properties geared specifically with students in mind.  These are where there might be four or five bedrooms associated around a common area common kitchen and maybe each student may or may not have their own bathroom.  It’s really built with students in mind from the get go rather than trying to retrofit an existing apartment building to accommodate students. It's a very robust and vibrant community business model and there are currently two listed REITs in the US that are very actively involved in the product type.

It's like a multifamily play but the cap rates going in are a little bit higher than traditional multifamily and if you buy the properties correctly and you have the proper management you should have high occupancy levels during the course of the of the calendar year with leases guaranteed by parents. Basically it's just a different skin on the cat and Rich Uncles is trying to create a second product type over and above the single tenant net lease that could be complimentary for investors. And for Harold, the assets they are looking for should have solid current yield with income streams adjusting annually upward hopefully at no less than the pace of inflation. He is not looking for value add deals or apartment conversions or adaptive reuse.  It is strictly a yield play, similar to the triple net lease deals they are also working on.

Typically they are delivering around a 6 percent current dividend yield to shareholders in the student housing product type and a 7 percent current dividend yield to our shareholders in their net lease single tenant product.  Leverage is in the 65 percent range for the student housing, so a higher leverage profile than the single tenant net lease product at 50 percent.

Harold is finding that the market currently for the student housing assets, depending where you buy them and how you buy them are probably in the sub 6 percent cap rate range.  With accretive leverage you can get your cash on cash up to north of six percent yield.

Interestingly, while there is no secondary market for the shares i.e. you can’t openly trade them on a market anywhere, Rich Uncles does offer some buy back options. Looking at the single tenant net lease REIT, they do have a share repurchase program where they will buy up to 20 percent of the shares per year annually from shareholders through our share repurchase program. That creates liquidity. They do have an administrative charge on a declining scale so if a shareholder wants to sell their investment back in year one, they take three per cent for an administration charge.  Between years one and two it is two percent, and between years two and three, one percent.  Thereafter there are no fee to get out of the investment and they reprice the shares annually in the single tenant net lease REIT to net asset value. It was, for example, $10 a share in 2017, but in 2018 it's $10.05. For someone selling shares they bought last year, Rich Uncles will redeem $10.05 subject to the administration charge.

Repurchases are funded through proceeds from new share sales, or through dividend reinvestment or otherwise and the idea is that the product they have is, even if you don't have the daily liquidity that you do with a listed REIT marketplace, there is some access to monthly share repurchase program.  Blackstone in their REIT paved the way for this 20 percent per year share repurchase opportunity and Rich Uncles mimicked their strategy with a similar share repurchase program. In short, while there’s no secondary market per se, investors can sell their shares back to Rich Uncles every month and, at time of writing, they have not failed to honor any redemption requests

And to be clear, they will buy back 100 percent of purchased shares today from any individual investor but cannot buy more than 20 percent of the outstanding shares in aggregate per year. Put another way, an investor could send all of their shares to be repurchased and Rich Uncles will buy all of them today, just as long as that shareholder and their fellow shareholders don't submit twenty percent of the outstanding shares in any given year. 

The option to limit this to 20 percent came about because it's historically been limited to 5 percent. Most people couldn't do more than 5 percent. But Blackstone paved the way through their REIT to allow up to 20 percent per year share repurchases and Harold followed their business model which, more precisely, is 2 percent per month not to exceed 5 percent per quarter as the amount of shares that they can buy back from shareholders.

There are no regulatory limitation on this per se, and Harold had known that that Blackstone had approved.  Harold chose not to try say 25 percent or 30 percent because this would have meant treading new ground and trying to plow new turf that had not been plowed. The reality is that they are able to repurchase 2 percent of the outstanding shares per month because they are growing the REIT by at least 2 percent per month from the sale of new shares.

The REIT is an evergreen fund that does not have a finite life. It's an infinite life trade and they just keep raising capital buying assets and growing the asset base. If shareholders want liquidity they can avail themselves of the share repurchase program.

The JOBS Act reawakened the initial premise for Harold that you can sell a real estate investment product through an online platform to non-millionaire investors. That's always been his business model and the JOBS Act allowed him to do that for all investors. Most importantly, it allowed him to generally solicit for investors nationwide. One thing that changed was that accredited investors now had to prove their accreditation to you which is a time consuming process but it really reopened Harold’s eyes.  He realized that people were going to jump into using this business model, that they were going to start putting together crowdfunding platforms because of the JOBS Act. Along with Ray, he decided to jump in himself even though they determined not to be one of these accredited investor only platforms. They thought to jump back in again and try for not accredited investors also.  Even when the economy fell in 2007, 2008 they believed that the idea was a good one. Having come through the Great Recession. They decided to dust off the concept and give it another shot.

That said, when Harold sat down with Ray and started dusting off this 2005 idea they realized that other operators would be jumping in to take advantage of the new regulations but were unaware of anyone specifically doing that at the time.  Fundrise was in its infancy and sites like RealtyMogul was also in its infancy at that time. Harold was not aware of them when he dusted off his business model with Ray and decided to do a public offering for California residents, non-accredited, general solicitation. They weren’t aware that that at that same time Fundrise and RealtyMogul were creating marketplaces, pairing up accredited investors on the one hand with real estate sponsors on the other hand. But he did anticipate that the JOBS Act would give rise to companies attempting to take advantage the intent of the Act which was to eliminate some of the barriers to raising capital for small businesses and that this would doubtless include real estate.

The biggest challenge for Harold’s model, as for anybody in the space, is customer acquisition.  How do you find the customer who actually wants to invest in real estate? How do you create a web platform, and get people to your website to begin with? And once they are there, how do you create a compelling enough story and journey to want them to make it and make an investment decision?

Historically Harold’s product type had been sold through financial planners and broker dealers who earned a commission to put the client in the product. There was somebody, the broker, who told a story, who was pushing the product on behalf of the capital raising client. The challenge was how to create an opportunity where the investor effectively pushes themselves to make that investment decision.

That was and remains the biggest challenge. How do you make the website known to people so they'll come visit the Web site and once they are there how do you create a compelling story that they'll actually want to make an investment.  To meet this challenge, Harold has reduced the size of the minimum investment initially from $2,500 in the first California REIT to $500 in their national net lease REIT, to $5 in the national Reg A+ student housing REIT.  They have chosen to create a barrier of making the investment decision so low that people say What the heck, why not give it a shot!

When Harold first started in crowd funding, it was just him and Ray initially.  They had the idea and they had an investment for the California REIT that they put in just to launch it.  It was a portfolio of Dell Taco investments that Ray and Harold already owned themselves and they exposed it to family and friends first, and then put together a very rudimentary Web site. In late 2013 Harold reconnected with a guy he had known for many years, named Howard Mackler.  Howard was a marketing guy and Harold had known him for as long as he had known Ray. He came from the real estate business, the shopping centre business where Harold had come from as well, and Howard brought to the team a marketing expertise that they didn't have.  Howard was instrumental in creating the Rich Uncles veneer to the platform, figured out how to get people to the platform, and how to create the website to make it interesting enough to invest in the platform.

Howard was a third partner that came aboard. In late 2014, the three of them initially had an executive suite we rented an office and were trying to figure out how to get this from A to B. Then as they grew it, they we layered on additional staff in four disciplines. One was real estate of course which was the core competency. Another was tech. They had finance and accounting, and the fourth was Investor Relations.

They are not a broker dealer so they don't go out and cold call people to try to get them to invest in the platform but they do have a staff of personnel that responds to inquiries that they get from people interested in the platform. Their growth has been slow, deliberate, and organic, and they have never raised money from a venture capital firm. They talked to several of and received some term sheets but they've always raised capital to expand our platform from friends and family.

Curiously, the most effective methodology for getting the word out was traditional radio advertising that has worked well for them. They advertised heavily in radio to get people to the web platform.  They did drive time FM talk radio which they found to be an effective way to get people to the platform. They’ve always used digital ads, pay per click, on Google and Facebook and those have been successful for as well. As they’ve grown over time they have tens of thousands of people that have actually registered on the Web site, so email campaigns that go out to the existing base of not just investors but other people that have expressed interest in the platform, are how they continue to move the needle along.

Rich Uncles ultimately converts about one out of every three people that register on the Website.  This is a very high conversion rate so the challenge remains getting people to the website, and once registered there, to create a smooth enough journey to make investment decisions.  They have a high conversion rate of leads to the platform.  Leads come through folk hearing about them, or if they have an interest they call directly and they speak to them.  Being on the e-mail campaign is important and then ultimately they decide to make an investment decision at whatever level. The idea is to have such a low entry point that it becomes a no brainer that it's easy for some to dip a toe in the water of the platform to see how things are working out and then down the road elect to make a more material investment if they desire to do so.

Long Term JOBS Act Potential

Harold is of the view that the long term is still open as to where it's all going to end up. One of the main elements of the JOBS Act that he believes was the most influential for real estate was general solicitation for accredited investors.  He thinks that the jury's still out as to how viable that's going to be are not going to be. Most of his competitors, those strictly in the crowdfunding space, have pursued that to various levels of success but nobody has really killed it yet with that strategy. The second major impact is through the Reg A+ investment concept. Harold wonders too if that will catch fire. He sees the likes of Fundrise are using Reg A+ or multiple Reg A+ products on their platform, as is RealtyMogul, and as does Rich Uncles now.  we now. He wonders though, if the Reg A+ concept is going to make it easy for real estate investment sponsors to raise capital and that it is still too early in the stage of that evolution to see how viable that's going to be or not going to be longer term.

Harold thinks  that the deciding factor will be the degree to which the market embraces investing in real estate this way.  The reason they’ve created a $5 product is to make it appealing to millennials. Harold’s oldest kid is a millennial and she and her husband think of investing in an entirely different way than he would. In contrast to when Harold was their age, today everything is done online through an app and so can you mold the investment behavior of younger people to think about investing in real estate.

Why not go to an online platform like Rich Uncles and do it all if you want to, if you want to invest investment exposure to real estate. You can make younger investors think of investing in real estate online through a platform like Harold’s and that would be a solution for them.  It is an option that Harold never had.

That's kind of where Harold hopes it is headed. But he wonders if you create some contagion amongst the millennial set to mold their thinking of how to invest in real estate through an online platform like Rich Uncles versus investing in a listed REIT or going to a stock brokerage firm and opening an account having them who will invest into a listed REIT on their behalf. Selecting Rich Uncles and the online option is where Harold hopes it's headed.

Listen to the podcast and read the shownotes here.

Jason Schwetz, President and Founder of Triple Net Zero Debt.  I am originally from Virginia Beach, Virginia.  I went to college in the mountains of Virginia and headed west, as they say, right out of college and got a job working for a shopping center syndication company out of Los Angeles literally starting at the bottom, collecting delinquent rents. That was interesting in and of itself, and I moved from collecting delinquent rents to property management, from property management on to leasing, from leasing to financing of shopping centers and from that went to acquisitions and dispositions.   

What I have enjoyed the most through the whole cycle has been working with companies and leasing space and understanding their businesses and how they're going to fit into the property, whether it's a shopping center or single tenant property, either way.  I have done anything and everything there is to do with shopping centers with the sole exception that I have never purchased dirt and built from the ground up. I have added on to shopping centers, torn down centers, and renovated anything and everything, but I have not done ground up development.

Then the Internet came along. And over the years of being in the shopping center business I've noticed that there was definitely the beginning of an impact on the bricks and mortar of shopping centers as a result of the Internet.  I got increasingly more frustrated because my industry just wasn't addressing the issue they almost had their head in the sand for years.

For years and years and years they just would not address the challenge of the internet.  There were no conferences on it.   And as a shopping center owner I'm sure I'm speaking on behalf of lots of shopping center owners across the country, there was no way to feel the effect. I remember the days of leasing space.  Let's say it was 12 or 15 hundred square feet and your space goes dark. Your tenant moves out and your list of prospective tenants were 25 to 50 tenants 50 tenants long. Today that list is pretty much nonexistent. I mean it is a short list of what is available to move into shopping center space. Yes, there's the traditional food which I think will be around for a while although I have my concerns for that as well. And having seen that and seen all of the unnecessary friction that went on in purchasing a commercial piece of property going through the process of loans which, as you know, is brain damage and all of the rules regulations and requirements of whether it was a governmental entity or the lenders that they put you through. Combined with the challenge of shopping centers themselves i.e. the effects of the shopping centers by the effect on the shopping centers from the Internet.

So that drove me to thinking that there has to be a better way. I went back and revisited as many of my deals as I could and I went through them and tried to pick out what wasn't necessary or what could I do instead to make the parts of the transaction unnecessary. And after a long time while trying to figure out a model where I could be internet resistant. I don't if there's anything out there that I would call Internet proof but I think it's safe to say there are tenants out there that are Internet resistant. It's a term I've been using for many years and I'm starting to see that that term being used out there.

I came up with the model that I have now which is, in simple terms, is buying single tenant triple net properties across the country for all cash.  And what I have successfully done so far is to make the transaction as simple as possible not only from my perspective but from a potential investors perspective.

I wear a unique hat when it comes to shopping centers in that although I have been a landlord many, I am also a tenant.  I also own and operate businesses in other people's shopping centers.  My longest business which I still have is a restaurant for which we just celebrated our 26 year anniversary. When I look at a shopping center I look at it from two perspectives. One is as the tenant perspective and I can see the impact of what goes on around me and I can also feel it as a landlord. I've seen what's happened to my rent rolls over the years and the types of tenants that I focus on to put back into vacated spaces i.e. tenants that are Internet resistance.  The impact has been you know there's not nearly as many trips to the shopping centers that there used to be prior to the Internet. They're just isn't. The tenants that used to fill shopping centers are not there the way they used to be. One of the biggest impacts on shopping centers going down the long road is traffic.  When you and I were younger, every single kid or ninety nine percent of those kids with an entrepreneurial spirit, that had that dream of starting their own business, ninety nine percent of them needed real estate. They needed a space. A lot of that was a shopping center space, some office, but a lot of it shopping centers. And when that dream came to life and they were able to put their business plan together and actually go out there and be that entrepreneur and start that business it was in a retail space.

That does not exist today. Ninety nine percent of the kids today they're in college or high school that have that entrepreneurial spirit and they have that brainstorm of a new idea. None of that includes a retail space. Those girls and/or guys are not interested in opening up a dress shop or a clothing store of twelve 1500 square feet in a shopping center. It's just not there. What you're left with is trying to find tenants that are resistant to the Internet. That actually understand business and can run a business and start a business and pay the rent. And that's very challenging in today's shopping center shopping centers and in today's market. Very challenging.

Triple Net Lease

A triple net lease is a form of a lease. They exist both in a shopping center as well as in single tenant. I migrated away from multitenant shopping centers to single tenant properties. What I liked about the shopping center business is you were diversified across many different businesses.  If you had a 10 or 15 tenant building shopping center you know your each tenant only occupied a certain percentage of your rental income. When you switch over to a single tenant properties 100 percent of your rental income is dependent upon that one tenant. You really need to be careful when you're out there looking in the single tenant triple net market.  You say to yourself OK what is a single tenant triple net? The best example I can give you is, let's say, a McDonald's. A McDonald's is a freestanding building that has one tenant in it. A credit tenant. And they occupy what we call in the industry a single tenant triple net property. Now the technical definition of triple net is the tenant pays for all of the taxes insurance utilities and maintenance.

There is a term that is loosely used in the industry known as absolute triple net. I will tell you this: I am very frustrated when I deal with commercial real estate people across the country that misuse the term triple net. You cannot have a triple net lease with landlord responsibilities. You will see properties advertised all the time that use the phrase triple net lease, minimal landlord responsibilities. That is an oxymoron. You can't have the two. But it's used. I caution people when they are out there and they're looking for single tenant triple net properties to be careful of the way these leases are written and the way it's being presented. A triple net lease is a lease and a single tenant property where the tenant pays for absolutely everything. And I mean everything.

I'll give you a classic example. You'll see an advertisement that says a single tenant triple net property, minimal landlord responsibility – roofing and structure only. That's a classic. That's not a triple net lease. It's just not. That's a double net lease.  It's misleading and it's frustrating because as someone who buys triple net properties somebody will submit a property to me that's claiming it's triple net. And I request a copy of the lease and I read the lease and sure enough the clause in there that says landlord is responsible for let's say the roof as an example. Well that's not a triple net at least then. It is just not.

A absolute triple net lease means you are buying the building and the land.  However, the tenant is responsible for absolutely everything and I'll give you a real life example.  Let's say – and I've actually had this happen – I get a phone call from the management of one of my tenant companies and they say Hey Jason you know somebody backed into the building and we're sending you a picture and I respond back with, You know I'm sorry to hear that but read clause 7 of your lease and that's the end of the conversation because literally everything is the responsibility of the Tenant. Everything. It doesn't matter if the roof leaks. When the real estate bill comes it's their responsibility to pay the real estate tax bill and then send me confirmation that it's been paid. When the insurance comes up it's their responsibility to pay the insurance bill and to send me confirmation that the insurance had been paid. In an absolute triple net lease literally the only thing that I do on my end is make sure the rent has been deposited into the account. That's it.

It differs, for example, from a ground lease because when you're buying a ground lease you're buying the dirt only you are not buying the building and the real difference that separates an absolute triple net lease and a ground lease is that if you are the lessor you own the ground, so you cannot depreciate it. You have nothing to depreciate on your taxes.

Triple Net Zero Debt

I was following crowdfunding and when it made that jump from business crowdfunding to Real Estate that was very exciting.  It has obviously grown and grown and it's going to continue to grow. It offers an opportunity to be able to have an audience, a potential audience that is nationwide as opposed to an audience that would be made up of either your family and friends or an extension of your family and friends i.e. their referrals. Real estate crowdfunding opened the doors to the rest of the country so to speak no matter where you're at.

Then what I needed to figure out was what to invest in.  The shopping center model as it's been around for you know for decades and maybe even a century is just not a model that I believed was sustainable. Shopping center owners are really needing to rethink the whole concept. I did not want to be in that space. You combine that with the level of difficulty of lenders. And when I say a level of difficulty lenders just their inability to understand assets and it obviously led to disaster in 2007 2008. I tried to figure out a way how can I avoid all of these issues and having gone through my past deals and trying to pick out what is not needed or what can I do to avoid those challenges or friction, I arrived at buying single tenant triple net properties for all cash.

The only way to do that, for me, was number one I wanted to invest. I wanted to diversify my own capital across many different buildings and as many different states as I could. In other words kind of being similar to owning multitenant buildings having the diversification of a multitenant building, but without the risk of a shopping center. I started looking at absolute single tenant triple net properties across the country. I only have a limited amount of capital so I don't want to own 100 percent of one property. I'd rather own 1 percent of 100 properties. That's just my personal investing philosophy. The only way to accomplish that would be to bring in investors, and what's the most efficient way to bring in investors?  In my opinion it's real estate crowdfunding. The traditional family and friends are still there that's still alive and well. But bringing in investors through the crowd because your audience now is this nation nationwide makes it more efficient. And it will continue to become more efficient.  Indeed, I'm very pleased to say that I have a 98 percent reinvestment rate – 98 percent of my investors have reinvested.

Challenges

It's getting your website up and then focusing on SEO –  Search Engine Optimization –  which is a whole other subject and quite difficult; quite challenging.  If you said to me what is the single most challenging part of real estate crowdfunding it would be once you are live on the Internet, how do you get people to see it. That comes down to SEO which is extremely challenging.  That's probably the single most difficult thing that links real estate to technology. It is difficult getting your name known or getting people to see you apart from the hundreds and hundreds and hundreds of crowdfunding sites that were out there and are still out there. So that was the most challenging. Your first step is getting your website live but then you not only got to get your website live but you got to get people to see it and hopefully make the phone ring and it just it starts slow and builds from there.

Investment Strategy

I look for single tenant triple net properties anywhere in the United States. One million dollars or less. The only states I stay out of are California and Illinois. Other than other than those two states I look anywhere in the country. Now I will say that that there's a variance almost all my criteria. I have gone over a million dollars on the last part that property I purchased which was a Hardy's. It was over a million but it was because it was a fantastic purchase – it just had all the right metrics that I look for and more.

I look for known tenants.  I don't buy individual mom and pops or or single tenant operators. I look for local, regional, national or international tenants. One of my tenants is the second largest Papa John's franchisee in the chain. They have just under 150 locations. That type of tenant I love. That's a great opportunity.

I focus very heavily on what's called the rent to sales ratio. It's especially true in businesses like the food business.  Being a food operator myself, I know where my rent needs to be in relation to my overall volume. I understand the food guys intimately, where their rent needs to be when I know that they are they are very profitable and the more profitable they are the more likely they are going to be in that space for a long time. I do look at the rent to sales; I also look at car counts if, for example, I'm looking to purchase, let's say, an oil lube and change place. I look at how many cars a day they're doing, I look at what's their average ticket price, and from those numbers I can determine how profitable they are. And again how likely they are to stay there for a long time.

All of our returns are anywhere from 6 percent and all the distributions are paid monthly.  The returns are anywhere from 6 percent on up to just under 9 percent. Most of them grow annually. And when I quote my returns I do it very differently than everybody else I've seen out there. I quote only the actual return that goes in your pocket each month. I don't do projections. I don't do anticipations. I don't do a term that they call projected ROIs. I don't do any of that. I do it the way that it was done 50 years ago where Sam and Bill and Sally threw their money into a hat. They bought a piece of property when the rent came in they divided it up and they went on their way.

Fees

There's obvious a cost of doing the deal escrow fees, title fees, things like that. In total, of my fees combined including escrow title and everything are usually under 3 percent. And the industry calls it load factor or whatever. I haven't seen anybody out there yet that has been able to have fees less than mine especially and be able to generate the returns that that I generate on all cash purchases. That's the difference. I charge no management fee, and instead there is a sponsor and investor split.  As the sponsor, my company, Triple Net Zero Debt, takes 15 percent and the investors get 85 percent.

And I'm also an investor in my deals thought amount will vary.  Inevitably I'll put a piece of property in escrow and I've got to say a million dollars and I'll get commitments. During the escrow period inevitably on almost every deal you get towards the end in some cases someone comes to me and says, you know Jason I was going to put in 150 but I can only do 100 right now. As we get closer I wind up putting up the difference and as a consequence my investment ranges anywhere from 10,000 on up to 60,000 in a given property.   I do like to stay above $75,000 per investor if possible. If it's an existing investor and they come to me and they they’d like to do 50 in a deal, as long as I know them and I know their financial background I'm okay with that. I don't want investors who are not sophisticated. The more sophisticated the investor the more they understand the better off they are and the better off I am.

Goals

I would like to close three to four more deals this year and that's going to be dependent upon, obviously, the deal flow as well as the investors continuing to get the word out to the marketplace that what I do is very different – Single Tenant, triple net properties, all cash with monthly distributions. That's a unique model.

And for those people who are looking for ultra-conservative commercial real estate investing that's me.

See the shownotes to this episode here.

I'm a partner in the New York office of Mayer Brown and am a co-head of the firm's capital markets practice. I devote much of my time to counseling issuer's, counseling placement agents, underwriters, and other financial intermediaries when they are thinking about or structuring a financing transaction – that might be a private placement to accredited investors or institutional accredited investors, or it may be a public offering.  In short, securities offerings are an important component of what I do.

The JOBS Act obviously is something that made some significant changes to securities law. I think people focus too much attention on the JOBS Act and its effect on the IPO market and neglect to talk about the JOBS Act and its effect on exempt offerings both on private placements, Rule 506(c), matchmaking platforms, Reg A crowdfunding and probably even more importantly, just the ability for private companies to stay private longer which obviously is now something that we read about almost daily when we commiserate about the declining number of US public companies and the relatively small number of U.S. IPOs.

The Accredited Investor Standard

The worries of, for example, Commissioner Piwowar who I think was one of the first to suggest it that about perhaps doing away with the accredited investor standard. Or the more recent comments that Commissioner Peirce made regarding accredited investors. It all derives from the same sort of public policy concern right. Do we need this standard? The accredited investor standard. Is it helpful? Is it still serving its purpose or, if you were to take the other view, if you were to take the commissioner Piwowar view, if companies are staying private longer and companies are experiencing more of their growth these days while they're private instead of in the years that immediately follow their public offerings, are we essentially doing a harm by not allowing a greater percentage of the investing public to participate in those offerings. I think it's interesting to look at it from both angles.

Unlike Commissioner Piwowar, I think there is merit in having an accredited investor standard There is good reason to have an accredited investor standard. I think that the current standard which includes some institutions – and I don't think that many people have quibbles about the prongs of the accredited investor definition that include that include non-natural persons – I think that's fine. What many have looked at is whether the two prongs that we now have for natural persons, the net worth test and the net income test, are still appropriate and whether those are good proxies for sophistication, for financial sophistication.

Dollar Amounts as Proxies

In the securities laws we have lots of instances where we use dollar amounts, assets as a proxy for identifying the kinds of individuals that can fend for themselves. For example, if you look at the definition of qualified client or if you look at the definition of qualified institutional buyer, qualified purchaser, any number of investor standards that we have sprinkled throughout the securities laws. We've always sort of resorted to having these dollar thresholds be a proxy for getting at whether somebody has the wherewithal to bear some investment risk or could, if an investment goes sour, it could withstand the loss. There's nothing wrong with that. It's important to have bright line net worth and net income standards. That's very helpful because it provides legal certainty because there are crisp answers that you and I can identify – we know what those are, we know what those mean. They're not subject to judgment. They're easy to verify. For broker dealers for investment advisers having that clarity and legal certainty is important.

Obviously, the Dodd Frank Act required that the SEC periodically review the appropriateness of the accredited investor standard. The SEC did deliver a report on the accredited investor standard. There were some recommendations which are sensible ones that certain individuals having securities brokerage licenses or certain designations like a CFA designation be able to be considered an accredited investor regardless of net worth or net income. There's a fairness to that because they are sophisticated. There's an ascertainable standard. The CFA designation is conducted over a period of time by an independent organization. FINRA administers the securities licensing exams. That's sensible. Things get murky and complicated with suggestions that there be some test that gets administered that then becomes the basis for assessing whether somebody is or isn't financially sophisticated. That’s troublesome.

Education vs. Net Worth or Income

Indeed, education and income or networth are not necessarily equivalent. Net income or net worth suggests that a person is probably going to be able to take certain financial risks. There may be a little bit of a paternalistic quality to that regulation i.e. deciding that we should only let those who can withstand risk of loss make an investment. However, it's important to have some proxies even if they're imperfect and net worth and net income are imperfect but there is merit to the notion that you can substitute net income and net worth. These are people who probably could withstand the fact that their investment in a startup amounted to zero; that they lost it all.

Keeping in mind that the accredited investor standard was promulgated in 1982 it may be a reasonable approach to index the standard to inflation, for example. We have inflation indexes written in to a variety of other thresholds and, perhaps, there's a lot of common sense appeal to that.  Of course, applying an inflation index to the standard would, however, reduce the numbers of eligible investors so to contemplate such a change, one might go back to some of those interesting public policy issues that are now coming about. There'd be some reluctance to limit the overall number of investors that are able to or that may participate in in private placements. This is because private placements have a more significant role in capital raising than they did historically. Then again, another way to go about things would be to require more disclosure in connection with certain private placements. You could attack the problem in any number of different ways.

For and Against Retaining the Accredited Investor Standard

The notion of our securities regulatory scheme is premised on there being investment decisions that are made when disclosure is provided. Section 5 of the Securities Act is disclosure based if there is a public offering, with disclosure requirements being relaxed in the case of certain private offerings or certain exempt offerings based on the theory that you're offering to investors that are sophisticated, that can fend for themselves, that have the ability to ask questions regarding the investments that are being offered to them, and that have the ability to have those questions answered. It presumes that we're not going to impose disclosure requirements or we're going to impose lighter disclosure requirements in instances where we're selling to certain types of more sophisticated investors or investors who can, at least, bear a risk of loss. That's a powerful argument for keeping the accredited investor standard for similar such standards and it's kind of built in to how we think about the securities framework.

Disclosure Requirements

Another alternative would be to modify or review some of the disclosure requirements that we currently have in offerings that are made to non-accredited investors. In 506(b) transactions or 504 transactions there are certain disclosure requirements but, one wonders, are those still current? It’s hard to know but that's another way to skin the cat.

Now for those that are in favor of just setting the accredited investor standard aside there is a good story to tell and that is that the capital markets have changed a great deal particularly in the last 10/15 years. We now have private companies with the ability to go out to a broader universe of investors and to conduct successive rounds of financing and to become Unicorn's and essentially to become household names and have some dispersed ownership while still remaining private. A lot of the wealth that's being built and a lot of that explosive growth that's being experienced by these companies is only open to institutional investors and accredited investors because, in order to avoid disclosure requirements, most private placements are limited to accredited or institutional accredited investors or equivalent. Wouldn't it make sense, from a public policy perspective, just as we once encouraged retail participation in IPOs to encourage broader participation in some of these exciting private placements?  That's the argument that would be made.

Gambling Has Only an Age Hurdle

People understand when they take their seat at the craps table that they may walk away with a significant return. Or they may walk away with empty pockets. Meanwhile it's all too easy for investors to hear about a startup with what they think is a promising business venture and to assume or perhaps be led to think that at least some portion that it's an investment that some portion of the money that they're putting up is not subject to complete risk of loss.

Process for Change

In the Treasury report on capital markets, one of several reports that was issued in response to the recent Trump presidential order, a number of suggestions were made, but it is only within the SEC's domain to evaluate whether the definition ought to be changed or not. Obviously the SEC has done its work. The SEC has completed its study. The study's been done for some time. There have been comments solicited from the public and submitted on the standard.

The SEC's investor advisory committee has weighed in on the standard and the takeaway from all of that is that most people would like to keep the net worth and net income measures, maybe with some indexation, maybe with some changes in the numbers, but also want to see added individuals who have certain designations. There is another recommendation to add knowledgeable employees to the standard which makes a lot of sense. The collective wisdom of the commenters, the Investor Advisory Committee, the SEC report, is to keep it intact but make some changes.

For any changes to occur, the SEC would have to propose changes to the definition and on the SEC's published agenda, the Reg-Flex agenda, one of the actions in the long-term category is consideration of proposed changes to the accredited investor definition, perhaps bringing it to the top of the agenda in no less than six months or so.

SEC staff would come to the commission with a proposed rule. The commission would take a vote on releasing the proposed rule for comment. There'd be a comment period and then presumably after a time the rule after giving weight to the comments the rule would be adopted modifying the definition in Rule 501.

Anna believes that the Standard will stay substantially the same, maybe with these added categories.  It is unlikely that there will be any reduction the number of people who qualify, rather, if anything, it's going to be increased.

Michael

This is actually my second career. My first career was in commodities trading. At the age of 19 years old I got a summer job down at the Chicago Mercantile Exchange and that was between my freshman and sophomore year of college at DePaul. I thought it was a summer job but it really became my career, and I was down there for a total of about 16 years. I started trading for a hedge fund in 1997, managing the futures risk on their portfolio and then after about a year or two I went off on my own and started trading for another sort of subgroup within the hedge fund before going off on my own officially in 1999.

Check out the Shownotes

I traded for the next nine years. It was a great trading career and I was blessed, and I ended up retiring from that business in 2005. The reason why I left that business were two-fold.  Number one, computers started to come in and take the edge away from what I was doing and I wasn't a good trader because I knew where the marks were going to be tomorrow or the next day; I couldn't see around corners. I was a good trader because I was able to react to information in real time and process it very quickly and that was my advantage and my edge and when all that information started to move to the computers it just changed the risk equation.

That was one reason and then the other reason was my life had changed. When I started trading I was single I had no kids, no family, no dependents and when I was done in 2005 I had two kids, one more on the way, I was married and had stacked up enough chips where I was comfortable in life.  We have a saying here that you only have to get rich once. So the next part of my career really went from building wealth to managing wealth.

I had invested passively in real estate for several years during my trading career as a high net worth individual, a lot of it passively and I'd also watched as a young kid my grandfather who was a real estate investor in Chicago manage his own properties on the West Side of Chicago. I used to help him out in the summers and learned a lot there and I saw firsthand the benefits of private real estate investing and for me I didn't want all of my assets in equities and bonds and I really wanted to take advantage of what I saw as an inefficient market. That is a market where it's not commoditized. Every piece of real estate is different. There's multiple strategies that you can follow and that's when I decided to go back to school educate myself. I got a master's degree in real estate in 2006 and then soon after that I started Origin with my business partner in 2007. We've been at it now a little more than 11 years and we built the firm originally around our own capital and that was the beginning.

When we started, in 2007 or so, it was definitely at the peak of the market but there's obviously a little bit of luck in every career and I think coming into 2007 in the market was quite lucky. Number one we were only investing our own capital and we were very cautious about what we were investing in. When you don't manage outside money it's a much different type of risk than risking your own money.  You don't have to look at other people if things go wrong and we had made some investments in 2007 that led us to switching our investment strategy in 2008 more towards buying whole loans and debt from banks looking for a big edge.

That was the avenue that we saw in the market at that time where there was just tremendous opportunity. We saw loan pools going for 20/30 cents on the dollar and it was just a great way to pay all cash for assets get in at a great basis while protecting your money. That was really how we got our feet wet and started the company in the beginning.  

Around 2009 we started gravitating as the market changed more towards value add larger assets and we also asked at that time ‘What do we want to be when we grow up’, and realized that in order to build the firm that we envisioned it was really going to take larger pools of capital than just ours and that's when we started inviting friends and family in syndicating deals, building the platform, bringing in people, and building infrastructure along the way. It wasn't till about 2011 that we had started our fund business so during the period of 2007 to 2011 we went from a family office to the beginning stages of an organization, bringing in friends and family while institutionalizing the process into the fund business, and creating a dedicated strategy and a coherent business model and attracting outside partners.

One thing that trading taught me is that you need an edge no matter what you do or what business model. There has to be an edge, a competitive advantage and it was very easy to see in 2008 when we looked at notes and, while those are financial instruments underneath, what was backing them was a physical asset and that physical asset had a value. What we were able to do was to really price the notes to a place where our money wasn't at risk. We were going in, buying the notes with the intention of owning the real estate and ultimately would foreclose on the note or do a deed in lieu or do something to take back, or we would cut a deal with the borrower to have him pay us off at a discount. It was a great time for us to learn about the real estate market from a hands-on perspective. At that time, it was really my partner and me doing all the work and using outside counsel to get to the real estate. It was sort of a moment in time that we took advantage of that really helped us get to the next stage. We bought some low-quality assets. we bought some high-quality assets and we met some interesting people along the way because, as you know, most banks don't sell bad real estate they sell bad people, and when you're on the other side of a distressed note you're inheriting those relationships.

Risk Management

From our perspective, wealth preservation and wealth growth strategies are not mutually exclusive to one another. You can preserve wealth and get into a great deal that has downside protection.  A lot of what we're doing in buying notes was getting into value added properties but we were getting in through the derivative of the physical property by buying into the note itself. Oftentimes we would buy a property that was 8 townhomes that were partially completed that we would ultimately take over.  We would finish them and then we would sell into the open market. Our value add strategy was consistent from buying notes all the way to the point where we launched our fund strategy.

The real difference was that the market changed and even in 2010 and 2011 the market got incredibly crowded and we couldn't make sense of the pricing of the notes at that time so we decided that there was less risk in actually going out and buying the physical asset and owning its fee simple from day one and underwriting with perfect information than there was in buying notes. While it was more of an opportunistic strategy it wasn't mutually exclusive to say that we were opportunistic taking high risk. I would argue that when you're paying all cash for an asset that you can buy at 50 percent of its market value you're actually taking very little risk with tremendous upside. That's always been our investment philosophy – looking at how do we generate high risk adjusted returns and take the least amount of risk and generate the highest risk adjusted returns.  That's what gravitated us towards the note business i.e. not the risk but the preservation of capital in that strategy.

Perspective

Our strategy today is buy, fix, sell. There is an argument to be made that some assets should be held longer than others. We typically underwrite between three and five years all of our assets and our typical whole period is right around 3 to 3.5 years. Those were in some of our earlier funds where took chips off the table after the value was added. In Fund 3 which is the current fund that we're allocating for right now, those hold periods will probably be closer to 4 or 5 years because a much higher percentage of our overall return will be coming through cash flow rather than just the appreciation of the asset itself. In the next fund that we're focusing on, it will be a kind of 50/50 combination to generating a 2x multiple on our capital through appreciation and income.

Crowdfunding

We expanded into crowdfunding in about 2015 and it was sort of an ‘aha’ moment when my partner and I were looking at what was happening in the market as we are always trying to figure out how we can enhance our product, how we can build more value, how we can make it a better experience for our investors and even for ourselves. There was one day I was just doing my own reconciliation of a lot of the projects that I had at Origin. I was on a spreadsheet and I just realized that I had a problem that I couldn't figure out my own positions and it took me a long time.  And I was looking at a T.D. Ameritrade app and it was so easy and beautiful and you could see all of your investments in one place. I went to my partner and said that we had to build something like this and he thought it was interesting and intriguing and we decided that by doing it we were really going to set ourselves apart from the crowd by building this technology.  Our policy has always been to set the standard in the business and do something to differentiate ourselves. Ultimately, we both agreed and we ended up investing a lot of money into our technology and our dashboard and what that really allowed us to do was to start to market and create a lead generation tool.

Embracing Technology

We had both been in a business in the commodities trading world where we saw firsthand how computers had taken over an industry and we both agreed that we were not going to watch this time as the market changes and remain still doing business the same way we were 20 30 years ago. We believed in our product. We believed in our team, in our strategy; everything. If you have a great product and you put it in front of more people you're going to get more people to consume it. It was as simple as that. We started then traditional marketing in late 2015 and our platform really resonated with a lot of people and we brought people in on individual deals and then ultimately most of our investors came into fund 3. Today we have over 600 investors at the firm whereas in 2015 prior to doing this thing we had 65 investors.  It has been a great way to meet new partners and to share our platform with other individuals. Our mission is really to transform the way individuals invest in real estate and everything we do now is consistent with that about focusing on high net worth investors like ourselves so that they can realize the true benefits of this asset class.

In the beginning when we were just concepting it, crowdfunding per se wasn't on our radar. The technology we built in 2014 and then we started marketing in 2015 and we weren't familiar with the JOBS Act.  However, we became very familiar with the Act and why this had never come up before and why was it happening now and we got up to speed very quickly.  What resonated with our customer base is the fact that we were an operator coming into a market with a ten year track record and two very successful funds in a market where most groups were aligning themselves as technology companies and not with the real estate part of it. We were really viewed as an expert in the market and the other thing is that when they hear our story about how my partner and I built the firm and the fact that we're the largest investors they look at our team and everything they really see a difference in our platform relative to other offerings out there. That is a big growth driver and is what helped us stand out in the market and have the success we've seen today.

Non-Institutional Capital

When my partner and I decided to start using traditional marketing to the firm it was not well received by everybody at the firm because a lot of the individuals who we have here have come from institutional companies.  Going to the ‘crowd’ is just not how people market. There's had always been this notion that we were going to go from high net worth investors and then jump into the pension funds, endowments, and institutional capital markets and that's how we would grow. When we announced the fact that we were going to market our platform and apply traditional marketing to Origin it was very controversial. We said, look we hear you we get it but we respectfully disagree and this is what we're going to do.  And we did it, and we did it with obviously a lot of risk and over time not everybody came on board but if you asked everybody in the firm today they would tell you that it's the best thing that we've ever done for this firm because today we have more capital demand than product.  In private equity you either have too much product and not enough capital or too much capital and not enough product and it's just the balancing of this.  Today we have a tremendous amount of demand from our investment group for product.

Marketing

When we started on this path we hired a marketing team. We went out and found Digital Kitchen who's a top-notch agency here in Chicago. We helped them rebrand the company, produce a new website for us, create collateral materials videos, tell our story, help us with the story. We hired a marketing team started on content strategy. We did everything, and we went all in and it was incredibly expensive, but it was probably the best money that we've ever spent and it came the ROI on it has been tremendous.

Investor Process

Some of our investors come via referral and that's obviously very different when you have a warm introduction and they meet you through that and they've already developed a sense of trust because with any organization what you want is other people talking about your product not you. That can be anywhere from a week to a month to six months where somebody signs up and there could be multiple conversations before they invest. When we get a cold lead, it could be that somebody signs up for our newsletter and they just receive educational material about us. It could be that somebody signs up for our portal and they're able to go in there and look at our deals and do due diligence. It could be that somebody signs up for a portal and request a phone call and we've put in all the steps in place and we have an amazing Investor Relations team that is very well experienced in not only our platform but in the world of real estate who have come up through the financial markets in real estate underwriting so they know everything about our PPM, our documents, our legal structure, the asset level risk, the fund risk, everything, so they have knowledgeable conversations with anybody who wants to get to know us. If anybody wants to talk to me and have a follow up call I'm always more than happy to do that. A lot of times people can just sign up and sort of sit on the side and never choose to invest and just read our educational material.

We like to get to know our partners as well and that's really what the investor relations department does. It gets to know them and educate them because it's a two sided street but the best investor is one who understands fully what he's getting into. It scares me, and we've had people do this, where they come in and sign up on day one. That's where problems get created because you haven't set expectations and then they learn along the way. So I would rather have somebody get to know us over time and really understand and see our value proposition and know exactly how our funds operate and what they can expect than just come in because a friend told them without knowing anything.

Investment Philosophy

Our investment philosophy doesn't really change from one fund to the other but what does change is our product and our strategy is evolving with the market.  What we might do in fund 4 is look at a more focused strategy on just multifamily. We haven't totally decided this yet but as we look at the risk reward looking at our track record across multifamily and office, the more we've narrowed the world down the more successful we've been. In fund one we were more opportunistic and we could buy any asset class out there. Yet as the funds has changed over time, we have actually had more success being more specialized and as the world has normalized you have to know how to operate at the margin in your asset classes and really understand the nuances. Where capital ruled the world in 2008-10, that's no longer the case today when it's really about having operational excellence and being able to spot pennies and be able to pick them up along the way.

Education

We only serve the accredited investor market so that implies that somebody has essentially a million dollars of net worth or more. Now what that doesn't imply is that they know anything about real estate and our customer base really consists of people who are at the minimum threshold of a million dollars and also billion-dollar family offices. Regardless of who it is there is absolutely an educational process that has to take place because every firm is nuanced and their experience with another firm is going to be different than their experience with us. Again, this is about setting expectations. Making sure they understand who we are. No matter who you're dealing with regardless of how much money they have there is always an educational process. Now there are certainly some people who are more experienced in the market than others. But education is the key.

The Real Estate Crowd Funding Review

Ian Ippolito came from the world of tech entrepreneurship. He had run a couple of companies and started some companies, some more successful than others. He had a few failures but over the years he had built up a bunch of different companies. In 2013 Ian sold a company called VWorker. It was an online marketplace that was sold to a company called Freelancer. He enjoyed a nice exit and found it was time to move from being a tech entrepreneur to his new job,  managing the finances of his family. He had to really get up to speed and had always been investing while an entrepreneur, but his job was his primary thing and he had invested passively in a whole bunch of things but had never really gotten down deep.

Go to the Shownotes for Links to Ian's Site

So at that time he really needed to get serious so he took a look at his entire portfolio and just redid everything because his risk was totally off. He had neglected a bunch of things and so started looking at stocks and bonds and traditional investments which were OK. But he also wanted to branch out to other things including branching out to peer to peer lending. Ian looked at Lending Club and Funding Circle which do business loans, and that's what led him to real estate crowdfunding.  When he discovered it he thought, wow, they're taking the idea of lending to peer to peer lending which is a good one but a lot of times is based on an asset that's not collateralized so you don't have any protection or if the person defaults on the loan they're gone. But now we're putting it into real estate so if you're doing debt it might be collateralized or you know you've got equity and then you've got this tangible piece of property behind it. And he was really intrigued by it.

This was in 2013, when Ian began in CFRE and at that time there weren't that many sites but they exploded really quickly. Everyone was really excited about the idea. It was kind of like a big explosion and then it kind of winnowed back and then another kind of growth spurt. But back then there were some of the names that people are familiar with today. One of his favorite sites was FundRise and Patch of Land was around back then.  A lot of the sites changed over time or changed their business models or maybe they changed their underwriting or whatever but those were some of them back then.

Limited Experience

Beforehand Ian had owned some rental properties so had knowledge of what being a landlord involved. He had invested in a couple of passive deals with varying success and had gotten into a one deal right just before the Great Recession. He invested passively with a syndication and just the bad timing didn't understand what he was getting into and didn't understand how to evaluate the terms of the deal. Looking back, it was something he never would have gotten into. Thankfully he didn't lose any money but it took about 12 years to break even. It wasn't something he wanted to repeat and he decided when he got into CFRE that he was going to do a lot more research to learn a lot more about what was going on inside and kind of up his game.

He came across a deal, did some research and contacted the sponsor directly.  It was investment in residential real estate and that was their business model. The minimum was pretty high – in the hundreds of thousands and came with a beast of a PPM. It was just a huge thing. He took it to and attorney because, well the thing you do is when you get these things is you need to take them to an attorney to evaluate them. And this is really important. He learned how difficult it is for people starting out because he didn’t know who to bring it to so he asked around who's a good attorney that understands real estate.  And the guy he chose to take a look at it, after charging him all of the usual fees and everything, told him ‘if you trust this person it's probably going to go ahead if not don't let me read it.’

This wasn't what Ian was looking for.  He wanted someone would had evaluated 100’s of these and could tell him that the terms look good or don't and so the experience was a kind of a wakeup call because he had to educate himself. It was hard for to find that type of expertise he needed to get to do it.  He found everything to be interesting but it was overwhelming because he there were debt funds, and equity, and they're investing in senior housing, or they're investing in apartments as well. What's the difference?  Some are value added, some are opportunistic.  It was really difficult at the beginning to piece together the relative risks and so he needed to create a coherent overall portfolio strategy and just going through the platforms and just taking it deal by deal which maybe is the way most people do it and that was the way he was doing it was just not working.

He wanted to understand what he was getting into; yes, the return looks great but how much risk taking and of course the sponsor doesn't tell you. So Ian took some time to figure out which investments he wanted to go through and thought maybe a good shortcut would be start with the platform's first because there were so many at that point and it had exploded and he thought he could find the ones he liked. That way he could weed out a whole bunch to start with and once he found the good platforms, I could start digging into the deals. So that was the way he looked at the different platforms. And there was nothing out there on the internet that would explain it which would have been the easy way. He realized he was going to have to figure this out himself. He had his research assistant help out and together they contacted every single one of the platforms, talking to the people involved. He talked to other investors asking how was their experience on the platforms.

He looked at their legal setups. If they go bankrupt what's going to happen? So just looking at what are their fees and comparing them to the other ones. So he started looking at all of these different things and it was just really for himself, putting it together over a couple months until he felt pretty confident that he had found those he liked and those he didn’t. Then people started asking him for it and then another pretty soon he found it was too much answering individuals and so he just put it out on a Web site. And that's how it all got started.

In the Beginning

To get going he just started reading and read as much as he could. And he found that after reading 30 or 40 PPMs you start to see patterns that are occurring over and over again. And then you notice something that's a little bit different; No, that's not super great of a term or you know that's pretty questionable or he’d find deals where investors were liable for a lot more than actually the money they were putting in or whatever it is. He went into a whole bunch of these things and just started looking over and over again and seeing which ones he liked and which ones he didn't.

To learn about the art of real estate, Ian went online. He wished there had been some source back then that put it all together into one place but unfortunately there was not anything like that. So he did it the way that he had learned to do his stock market investing and his mutual funds. He read everything out there and digested it, repeating over and over again each investment doing the same thing over and over again until, eventually, he figured it out.

Since the Beginning

There definitely has been lots of change in the industry in just a few short years.  There was kind of the initial explosion where everyone was trying to get into it and people were raising a ton of money from venture capital. And there was an explosion of platforms and it was a very exciting time. Then there was kind of a period where if you remember there was a scandal with LendingClub and there was a financial accounting scandal. And maybe they did some things that were improper. And when that happened all of a sudden the entire Fintech space was no longer as desirable to investors. All of a sudden these companies that were raising a ton of money couldn't raise their second round or the third round. So a bunch of companies started they were laying off people massive layoffs or they were shutting down. So there was a kind of a contraction.

What we're seeing right now in the last year and a half is like another expansion that's being done in a different way because of that VC capital is no longer flowing in. Instead people are actually turning to the newer crowdfunding rules that allow crowdfunding platforms themselves to raise funding for themselves versus with the investments. And we're seeing a new round of expansion to the ones that are successful on that.  Sites like Fundrise  and you've got Groundfloor raising millions for their own corporate development.  This is a great way for a company that maybe had trouble with the VC market or VCs aren't the best thing for a company that is not going to explode and because it pushes companies to do that. So this is kind of like a slower growth model. It seems like there's a lot of appetite for it. People are buying up these shares left and right with all these deals filling up very quickly.

Of course, investing in equity in the platform is a speculative investment where it's not a real estate deal where people are going to get income coming in on a regular basis. You're hoping for some sort of exit at the end or maybe the platform was sold to somebody else and maybe did an IPO. And then at that point then the person hopefully is going to see a return on their money.

Deal Quality

Deal quality has not been totally positive. The deals earlier on were much better. They were higher yielding and were taking less risk and as the cycle has aged the risk has been ratcheting up the yields have been going down. Each quarter it’s been getting a little bit worse and worse. So a deal that would be considered maybe a good deal in 2018 would probably be a deal that maybe would not be such a great deal earlier on. There's so much money right now that's just chasing not enough deals. And you know definitely it has deteriorated.

For example, you would find on a particular platform you could find conservatively underwritten debt deals so that maybe 65 percent loan to value or less first position a residential flip or something. And that would be yielding double digits. Now to get something conservative like that is very difficult unless it's some sort of more speculative like some sort of huge construction project or something that's not going to be double digits, most likely going to be maybe like 9 percent or something like that or eight and more likely even less. The other way that there was a change just on the debt side. It's just that back then prices were cheaper. So because prices were cheaper it just made all the underwriting that much easier. Now prices have gone up but we've had a really good run now as a result of the great performance of all those old investments. Now a lot of the properties are really expensive. So it gets harder to find the good deals.

Finding the Deals

Ian does a bunch of things to find deals.  He subscribes to all the crowdfunding sites and is constantly having new deals come to him.  Just at this stage we are in the cycle you know, it's not going to last forever at some point it's going to end and there's going to be a downturn. And for Ian what he wants to be in at this stage of the cycle is a very experienced sponsor who's gone through a downturn and not lost money. And it's difficult to find it on a crowd funding site. Probably 95 percent of investments if not more. So he ends up networking with people, going to investor groups and talking to other investors. A lot of the deals just don't work out, but looking for them is Ian’s job, basically working on the investments so he spends a good portion of his day doing that.

The Real Estate Crowd Funding Review

Ian created this place where he puts the ratings of the different platforms out there so everyone could see them. Once he did that people were like hey what about the non-accredited platforms that were springing up.  So he I did a ranking of those that up there and then just started talking about things like real estate news as it were coming in and blogging about it; Here's my opinion about this or my views about that.  And that kind of grew to a following.  There are about 1600 or 1700 people who subscribe regularly. The site is getting maybe 7000 or 8000 visitors a month. So it's quite a few people are starting to come follow.

And then what's happened is he wrote something a little bit negative about one of the sites and it was an investment on a site and he felt that they were being very deceptive in their marketing and felt they were giving a guarantee that they couldn't give. There's no such thing as a guarantee really on investing. There's always risk. Anyway he wrote about that and they threatened to sue him. They looked up every single address he’d ever been at. And they sent their threats to it. They went all out and they said you need to take this down and it sounds like well you know this is a political thing as Ian was doing it for free he thought well he was going to have to shut it down or find some other way to get the information out there or do something else. So he created a private investor only forum on the Web site and vets the people that come in to make sure that they are truly investors and not associated with the platform and then that way the people themselves feel free to share information. Whether it's positive or negative. But to share it freely.

Power of the Crowd

Every single time someone asks a question it's helpful. It may be something Ian’s thought of before but a lot of times it might be something that puts him in deeper or maybe at first he thinks that's an annoying question but then he thinks about it and realizes, no that person has a great point and he digs in deeper. That kind of give and take is really important and investors on their own are kind of in a little chamber and so to have other points of view is really powerful.

The Future

Ian thinks that with certainty that there's going to be a downturn coming up eventually and he suspects that we're closer to the next downturn than we are to the last one. He is positioning the real estate crowdfunding review with this in mind and focusing on the investments he’s interested in which are these conservative investments, sponsors who have experience doing multiple cycles who have not lost investor money or maybe they are debt funds that are very conservatively underwritten.  Maybe they are real estate funds which is maybe a little bit too boring for some people but for Ian it's perfect for this part of the cycle. So a lot of the focus is on those kind of things a very conservative mindset trying to preserve principle not trying to extend too much and with the idea that hey after the downturn maybe there's going to be some opportunities there. And have some cash and some dry powder might be a really good thing.

Rethinking Real Estate

Dror Poleg has spent the bulk of his career, a little over 10 years, in China developing institutional real estate.  There he developed around thirty million square feet of shopping malls space, offices, about twenty-six thousand apartments and some serviced apartments.  Together with a Dutch Israeli fund some of these assets were sold to institutional investors, and they were partners with BlackRock in most cases selling other projects to private equity funds in Asia and to a REIT in Asia.  His experience is, therefore, across the whole real estate development process from beginning to end; buying land, developing large projects, leasing them and then either selling or stabilizing them.  He has consistently brought in financial partners and taken assets all the way to being owned by an institutional investor once they become mature quality assets. He arrived into the real estate world from the world of online development and design –  digital design of all things. He was partner of a digital design agency in Israel which is where he is originally from, and then worked in Australia, in China and through helping real estate developers on some projects he gradually got sucked into the business from the marketing side to the market research side to the presenting to investors and government to leading the leasing of commercial assets and then finally to really just handling the big deals.

Check out this episode in the Shownotes here.

Today Dror operates a small consultancy based in New York City advising large scale real estate owners and operators and private equity firms on innovation in real estate. He covers anything from understanding long term trends that are driven by technology such as, changes to the nature of work, how people get married, or education trends,  autonomous vehicles different things that impact the real estate industry, longer term to more immediate terms such as different technologies and tools and business models that they can implement today in order to produce more value out of their assets, up to really looking at the underwriting of specific deals that involve some innovative components mostly co-working, flexible office, co-living, or anything along that spectrum.  On the other side of his business he works with startups that are focused specifically on the real estate industry. This includes anything from modular construction, building management systems, different sensors and IOT, to kind of more communal ventures and operating systems for a whole neighborhood.

He does not have a typical client having worked with clients in Japan, in Turkey, in the UK, in New York, on the West Coast, in China. It is really diverse.  His clients range from startups to very large owner operators companies like British Land which is a company with about $25 or $26 billion of assets under management, as well as some smaller real estate companies of around $5 billion assets under management and above, and some funds that are either based in the U.S. or based out of Hong Kong.

Private Equity

Private equity in Real Estate is, basically, using private money as opposed to public money in order to fund the equity or to acquire and operate real estate projects. Similarly, REITs are public equity that allow retail investors to own a piece of a real estate portfolio, and private equity mostly refers to funds that are managed in order to acquire and generate as much value as possible out of, usually, large scale real estate projects. These funds are usually capitalized by institutional investors or high net worth individuals.

Funds

For a private equity fund the clearest division is between what is called the general partners, people that are actually actively managing the fund and its assets and are also partners in the fund and the limited partners.  The general partners sometimes put in some of their own capital into the fund and the limited partners are people that bring money into the fund but do not have any managerial responsibility and thus no liability in some ways, at least in terms of their legal exposure. Limited partners do, of course, have liability in terms of being able to lose the money the invest and have no control over, or limited control over, how the general partner manages the fund.

These limited partners are often institutional investors.  People that have a lot of money to allocate are not necessarily real estate specialists, so like a pension fund, an insurance company, a sovereign wealth fund, people that manage a lot of money and have huge portfolios where usually a very small percentage of them is allocated to real estate. The general partners are the folk who manage the fund.  They are usually property professionals or private equity real estate professionals that have experience of actually running an asset.

Typical Structure

It's an interesting because the daily life of a fund manager is changing in line with technology. Most of these funds originally have relatively small teams. If they have several offices or focus on different geographies they might have a handful of people in each area. That would mean, several general partners who are really the ones managing the fund, and then a few analysts. Sometimes, depending on the type of assets that they invest in they would have additional people that have operational capabilities or specific expertise, let's say in shopping malls or, office leasing. People that can help when you do due diligence on an asset or when you oversee the people that are operating the actual asset then you can kind of know when you know things cost too much, or you can leverage relationships that you have for other assets in order to make that specific asset better. But part of what is changing now is that real estate as a whole is becoming much more operationally intensive. And if in the past the operators were almost like commodities, and the owner could just hire people to do certain tasks, today more and more you see that the good owners, which means a good fund managers, are people that have unique operational expertise as well, or unique relationships and in some cases even unique technology.

Raising Capital

The vast majority, or a lot of the time of the fund managers, is dedicated to raising funds, and some would even say that their main skill is the ability to raise funds, so more than actually picking the right investments, and definitely the traditional fund, the ones that are still leading the market today are.  Their success is very much attributed to the relationships that they have and that they've built over the years with the investors so their ability to raise capital.  When they set up a new fund they go and try to raise money for it, they usually have a target. They either rely on their direct relationships, they can rely on companies that are called placement agents, which are companies that assist limited partners so institutional investors and high net worth individuals who allocate their own capital into different funds. Placement agents are another type of middleman. They're theoretically familiar with all the different funds around the world. There are other third-party companies that grade some of these funds assuming that these funds have a track record. When institutional investors are looking for investment they may have placement agents to assist them and they have third party bodies that, that give them feedback or kind of rate the type of funds that they about to invest in.

The general partners go to institutions and the institutions there are individuals who are responsible for huge amounts of assets that they have to deploy and they have to allocate a certain amount. An institutional private equity will fund to raise $50 or $100 million from any individual institution, and that will typically be based on the relationship, probably with, maybe just one guy at the institution that they have, whose job it is to allocate those funds. Now at the institutions they're going to have investment committees and whatever else they're out to authorize the divestments.

So relationships matter but it is definitely not one guy's decision. There are investment committees. These institutional investors to begin with have their own mandate and very strict criteria in terms of their risk profile. Sometimes geography, sometimes type of asset, sometimes the holding period. The fund has to feed all of these. Another thing to note, is institutional investors also vary in terms of the size of the team and level of expertise that they have. If you start at the top you have some sovereign wealth funds like JIC from Singapore, or the Canadian pensions which have very relatively large and very professional real estate teams.  They really have their own knowhow and ability to evaluate funds. They also invest in assets directly because of their capabilities, and on the other hand you might have, we can call it poorer institutional investors that manage a lot of money but have very small teams and very small budgets in terms of their own overhead. Something like the Illinois pension management board or institution which operates with a very small team and really relies completely almost on other people's opinions and feedback when they decide how to invest.

How Fund Makes Money

The second that they close the fund, basically once they're done raising the money, they're already starting to make money, in theory.  So, the compensation models for these funds is along the lines of what is called 2 and 20. They take a certain percentage, 2 percent, but these days probably less, one and a half or one percent of the total funds raised per year as a management fee and 20 percent or, less these days, in a carried interest profit which is the added value that they create through those assets, so, 20 percent from the upside.

Deal Types

Depending on the strategy of the fund, there are four main strategies that private equity funds look at, starting from core investment which are really the most stable best quality asset in the center of main cities. Core plus which are assets of the same kind but that might have some, some very limited value add potential such as leases that are lapsing or renovations or certain little things that could improve them, then complete value add which are assets that are still relatively good and developed but have some more major potential for value creation. Either the occupancy is quite low and there is room to change things or there's one tenant that has issues that could be replaced or needs some type of negotiation skills that the existing owner can't handle or several leases that are lapsing within the next year or two that the new buyer assumes that he could find better people for that will pay significantly more, or sometimes on the financial side, restructuring, refinancing of different kinds that can ultimately create a higher return for the new equity. The last category is opportunistic investment, which entails significant more risk. This includes anything from ground up development, taking distressed asset and repositioning them; basically doing things that are riskier and targeting much higher IRR, towards a 20 or higher.

Deal Execution

Fund managers do not typically execute on the business strategies themselves although sometimes they might. Sometimes they cooperate with others. They go and look for deals, like the rest of us in some ways. They use brokers, all the large broker firms like Cushman and Wakefield, Jones Lang LaSalle, CBRE, Savilles, Colliers.  They have their own capital markets team or kind of investment brokerage and people that tend to these types of clients and try to find them opportunities. They also leverage their own relationship, again, through their own network, looking for opportunities to invest in.  Some funds also specialize in sourcing deals and they have unique sources for whether its different types of foreclosures or other similar large investors that own certain things but need to liquidate for certain reasons. They buy or sell from other funds that are focused on different strategies. 

Let's say, there's one fund that has an opportunistic strategy.  It owns an asset that was under development and once the asset is almost stabilized it can sell the asset to another fund that has let's say a value add strategy and can take that asset from 80 percent occupancy to 96 percent occupancy, at which stage you could sell it to a core plus fund or to a core fund that could just buy it as a stable asset for a much higher price and not bring much more value but just enjoy the yield, which is what institutional investors ultimately want.  Institutional investors don't want to take a very high risk. In a perfect world they would just buy you know something that brings in 5 percent a year or 6 percent a year, and not have to do anything to it and just be happy. But it's getting harder and harder to find assets like that especially when you have so much more new money to allocate each year.

Controls

One of the projects Dror developed in China was a shopping mall. It was still a new mall not fully stable yet at around 80 or 85 percent leased.  About 80 percent of the space that was leased was already open and operating. They received an investment from a fund that is owned by BlackRock, which is more known for managing other investment products but they also have like a, small about 10 billion dollar real estate private equity business and they bought 50 percent of the holding company of Dror’s mall, and became their partner. To do that though they arrived at the deal through a broker, in that case through Jones Lang LaSalle. They spent, a lot of time several months, doing due diligence ahead of agreeing to a deal, looking both at the market at large and specifically, at the project and everything the operator/developer could tell them about it including assessing them as managers, so spending a lot of time with the team. They challenged them on the rent roll and on each specific tenant that they had; Why did we give them these terms? Why not those terms?  Blackrock looked at underlying assumptions about the additional space that will be filled et cetera. Once they became partners, they sat on the board, they had a seat on the board of the project, and in the operating agreement which was signed when they invested, they also defined certain key decisions that they have a say about, or even a veto on. The original company remained operating the asset but major decisions such as major capital investments, changes to more than a certain percentage of the tenant mix and other things had to be approved with them or by them.

The most contentious issues are things that are purely financial. For example, if the management team wants to refinance the assets. If they want to sell a piece of their ownership. What to do in case there is an opportunity to sell the whole project. What to do if they buy the whole project and the managers don't own it anymore. What are the responsibilities in terms of operating it and ensuring that there is a successful and smooth transition. Mostly these type of things are very common to any type of kind of merger or acquisition elsewhere.

Default Triggers

Triggers that could allow the investor take over the project included terms of not performing as had been projected.  Although the investor does not want to run the project, at the end of the day, they invested in an asset that they assumed that they're almost unable to operate, without their partner. But the terms allowed for them to bring in a third party. Part of the assumption is that they're taking a big risk and that they trust you and if they wouldn't, they probably wouldn't go into the deal to begin with especially with something like a shopping mall or a hotel which is very operator dependent.

The investor can, de facto, replace certain people in management. In an extreme situation they can replace the manager completely as operators of the assets, who would remain their partners in ownership until there's a new buyer but who would have to cede the actual operation to another operator. There may be a budget approval procedure each year with quarterly reviews. During that process, if they want to make life difficult for the manager in terms of how they spend money on a project they can make it difficult.

There are bad boy clauses, key man clauses.  These limit what the manager can do if they have some really talented person there that the manager might want to move to another new project that's something that they may not be able to do. There's all sorts of things. In China mostly the bad boy was about indemnifying investors in case the manager did certain things like bribing or doing something that is illegal, locally or internationally. These terms are very similar in the US too.  The investor’s goal is to be completely indemnified as much as possible from anything that the manager does but on the other hand they want to have as much power as they can get away with, in balance with the previous point.

Promote & Fees

Deal structures can vary.  In some cases, the sponsor could be a straight up partner, or it could be a 50/50 partnership. In those cases there's no waterfall and there's no promote. Basically, both own the asset. If the asset does well, both make money. In that case it also means that probably the 50 percent that the private equity fund owns, or was sold to it by the sponsor who originally brought in the project.  So assuming that the sponsor already made some money already, on that piece of the deal on that half and when they both sell in the end, they're going to make more money.

Other structures, have a promote which is very similar to how it works in smaller deals. The sponsor can get sometimes a small piece in the beginning just for bringing the deal.  Something between half a percent to 2 percent, which sometimes is expected to be reinvested or kept as part of the deal. Then upon exit or other major financial events such as refinancing there's a promote structure that means that once the returns for the private equity investors meet a certain hurdle, and that depends on the type of the asset.  It could be 5 percent 8 percent, 12 percent 15 percent.  Then the rest of the returns are split between the two partners. Whether it's 80-20, 70-30, 50-50, or even with a few different steps and a more complex waterfall.

Impact of CFRE on Private Equity

There are several ways in which crowdfunding impacts private equity, both directly and indirectly. First and foremost, technology means that access to information is being democratized, so, suddenly everyone can know almost anything, both about investment opportunities and the investment details of specific opportunities. Also, they can know a lot about the market, like today. Definitely in development markets in a place like New York City almost every building that you look at, you can find online. You know how it is performing, who are the tenants who bought it before who bought it later, if there are any violations or complaints. You have access to rich information that previously only people with unique expertise, or with unique relationships, had access to. Technology does that and crowdfunding contributes to that and benefits from that.

Second, it democratizes access to capital. Which means that developers or sponsors today, that have a good deal or a track record. They can go directly to people with money and raise money from them instead of relying on private equity funds or larger investors. They can pull together resources from smaller investors and still get larger and larger projects done. As is happening.  Which means that to an extent it poses an alternative to private equity funds. Not a significant one yet but a growing one. It empowers, in a way, the flight of talent, from, big funds, and big developers. So. If in the past someone was managing, working for a private equity fund and they were doing really well, they could maybe go and find a job with a similar fund. But today, there's actually an alternative for that person to say 'Hey I'm actually really good at finding those deals. I have relationships with developers and maybe even with the government. I know the market better than anyone. Why don't I just go and syndicate myself?' They can then put themselves out there and raise money through crowdfunding. It's incentivizing executives to go at it alone albeit in a limited way

CFRE also does things that in some way benefits the larger private equity, real estate funds.  Crowdfunding is mostly focused at the lower end or the lower part of the market and, in a sense, it makes the market much more fragmented than it was because it empowers a lot of small players which means that those funds that are really large and usually have unique operational capabilities as well are only getting bigger, and it's harder for medium size funds, or for medium sized operators to compete with them or gain leverage when facing them. If we need an example, we can start with the retail world because their dependence on the operator is most obvious. You can have companies like Simon or Westfield which have unique operational capabilities. They're proprietary brands they have proprietary technology they have proprietary relationships with tenants. And they have their own fund management business so they can raise money. And they leverage their network and their scale to benefit all the different assets that they own. To the extent that if someone just buys one shopping mall, it would be very hard for them to compete with these guys, in terms of their leasing capabilities marketing capabilities, and asset management technologies etc. And when the middle and bottom of the market is getting more fragmented, it means it's harder and harder for people to climb out of that space and compete with those really large operators or fund managers. Another example is Blackstone. These guys manage more than $100 billion of different real estate assets most of it is office, and they're investing in startups and companies that specialize in operating office space and in technologies that optimize the way energy is used, and the way space is marketed etc. And unless you're a very large, it's hard for you, as an owner of one asset or five assets or even 20 assets, to compete with them. This is going to get harder and harder.

Impact of Tech on Real Estate

Technology at large, meaning not one technology but different technologies together, are creating dramatic changes in the real estate industry, starting from the way they impact the way people work, the way people raise their families, the way people move or don't move, the stability of jobs in general the fact that even people that are doing well and are educated and experts, don't have 20 or 30 year careers with the same company which means that, they are less likely to stay in the same place less likely to take a mortgage, sometimes less likely to even want to own anything. Technology is impacting real estate this way which is indirect but it's very significant.

More directly, technology is basically redefining all the basic tenants of real estate value, starting from the meaning of location, and the value of location, and the meaning of visibility and accessibility. The meaning of regulation. We've seen in the past few years, the technology redefined each one of these aspects because of, you know, ride sharing, autonomous vehicles, remote working, online marketing, which means that you get your lead not by being in the most prominent location but actually most of your tenants come through online channels and other channels.

The fact that disruptors can leverage the crowd to undermine regulation and rules. If you look at what, for example Airbnb has been doing.  The hotel industry was assuming that since Airbinb was illegal, it's not going to compete with them but they've seen that Airbnb has so many users that depend on it, and love it, both the people that lease space and the people that are guests, that governments in many cities basically succumb to or had to adjust regulation, in ways that people couldn't imagine before. Technology is undermining all of these things and that boils down to maybe the most important point which basically means that real estate as a whole, even the most stable asset that people assumed previously, that are valuable forever, just because they are where they are so they have inherent value. These assets are becoming destabilized to the point where unless they're operated very intensively and very creatively and probably, reinvented and readjusted constantly, they do not retain their value. To cite an example, if you look at office buildings in central Manhattan, that until a few years ago people assumed that they can just buy them and they'll have a stable yield and it’s a very boring business. Today they are competing with people like We Work in the building becomes dependent on its operator. If we look at retail, retail on Fifth Avenue again, until a few years, the safest bet on earth. No longer safe. A hotel next to Disneyland. Likewise, Airbnb suddenly comes over, partners with a local developer, and starts competing with your hotel and create new supply that is not zoned as a hotel even, sometimes, basically serves your potential customers.

That's the ultimate impact of technology really destabilizing what real estate means. This has immense implications to the institutional investors which means immense implications for our own pensions and our own savings for the future, what we can assume about the returns that we're going to see. Something to keep in mind.

From Zero to 300 Million

When he formed Patch of Land, Jason Fritton hadn’t had any career experience related to real estate. It was an aspirational, ‘somewhat naive goal’ of his to start a real estate company, as he describes it, and he came into it with absolutely no knowledge beforehand. Jason’s background is more on the technology side. He had worked providing solutions on the telecommunication side for very large public sector clients and had done very well with that and had built a nice company that he owned 100 percent of. Unfortunately, in 2008 and 2009 when the financial crisis hit, he learned the mistake of having just a few clients or one very large client and when that client went away his company went away with it.

See The Narrative and Listen to the Podcast in the Shownotes

This was an extremely painful experience. He lost everything and wanted to do something again because, as he says, “once you start a company that does well that is what you're going to do for the rest of your life. It's in your blood at that point.” Jason had to take a day job in deciding what else he was going to do next. He wanted a company that had thousands of very happy loyal customers and clients. He had known the CEO of a company that was doing crowdsourced graphic design and who was just blowing up the entire industry and doing very well and this gave Jason the idea that this kind of company was the future. He felt that this is how things are going to move because we're so interconnected today that the ability to be able to reach out to people that you didn't have any sort of previous relationship with, and to be able to focus their resources their skills and their experience into what had previously or what would otherwise be very difficult project was very powerful. 

Jason sat down with a scratch pad on his couch one day and asked himself ‘how would this type of thing work in a big scalable fun sense?’ Driving his inspiration that day, was that one of the biggest things that was really traumatic to him about losing his company beforehand was that he lost his house and a lot of people really take for granted just how nice it is to have your own place your own piece of the planet your own patch of land – which is where he came up with the name.  Real estate resonates with people. Deep down everybody wants to feel like they have some corner of the earth that is theirs.

Even though he didn't know anything about real estate at the time, around 2010 which was the depths of the market, he went and took a look at the auctions out in Chicago to see what type of opportunity was there. What he found was that there was always just the same group of 12 guys at this particular point that were bidding on good properties. These were smart guys. Highly experienced guys.  Wealthy guys. Always the same small group of people that were on a first name basis. It was a very insular group.

At one of the first auctions he went to there was a property that came up nearby where Jason was living. The current appraisal on it was $300,000 dollars. By today's standards after the recovery it is probably worth $600,000 or more. But back then that appraisal was $300,000 and minimum bid on it was $20,000.

And nobody bid on it.

The clique of regular buyers who all knew each other were highly experienced and at all those auctions they were bidding on the big properties and multimillion dollar properties and small properties, that Jason considered to be the bones of real estate, were a little bit beneath their attention at that point. Not only that, but because it was the depths of the housing crisis nobody else had the money because banks weren't lending. Private lenders really had massive liquidity problems and the usual real estate professionals didn't have access to the capital. So this great property went back to the bank or was abandoned and in this Jason saw a real opportunity. He went to his attorneys and to a bunch of mentors that he trusted and told them that this was what he wanted to do.

And without exception they told him that it was a great idea and there's something that they would be really excited about it but that if he did it, he was going to go to prison. They were worried about public solicitation over the internet but Jason, who describes himself as being a stubborn guy always trying to find solutions to complex problems, found out there were a couple of Congress people that were cosponsoring what became the crowdfunding exemptions to what became the 2012 Jobs Act. He worked to advocate for the passage of the idea and once the President indicated his willingness to sign the bill Jason put together Patch of Land full time in an incubator space out in Chicago.

Now the company has gone from that little tiny company built from his couch to one with a run rate of about a third of a billion dollars in annual lending, and climbing rapidly to half a billion by the end of 2018. Jason started from not knowing anything about real estate and now has reviewed billions of dollars worth of opportunities.

How POL Grew

Jason says that the growth of the company is down to one thing, that “begins and ends with a lot of hard work and determination.”  When the company first started he was fairly new with the idea of providing access to real estate to people who may have no prior experience whatsoever and the goal was to allow people to invest in real estate from two minutes flat from their phone from their couch from their pajamas if they want to and that was exciting to the wider public.  They started doing some press demos and Jason put together a small team in the Chicago incubator space and got a minimally viable product out doing just the absolute minimum of what they would need to be able to get business done in a very minimal sense. They started doing some tech demos and started to get a little bit of press about this. It kind of grew organically at that point. It wasn't something where they just took off and the Wall Street Journal picked up on them. It was very homegrown.

“Every entrepreneur has huge dreams or you wouldn't be an entrepreneur to start with,” says Jason, “And of course along with every huge dream comes every bell and whistles you can think of that's going to great for your customers.  A problem is if you go that route right from the very beginning you end up with this development paralysis essentially where you never get the product perfect. It's not exactly what you envision in your head and you delay launching until the opportunity has passed you by.”  To overcome this issue he and his team wanted to put together a basic framework online that would allow people to review good real estate opportunities and then place a commitment within them. That was the base of the problem they were solving. They wanted a thousand people to come together and to put a little bit of money into an opportunity to make a big opportunity happen that wouldn't have been possible with these folks individually.

The minimum viable product that they developed was really just providing the ability for somebody to view a real estate opportunity online, review the due diligence, for POL to upload docs and everything to show why it was a credit worthy, good project and then be able to place a small commitment fractionally and have that tracked. Once they had accomplished that the story became real because for an entrepreneur what you're trying to do may be very clear in your head but one of the biggest challenges to getting something off the ground is communicating that to other people and getting them to believe in it.  Consequently, you have to be able to show somebody relatively quickly and to be able to show the wider public relatively quickly what your idea is. What exactly is the value of it. With their MVP, they were able to show that someone was able to come into a deal and put a tiny little bit of money into real estate and be able to own real estate across the country and that they can do it from their phone. 

That was enough to get some articles written about them even though they hadn't done any business at that point, it was enough to be able to say “hey, look at these guys over here. They have this kind of cool little idea,” and it blossomed from that because you never know who's looking at those type of articles. And somebody else who was looking at other marketplace lending companies at the time all of a sudden saw this and said “OK I've got real estate experience and this makes complete sense to me” and that person was Carlo Tabibi, Jason’s co-founder.  He has a very prominent powerful family out in Beverly Hills and he's done hundreds of millions of dollars worth of real estate on several different continents.  Carlo came to Jason told them that if they were willing to relocate to Los Angeles he would put in a few hundred thousand dollars worth of seed capital to get the company started.  So they started from this very simple idea, without actually having done any actual business to getting the right person to believe and that took them to the next level.

At that point, however, Jason could not move his entire Chicago team because they had families and lives in Chicago. So just Jason and Carlo who started up the business in Los Angeles.  Jason moved to L.A. and put another team together and did that very slowly because they did basically all of the work themselves to begin with. They worked 16 hour days every single day, seven days a week to try and get the platform ready in anticipation of launch.  He arrived in Los Angeles in September of 2013 and launched the Web site with their first little tiny opportunity in October of 2013.  They were set to go speak at a trade show so launched their first project and jumped in the car to go out to Las Vegas to do the presentation. 

The deal was only for a $100,000 project and they expected it to take 30 days to fund. It funded in hours and that presented its own problem because they didn’t want to have dead space up there where they didn’t have anything new for investors to get involved in and then see them lose interest. So while in Vegas they had to crunch to find a new a new opportunity to launch from there. From there they picked up speed and really operated in kind of a beta sense. When you have a real estate investment company where the founder doesn't have a whole lot of real estate experience they wanted to take things slowly. Working with other people's money, they were cognizant of that and respectful of that, so they operated most of 2014 in a beta stage while they put the system together.

Scale

They wanted to build a platform that was scalable. Essentially a lot of real estate companies are real estate lenders are built around a few men and women that have been in real estate for a very long time and have a big book of business and they operate off of that that book business but they really don't have the ability to grow far beyond that without finding other men and women who have that type of book of business themselves and getting them to come to their company.  Jason wanted a system where they could generate the book of business internally with a very strong conversion funnel on externally developed leads and then be able to have a strong group of smart people internally that they would train up into their products and into their system that could convert and close the leads and be able to handle clients respectfully, efficiently, and with a positive experience. They spent 2015 and 2016 building that system.

Capital

Patch of Land was financed through a few hundred thousand dollar seed round provided by Carlo in Beverly Hills. Then the company raises a Series A.  They went the traditional venture capital route which Jason found to be exhausting. You have to convince very smart people that not only do you know what you're talking about directly but that what you're building has the ability to grow into something that's 100 times the size of what it is today and to be able to do it in a relatively quick timeframe. He found that at the same time as it was very challenging, it could also be very discouraging because most VCs will take a look at a hundred different companies before they give one Yes. Which means that say all things equal a company may get ninety nine no's before they get one Yes assuming they ever get a yes.

In addition to the VC community, they also went to Wall Street.as well as to family offices and that's eventually what allowed them to get a lead for the A round. They found a very prominent family office that was also involved with other marketplace lenders like Avant and Ondeck and other companies in different asset classes that had experience with it. They promised a good amount of capital to begin with and then Jason went out to his crowd. The nice thing about building a crowdfunding marketplace lending type company is you end up with a great deal of very happy customers, assuming you're doing your job right. They tend to have significant resources of their own and the entire baseline idea still stands whether it's funding real estate or funding a company that a small amount of capital from a whole lot of people adds up very quickly.

They were able to produce the Series A with a very sophisticated lead from a big family office and then fill it out with clients and who were the best investors because they know what you do and they've had an experience working with you and they're happy with who you are. That's a big advantage that POL has even today.  If they ever get in a position where they need capital they have thousands of investors in the platform from whom they can potentially raise capital as long as they can show that they have a good plan for making them a positive return on their investment.

Prefunding

The Series A round raised a little over $23 million and was built from a combination of debt and equity. Some was a straight cash infusion and then an additional amount, a larger amount was POL’s first prefunding line. When they create an opportunity with a real estate developer they have to move fast and can fund a deal on a property in 46 states in as little as a couple of days.  But to be able to do that they can't and go have it staged up on the Web site and go out to investors and have them wait for their money to come in.  That's not really workable. They found that they had to be able to use thei own capital to fund the property to begin with and so depending upon how quickly they scale, if they’re doing $20 or $30 or $40 million dollars a month, they have to have that amount of capital available to fund deals to begin with. Once funded, they can then take it out to investors. Much of the Series A was earmarked for that capacity.

Another part of the A round was used to reinvest in the company. They needed staff, they needed offices, they needed marketing materials, they needed marketing channels, they had trade shows to attend and they needed press releases. Most people don't realize how quickly money goes when you're a new company. It's a huge achievement to eventually get to be cash flow positive.

Finding the deal flow from developers or generating the investor base presented respective challenges. Sometimes one drove the model, at times it was the other depending on the stage of the company’s growth. Initially they had a decent amount of opportunities to be able to fund but they had no investors. So they had to get new investors on board because you can't promise a real estate professional you're going to fund their deal when they may have earnest money down on it if you don't have the investment backing to make it happen.  At the same time how do you get those investors if you don't have deals. So there's a chicken or egg argument early on.  They needed capital just like any small company to make these opportunities actually happen and it can be difficult advertising for this type of opportunity. They had a constraint in capital initially both on the warehouse lines for prefunding and as well as just investment capital from investors.

Deal size was also a constraint.  They can't do a $10 million deal if it's going to take two years to be able to fund while sitting on a Web site. And then once they started getting a lot more attention they started to grow organically on the investment side. They were producing around an 11 percent return backed by solid hard asset that was worth more than the investment to start with. So that was a very appealing product. And once their investors started to see a good return on their investments and be able to get their money flowing in every single month they would tell other folks and it would grow very organically from that. Eventually you get to the point where that balance started to tilt towards having too much money and not enough product and then we had to take internal capital and market back out and find out how to reach out to what can be a very insular group of real estate professionals to be able to get the opportunity to work with them and then it goes back and forth depending on what stage of the company you're in. Today they have billions of dollars worth of capital commitments and can fund pretty much as much as they can get in as far as solid opportunities are concerned as long as there are good opportunities.  They get a lot of applications from folk who have big dreams but really don't have a good plan for how to make their project happen and, naturally, they can't fund those. As of the date of recording the podcast, they were constrained on the deal flow side as opposed to the capital side.

 Deal Types

 Currently, POL only works on construction opportunities with real estate professionals on non-owner occupied properties. A lot of what they do can be called a fix and flip or a fix and rent or a refinance to rent. They deal with folk who know what they're doing in real estate. POL goes back to their investors and are able to say this person has a reasonable expectation of being able to pull off this project primarily on single family residential and small multifamily although they are now branching into small balance commercial as well in the $1 to $5 million dollar segment.  They are also doing new construction in specific markets and they are going to be expanding aggressively as they continue to develop skills and making sure to adequately underwrite additional markets for that type of product. They also want to move into long term investments.

To date they have been constrained on doing long term because they have been working with the crowd and the crowd doesn't want their money tied up for five years or seven years or 30 years but that's 85 percent of the market. So it's absolutely a priority for POL to get into that market. As they have grown they’ve developed credibility have been able to engage and interest billion dollar Wall Street firms. Those firms take a look at the loan tape and their underwriting criteria and the viability of the company itself and they've been able to do a forward flow for this type of product. For the longer term product they are currently negotiating and expect to have something in place by year end 2018.

The new products will be along the lines of a 5/1 ARM for a rental portfolio and not owner occupied. They don't want to move into owner occupied opportunities at this point simply because of the regulatory environment is extremely burdensome. When they started this they started because there was a massive fragmentation. There was a failing in this type of industry where the banks wouldn't lend on these types of opportunities but there is a huge market and hundreds of billions or even trillions depending upon how far out in the asset class you go. But the banks didn't do a good job with it. So there's a huge opportunity. The banks do generally a pretty decent job with residential mortgages but Jason believes that POL is in a much bigger market that is so huge that even if he is able to scrape together a tiny bit of market share he figures they will be doing very well.

EquityMultiple

Charles Clinton started his real estate career as an attorney working at a firm called Simpson Thacher in midtown Manhattan mostly for big private equity clients like Blackstone, KKR, Carlyle and others.  All the real estate giants.  He worked on huge, multibillion dollar transactions and found that his actual exposure to real estate investing was pretty limited and opaque and during the day and oftentimes late to the night he’d be working on these big real estate deals, but when it came to investing his own money, he always found that a difficult thing to do.  Maybe he would find a friend doing a small deal or looking at buying part of a brownstone or some such thing, and it just seemed like such a weird mismatch to him. So when the JOBS Act passed in 2012 Charles was immediately interested. He started reading through it and especially as the first companies like Fundrise got into the space, was interested to see where it could go. It seemed like this was the path really for solving the mismatch.

Read this in the Shownotes to Today's Episode Here

Fast forward after a few months of studying up and trying to figure out what his path of entry into that space might be, he enlisted a friend of his, Marious Sjulsen, who was in real estate private equity on the buy side and had been doing it for almost a decade. Marious was of like mind and similarly thought that this really was going to be the future. And so they set out trying to start a company.

Entrepreneurship

Despite having taken the safe route and going to law school and becoming a lawyer, Charles has always had a little entrepreneurial spirit in his heart; a willingness to bet on himself and see what happens. He also had a real conviction that CFRE was going to be a major disruptive industry that would change the way that individuals invest in real estate. If you look at kind of the big picture of the real estate industry you have professional investors and endowment funds investing 10 to 20 percent of their total assets into real estate and then you look at your average individual high net worth investor much less your non-high network investor. And they're averaging under 3 percent of their net worth into real estate outside of their home. There's just such a big systemic imbalance here. Charles thought that if he could be just a part of correcting that imbalance there's really a tremendous opportunity there.

Transformation

How CFRE came about is complicated but the end result and why this will change things is really pretty simple. At the end of the day especially for investors it's about access.  Access to direct real estate investments just hasn't really existed historically outside of personal connections or the country club or that that kind of thing. And if you look at the way that people have invested in real estate it's been through REITs primarily. You have the publicly traded REITs which have their own risks of market volatility and then you have the non-trading REITs which really have been decried by investors in the know in the SEC for almost as long as they've been in existence because they're just opaque and they have really high fees and that's a lot of what real estate crowdfunding will be is the replacement for; that world of non-traded REITs. It can offer access into clear, transparent investments in real estate. It can normalize having real estate be part of everyone's investment portfolio just like it is for professional investors.

The process starts with the information that's presented about the deal that the investor is going into. For one of the deals on the EquityMultiple platform, for example, you can sign in and you're going to see long web page filled with an overview of the deal, pictures, a description, the business plan, the financials, information about comparable properties, about the markets, about the condition of the property. In short, information to let you as the investor know exactly what you're putting your money into and make an informed decision.

Vs. Non-Traded REITs

You can contrast that with the typical non-trading REIT where the sales process has largely been people sitting in a warehouse cold calling and trying to sell a product over the phone where you don't know exactly what you're investing in you're just investing in REIT number 472 maybe it has a particular strategy but you have no idea what the properties are.  Furthermore, information about the fees which tend to always be extremely high as high as 10 to 15 percent annually is buried in tiny fine print and really it's about pushing a product on people and trying to trick your way in versus presenting something laying out all the facts and letting people make their own decisions.

Plus, when you invest in one of these non-traded REITs, you don't know what the assets are in the portfolio. The investor may know some of the prior investments but won’t know any of the ones that the future dollars, including your investment, are going to be spent on. Sometimes it's even difficult to get real good data on the existing portfolio. That's just really the exact opposite of what EquityMultiple is trying to do and what most of the good crowdfunding businesses are trying to do.

EquityMultiple

To start any company you need money. Like many firms Charles and his partner went out and started pitching their idea but instead of pitching it to venture capital the normal place you'd go to raise money they capitalized the business with their own money and also went out and targeted real estate companies because ultimately what they saw from their prior institutional backgrounds was that the real value and the hard thing to find in real estate is good transactions from good reputable operators. They spoke to several real estate firms and ultimately ended up finding a good partner in a firm called Mission Capital. They are a real estate capital markets firm. They have several different business lines they have offices throughout the country. They've done over $70 billion of transactions over the last 15 years. What they provided at the outset and still today is a good pipeline of deals that they can then diligence and look to offer out to investors.

That how EquityMultiple tried to get out on the right foot and differentiate themselves from the start. Charles says that “the big challenge that you think you're going to have at the beginning are not the ones that you end up having.”  He believes that it is important to do and see what works and see how the industry evolves to know what your investors, your customers actually want.

Initial investment capital was used to scope out the legal and regulatory framework and in  figuring out how they could take something that was really a pretty bespoke, these interests in ownership of a building, and to make that something that is scalable and where you can efficiently bring in smaller investors into these bigger projects. They spent a significant amount of time and money and effort building out the technology platform itself which they did in-house with their CTO and getting that up and running.  Making something that at the end of the day is easy and intuitive and makes everything more accessible is an important piece too.  From day one from when they were funded to getting our first deal off and running was about nine months.

Investment Strategy

EquityMultiple’s investment strategy has evolved as the market continues to develop and the principals of the platform try to stay responsive to what investors are actually looking for. Geographically speaking they are pretty agnostic.  They work both the east and west coast and everywhere in between. They do limit themselves almost always to primary or secondary markets and have done the largest number of transactions in Los Angeles. They have done a lot in Texas, in big population centers where there's more natural stability through rockier economic times. In terms of asset class, they are strictly commercial real estate. Their biggest investment category by volume is multifamily. They have also done office, industrial, mixed use and then a couple more esoteric things like mobile home parks which Charles thinks are a fantastic little sub niche investment.

What they have found is that they are placing more of a premium on shorter duration investments and investments that have a bigger percentage of their total return being paid out along the way in the form of dividend distributions rather than having most of it be kind of back ended. And that's a little bit of a change from the partner's backgrounds where they would really look at the longer-term value add hold for five years and it's okay if there's no cash flow upfront.

Some of that is what they have seen investors want and some of it is given where the market is they don't want to bank on that asset level appreciation as much; they really want to make sure that the business plan is something that can work right now. That it doesn't rely on a 5 percent year over year growth or anything like that. Their returns on equity investments and preferred equity investments are targeted at somewhere between a 13 and a 20 percent total annualized return and somewhere in the high single digits to low double digits being paid out currently along the way.

Returns

EquityMultiple is transitioning to find things that they either can fund with an interest or reserve up front so that they can support that cash flow during the value add component or that have cash flow in place right away and then that cash flow can just strengthen over time through the whole period. They have found that investors place such a strong premium on that that they realized they had to also.  They are also doing a lot more preferred equity structures.  Preferred Equity is essentially a hybrid of equity and debt. You get more upside and the returns tend to be higher than for debt investments, but you also have some good debt like protection. You're going to get paid before other investors or sponsor operator in the project gets paid. EquityMultiple found that those are popular with investors because they produce current cash flow even if it does need to be prefunded upfront. At a time when there is be market volatility they will also offer some good protection.

To illustrate this, a deal on the platform right outside of Mempis had a 7 percent current pay to investors starting in the first quarter after the investment closed. Then investors had payment priority ahead of all the other investors in the deal. This is just for equity multiple investors. Once the deal is refinanced or sold they get their principal back, and they'll also get another 7 percent return annualized on top of that for a total 14 percent annualized return. Maybe if the deal does fantastically the equity holders will make more, but the goal really is to really increase the chance of getting to that nice strong low teens or mid-teens returns.

The [common] equity investors are behind the preferred equity investors in line for the cash flow and they're also behind in line for repayment. If the deal does really well, then they have more upside. If the deal itself produces a 20 percent return they're going to do really well, perhaps yielding a 20 something return. But if the deal produces a 10 percent return then equity multiple investors will still make a 14 percent return and the equity investors will make very little if anything.

In short, EquityMultiple investors i.e. the preferred equity investors, are capped at a 7% pref plus 7% if the deal goes well, whereas the [common] equity investors who sit on top of that in the capital stack have more upside but also a higher risk of non-recovery of principle. The sponsor and their investors generally take the common equity slug in the deal.

This structure comes out of the institutional world where it's very common there to see these kinds of different tranches of investors. EquityMultiple thought that this was not just a good fit for the institutional side but also a good fit for individual investors because it checks a lot of the boxes that they believe investors are looking for to deliver a nice return. They are still getting a good portion of that return on a current basis, but there is also some real protection in the event that the investment doesn't perform as well as the sponsors is projecting.

To education investors EquityMultiple is putting a lot of emphasis on two things. In addition to having a lot of resources available explaining everything from the basics to the most complex subjects, they also provide customer service and Investor Relations. One thing they try to do extremely well is that they’re very responsive to questions whether it's by phone or email. They talk to a lot of investors in a very old school sort of way.  They have a huge range of people from a doctor who's never invested in real estate before to someone who is in the real estate industry sitting in the middle of an office in Manhattan or L.A. or Houston or something. They try to cater to that range in how they explain things and the level of detail that they provide.

While in some ways the background structure of their deals might be a little more complicated on an investment when it’s done as preferred equity there is something that's also very understandable about fixed rate returns; that the investor gets paid after lenders and before the equity investors and EquityMultiple finds that they are dealing with smart people and they have found that it is something they have been able to communicate effectively.

Challenges

Finding new investors and getting the word out has always been a challenge. It is part of the reason why they love doing podcasts like because in doing so they reach new audiences.  There's still a huge swath of the world of the country that doesn't know that this kind of investing exists. They are definitely starting to see some real snowballing momentum on that side of the business. As they look to the future they see a situation where their challenge becomes the other side of the business i.e. in sourcing and underwriting enough good quality deals to meet investor demand. That's the problem where EquityMultiple feels like they have positioned themselves well for. They are ready to kind of grow to that stage of the business.

The Future

Charles sees that the CFRE industry is at the absolute beginning still. We're in the very first few innings and have no really hit the point of mass adoption yet on either side of the business, whether it's real estate companies looking to bring on new investors or investors looking to get into real estate. That's still lurking in the future which is great. The world of non-traded REITs  is going to start being displacing in a major way by CFRE.  The introduction of disclosure rules decimated non-traded REIT volumes and really opened the door for the real estate crowdfunding industry to come in and start filling the void because the demand is there and investors are interested in real estate. They want to allocate a portion of their money into real estate.

Charles sees a real spike in demand likely from investors over the next few years and suspects with that we're going to see further consolidation in the industry. We'll probably see some of the bigger players in the real estate or the asset management world looking to come into the space either directly or possibly through an acquisition of one of the existing businesses. We've already seen sort of more specialization right. Fundrise has now gone into the REIT space. They're really raising money for their own non-trading REIT albeit in a new way. There are platforms like Peerstreet that are very honed in on single family kind of fix and flip lending and really concentrating on growing that space. We’ll probably continue to see that and continue to see the good platforms grow stronger and deeper and, in Charles’s view, there's really room for several different variants of this business model that offer different value props to investors so as you look out as an investor your options are only going to continue to improve.

REITs in the Crowd Fund World

KBS was basically an analog company built on the broker dealer networks under the old non-traded REIT business model for capital raising, but that business just fell off completely because of regulatory changes. Robert Stanger came out with an article where it showed that they were raising $20 billion a year and now they're raising somewhere around $1 billion a year.  This is because rule 15.02 now requires more transparency in the way that non-traded REITS are booked and now must show value less any load, whereas before they didn't do that.  Additionally, changes to the fiduciary rules and the way that's changing the requirement of disclosing fees, or not even selling into retirement accounts by broker dealers, when they have high load products.

See this episode in shownotes here

This has fundamentally changed the way that capital is aggregated for investment by the major wire houses and that's now shifted from commissions salespeople to registered investment advisers who are people who work on a share of assets under management as opposed to a transaction fee. With all of that then came the JOBS Act in 2012 which opened up the doors to general solicitation and advertising in a way that go beyond just the accredited investor.  There has been a lot of success with the bigger institutions waiting for the smaller guys to figure this area out before they became adopters.

Now you're seeing Hines and KBS getting into the field, and guys like Ray Wirta who founded Rich Uncles and Fundrise and RealtyMogul who were the pioneers are out now able to raise at some greater scale. People are becoming more comfortable doing things online and mostly the drivers of this economy are the Millennials and Gen X’ers.  These folk don’t want to have to shake your hand if they want to do a transaction, they just want to trade it directly or buy it directly. It's just the way they are.

So now the trust factor is the big thing for the person who wants to invest online. Getting big institutions or people with big names is logical because it's typical network dynamics.  You’re taking an influencer or using that brand, or having other people who are influencers maybe at a smaller level, and going all the way down to the retail customer at the end of the day who's influenced by all of them. You can call it the Warren Buffett effect for business or you can call it for fashion the Kardashian effect.

These younger generations are people who are influenced by people they trust, as in the case of Kardashian, people who vouch for a product. Nike has been doing it for a long time with brand athletes and so has Adidas with Ronaldo. It's the same thing in any business you find. But it's not like you grab Ronaldo and he tells you to crowdfund. That's not going to work. But if you grab Ronaldo and he tells he's going to do a masterclass on soccer you're going to subscribe to that. So just like in real estate if you've got somebody who is a Sam Zell who goes direct to the public and says you can invest with me and you get my management, you get my ideas, you get my timing, you get my capital along with yours; you're going to invest in that because you know that Sam knows what he's doing.

Sam's not going to crowdfund for you know he doesn't want to deal with investors. He wants to do it himself, but an institution like KBS or Grubb & Ellis or whoever you know, like the old guard types like Ray Wirta, you’re looking at people who've dealt with a lot of capital in the past.   For example, you couldn't invest with KBS unless you were a government or a sovereign wealth fund or a pension fund.  Behind KBS there's a whole organization to serve that caliber of investor and they're highly monitored. They have an institutional understanding, they've done public offerings, they've done joint ventures. KBS is a very sophisticated shop. It's not like a typical Crowdfunder like somebody who's kickstarting a baseball cap with a fan in it.

The primary reason there are no widely known celebrities in real estate is that they couldn't advertise.  Even for a company like KBS which has done public offering, has launched seven REITS, they were not allowed to advertise; cannot make any forward statements. The regulations are very precise; you have to be very quiet. Historically it created a culture of everything done behind closed doors.  Now with sophisticated players like KBS, the key is being is being a gentle person, whether gentle man or gentle woman, but someone who is rational and reasonable and not out there like crazy Eddie trying to sell stereo equipment.

In the past though they couldn't say anything, whether it was cultural or advertising prohibitions, and now with the JOBS Act people can get to know who's behind the real estate. People can get to know who really is a star in the area.  Who is the Warren Buffett of real estate, or the Warren Buffetts of real estate because if someone can invest with a number of major people in the field, they are going to whether it's a Draper in tech or Buffett in stocks or somebody like a CIM  in real estate or Oaktree in debt.  Investors know those guys and know who the celebrities are and that they are not able to invest with them because they are getting money from other people with much greater scale.

Now, however, there is an addressable market that exists for people who can reach them and can communicate there for the first time.  They can learn who the superstars are and why they're so good. Hopefully that transparency and the ongoing relationship that can be developed through a community on the Internet will end up being a new capital aggregation model.

People like Sam Zell who recently wrote a book that was published; Sam is known as the grave dancer. He buys a lot of distress although Sam is so diversified that a much smaller percentage of his assets are in real estate. He was the largest owner of apartments in the United States and had Equity Office. Sam's a star. When he shows people know.  He's the best salesman there is. In industrials there’s somebody like Dick Ziman who people know from Arden. I'm the chairman of the Board of Trustees of the Ziman school at UCLA and Dick called the industrial surge a while ago and created Rexford. People know him when he shows up.

However, the idea of accomplished professionals stepping into a broader limelight is nothing but a notion other than trust and verification of whom investors should entrust their money to and on what basis.   To the extent that the investor is seeking something which is institutional one has to look at the sponsorship and that comes from someone who's a serial achiever.  Those serial achievers are the people that you want to be investing in, because it's about the real estate first.  In commercial real estate, it's about the people who are operating that real estate, collecting that money for you, dealing with the expenses, getting it back to you and knowing when to sell and knowing when to buy.  Real estate is pretty complicated and that's what you're paying for.

If you're paying for management that's one thing, but if you're paying just to get into that deal and get into access that's a problem.  Investors don’t want to pay points just to get into deals but they’ll put their money with somebody like Zell, or Ziman, and pay them to manage it without having to pay a bunch of intermediaries if they don't have to.

And that's really where we are today. We don't have to pay the intermediaries anymore but we do have to trust the people we're working with.  In real estate you're probably not going to end up with branded athletes, but is Warren Buffett a branded athlete? Perhaps he is in financial services. In Berkshire Hathaway people invest because Warren Buffett says it works and he's been right. Perhaps if someone were to invest with Chuck Schreiber and Peter Bren in KBS, you'd realize that they have been right for a long time. Peter really saw these opportunities and he's been around long time and he has a great mastermind of other people who can help him look at markets and figure out where those high job growth markets are when they go in and where they can add value.  

What the elimination of the advertising prohibition achieves is the opportunity through the Internet, through videos, through speaking engagements, through podcasts, for these superstars of real estate to become known. Online is where the true transaction and people connection can be made. Mike Milken talked about prosperity, economic and social prosperity, being a function of the application of technology to three things: real assets, social assets, and human assets. By taking real assets and combining with tech, giving data to the investor, giving data to the sponsor to know who the right investor is, having the ability to use that technology to better manage property, better communicate with investors the social aspects of it, it's going to just add to the prosperity. However, it all depends on the human capital applying it, and that's when we talk about how do we know, who we're investing with. It's that human capital and the technology.  The technology that can magnify who that human capital is because that's really important when it comes to commercial real estate.

Choosing the Crowd Fund Route over the Institutional

While KBS is building a fund based on a crowd fund platform, for the company the institutional funds don't stop. The way that money is raised and from whom it can be raised depends on the vehicle and also depends on the institutional appetite for being in a comingled fund with other investors. This direct investment vehicle is not a substitute for pensions, it's not a substitute for sovereign wealth.  It is an additional channel for aggregating capital for real estate projects.

So why do it? It's because it's available now where it wasn't before.  It's no different than what used to happen in the days of Fred French and the Manhattan syndicators, Leonard Wien, Harry Helmsley.  Those folks would get people in the Jacob Javits Center and syndicate for $90 million or whatever the Empire State Building cost, or they bought the Plaza Hotel or the Gray Bar or The Fiske or any of the things that were there and they did it with physical signatures and a serpentine distribution of signature pages throughout the Javits Center.  They’d have 3,000 investors who would all buy into that. So that was the 1950s and 1960s.

Since then you've just had changes and regulations and other things which have obfuscated that, that have just made it much more opaque with regulations and a bunch of other things. Not many of which are very helpful, though good accounting is helpful and proper disclosure is helpful. All the things that are necessary to ensure that the correct story is told and that nothing is missing, and everything's included good bad or ugly. At the end of the day, though, all those regulations add up to a lot of expense and then with enforcement actions and other things behind them, which are extremely necessary, it tends to make raising money just much more expensive than it was way back when things were, and it's hard to call Manhattan the Wild West, but when it was the Wild East.

Today what the Internet has done with the JOBS Act is it has brought us back to a place with good regulation in terms of disclosure, and greater transparency because everything is listed. It’s easier for the FCC to audit, easier for state and local governments to audit. Clearly requiring registration under Reg D or Reg A, to make sure that the government knows what's going on. There are things that are in place, but the big difference is that you have a computer screen just like your broker did - the guy who was selling a deal to you and charging you 12 or 15 percent at the end of the day to get access to a building. Now you don't have to pay that. Now you can get access to the building, directly, as an individual.

The second factor is that KBS wants to democratize the opportunity. It makes sense to set the minimum at anything you want $25,000, $50,000, $200,000, $1 million, but in KBS they want to get people familiar with them.  So they lowered it so that people can come in and they can make money and then they can add overtime.

At the same time, KBS will continue, as a must and as it desires, working with the sovereigns that they work with and working with the pensions that they work with that's not going to go away. The best capital aggregation model always wins. Institutional capital remains the cheapest and the most transparent one unless regulation comes in and there's fraud or something crashes.  Many people are concerned about that; that there is going to be a lot of internet fraud in real estate which if you have a funnel where you stay with the quality management and stay with quality product and read the documents, having confidence that the person who is the sponsor is giving you the full story, then you can invest and then you can make money and make money to have a stable source of income or appreciation or in the case of a growth and income product, both.

Crowd Funding

Initially, people were suspicious of crowdfunding. Certainly, the product crowd funders like Kickstarter and Indiegogo gave people the confidence to invest or buy a product, but a lot of people like banks and like brokers and certainly want advice as to how and where to put their money when it comes to investing.  The generations though that are comfortable with Indiegogo and Kickstarter as a way to raise capital, or Seed and Spark if you have a film, or Thumbtack if you want to get service providers, whatever it is, the use of disintermediation is a trend that will continue.

The use of data to provide greater information to those who are educated to be able to make informed decisions and not through gobbledygook but through true community will continue. There is demand for products where you don’ t have to deal with people in a world where we're barraged by so many pitches made by so many different people who are trying to get our attention. It requires the ability to filter things out to find out who you can trust and not to be the schmuck. It’s the Amazon effect of just being able to go in and save your time and find what you want and not have to go to Black Friday is exactly the same thing that exists in investment today. It's why in 1985 Accutrade turned into an online brokerage that is now E-Trade, and in the late 1980’s you saw the banks come online and the ability to save time, not get into a car if you don't have to, use your brain and use your data to distribute and to originate.

That's the future that's here today. It's happening.

That's the social and economic prosperity that results through the application of technology to human capital and distribution. Capital flows are and will continue to benefit from transparency. That's what killed the non-traded REIT world. Investors saw the transparency, they saw the fees, and all of a sudden it changed and the aggregation model is now from that to let's go direct, let's avoid broker dealers who charge these fees, let's do what's best for the investor and instead of being paid fees to manage let's go side by side with the investor which is what the KBS's, what the Fundrise’s and the RealtyMoguls and others do now.  KBS, when compared to the young wonderful incredibly bright and brave talented people like the Miller Brothers and the people who put together RealtyMogul, are very different animals but they're using the same technology.

Challenges

The biggest challenges are more for real estate and not for the Internet.  The prospect of a downturn is real. This is real estate first, technology second. It's not the application of real estate to technology, it's the application of technology to real estate. So as real estate goes, there are a variety of sectors. There's industrial and today's industrial is hot because we're dealing with the Amazon effect.  The KBS effect is the idea of a direct origination, direct distribution model through the Internet.  Last Mile is a big area. Now, for same day delivery or even same half day delivery you see Amazon acquiring WholeFoods so they could have internally at the worst case they have some of the best distribution in urban environments in the country.

The hotel area's different. If you look at hotels they're very much dependent on the cost of energy and the amount of disposable income the consumer has.  When the economy is doing well, hotels do well, when the economy is doing poorly, hotels do poorly.  People can invest in that, but you go into residential, and you can go all the way through the different food types in real estate. It's real estate First. When we have a downturn in real estate we're going to have a downturn in real estate investment. We're also going to have direct investment vehicles that will allow people to buy into distressed funds that invest in the down cycle that are truly value add or Sam Zel graveyard type funds which in many ways built much of what you see today, like Blackstone and OakTree and a number of those who went out during distressed times and bought assets. Large homebuilders do it all the time.

There be funds that can scrape and invest in a bunch of different offerings and you can invest in those with kind of robo trades. There's a lot that can be done far in the future. Right now sponsors are increasingly going online to reach investors or to manage investors and many of them start that way where instead of sending out paper to everyone they have them log in and they have a box and that's the way Crowdstreet works.  They really started as a marketplace but they quickly shifted to investment management software for their sponsors and capital raising software and now they do both. RealCrowd does their marketplace. They don't really sell their software.  They’re a big media and marketing machine to get the word out so people can invest for their sponsors. Fundrise and RealtyMogul are REITs and what they do is they raise money in Regulation A from either accredited investors and from unaccredited investors and the people there can invest as little as $100 at a time and build exposure to commercial real estate that way.

People say, ‘well, just wait till there's a downturn.’ As underwriting is constrained and people aren't doing the crazy 110 percent loans and we have a governor on the amount of capital that can go into these deals and the amount of leverage that can go into various product we're fine.  That’s why a commercial REIT like KBS direct will never take on more than 50 percent debt. Ever.

REITs are going to be viewed on how much debt they have because people want security when it comes to their dividend that they're going to be receiving from that REIT. They also want to know in a downturn that their property is not threatened, so there's a certain amount of discipline.

Lew does not believe that CFRE is going to be the next mortgage meltdown. People will lose money along the way like they do in other investments and so that's why the trust factor is the most important thing.  Knowing who you're investing with as well as what you're investing in before you put your money in is paramount.

Heritage Capital

Lew was a lawyer for about thirty three years. He still is a lawyer and he still does a bit of practice.  Primarily, however, he puts money in companies that have what he views as having great ideas that solve important pain points and problems, and he believes that direct investing is a great idea.  He looks for problems to solve, and then looks for really talented people who have demonstrated ability to execute on the ideas and the execution.

It's in your control to select the people that you associate with. The First Amendment is great because it gives you a right to associate with anybody you want to.  You can even travel places, talk to people. Those things are important, but what you can't control is timing. You can get a sense of it. You can look at history. Mike Milken said the best investor is a social scientist. You can get a sense of that but you can't really control timing. Black Swans events happen. You do your best to see what the risks are, and that’s what Heritage looks at.  They invest in business models that look like they have some kind of a clear path to an exit or for scale. And they like to do inflection investing.

Find a company with a great idea, a proven concept and then take it and scale it and move it. The last factor is that the people Heritage invests in can see that they can benefit from Lew’s involvement and that his capital is strategic and is worth more.  As Sam Zell would say, his simple rule is to go where gus capital is worth more.  He won’t go to China because it's not transparent enough so his dollar over there isn't worth as much, but he can go to South America, to Brazil or to Manhattan where he sees there's an opportunity and his money is going to be worth more because he understands Manhattan. He understands Brazil.

Heritage employes Sam's rule.  They try to go where their money is worth more, where their money and that of their investors can benefit much greater. That usually means you’ve got to just roll up your sleeves and get your hands together and get to work and be active. Lew has come out of real estate and saw tech and the application that.  Folk like Nico mêlée who wrote The End of Big, and Malcolm Gladwell with David and Goliath and Mike Milken with his Milken Institute and Wharton.  All of those things have influenced Lew to see how tech can be applied to simplify the way that we live and we work and we engage. He invests in thematic investment either in something with data, something with social, something with distribution.

He tries to keep those themes in mind as he looks forward but disintermediation is a big theme that he likes, and knowing real estate he ended up just falling in love with the idea of direct investing and helping smart people get access to deals because we think about the capitalist system as being one where we're free to earn income, but the capitalist system is where you're free to get capital, and real estate capital and capital assets produce value.

The only way to create enduring wealth, people say, well the American dream is getting a house. That's how you get enduring wealth. It's true but that house goes up in value but you have to buy it first to make sure you're getting all the value. With commercial real estate you can invest in that same kind of asset and get income from the first day. A lot of books are written on that stuff. The Rich Dad Poor Dad whole kind of thing that came out of it. The Goofy Ranker infomercials of how to make money in real estate. All about cash flow, but to do it with institutions other than through broker dealers and having lots of points taken from you. That's all brand new and it's where everybody should be. They should be able to have capital access and access to being capitalists so they can get wealth today and maintain income. To me the travesty of what existed in the past is just how inefficient the information flow has been and how coagulated capital becomes in places like Wall Street. You go back to someone like Mike Milken and while he's not necessarily what everyone holds up as a great general standard bearer he's done a hell of a lot of good.  More importantly he in many respects was a disintermediator who was penalized by Wall Street. He took bonds off of Wall Street into Beverly Hills, looked at a company and figured out in 1982 that the company wasn't worth its price earnings ratio, it was worth the application of finance. You know what happens if you apply a different interest rate and loans to the cash flow that's coming from a business, that's the value that you can produce and if it's worth more than what the stockholders are valuing go buy it, take the difference.  That’s what he learned how to do. That's where the LBO came from and it's just a simple arbitrage not basing things on an old formula. That’s what got him in trouble because people on Wall Street didn't like the idea that it could be done anywhere and you could take  Main Street banks and acquire Wall Street companies. Or build Las Vegas without them etc.

There are a lot of companies being pooh poohed in an area that's new when a paradigm shifts but there's no doubt that Las Vegas is real.  There's no doubt that all the people from Oaktree and CIM and Patrick Soon-Shiong in Los Angeles is incredible in the bio area, and others have benefited by viewing and created so much prosperity by viewing the paradigm differently.  Lew sees what he does as he tries to look at the paradigm a little bit differently and invest in these inflection companies. Fundrise, KBS, Patch of Land which is a fix and flip lender, Pay Forward which is a rebate company that uses instantaneous technology to send a dollar in a hundred different directions from new rebates that come from families but doing it instantaneously and it can go to pay mortgages or health care or whatever rebates that people don't even know they get. Things like Wiki Realty which fits in the qualitative space between a Trulia on the residential tech side giving access to homeowners to things like walk scores and school scores which is now merged with Zillow which is very much a broker, a property feature but nobody talks about the neighborhood.

Those are, whether it's home tech or construction tech or direct investment, those are the kinds of things that Lew thinks are continue to make sense; he tries to see trends and to be that social scientist so he can be a good investor.

KBS Direct – a $1 billion Fund for the Crowd*

 Chuck Schreiber is a fifth generation Californian who grew up in Southern California. Loving mathematics he went to college to study finance and gravitated towards real estate and real estate investments because it was an investment opportunity where he saw opportunity to actively improve the performance of assets through their management rather than the passive activity of selecting stocks or other securities. He started his career in a brokerage company before forming a partnership with Don Koll, of Koll development, and Peter Bren in 1991 that was to be called KBS. 

 Listen to the Podcast and Read the Shownotes HERE

At the time the firm was formed, Peter Bren had a relationship with a public pension fund and had closed on a bank portfolio from Nations Bank with over $200 million dollars of cash invested. The bank wanted to sell another allocation, so Peter was looking for a company with resources around the country. At the time, Koll had formed Koll Management Services Company and was building it up, so they had national presence in commercial property. Peter shared the opportunity with Chuck and they subsequently acquired two more bank portfolios which they followed with a comingled fund where there were 11 or 12 different, mostly public, pension funds for about $250 million allocation. To date they have now done somewhere around 28 different funds.

 Non-Performing Loans

 In the first portfolio there were around 32 different loan investments that the banks called sub-performing but in actuality were non-performing.  They were primarily construction loans that the bank had identified as bad assets that they needed to sell to free up liquidity. Chuck knew the loan officer who set up a data room and with about, half a dozen different investors, they went ahead and bought that portfolio. 

 That was in 1992 at a time when what had damaged the market so much was overdevelopment primarily for commercial properties and this had led to considerable vacancy. It was very difficult to sell a building because buyers couldn't get loans.  If you had a $20 million building you could not go to the bank and get even a $5 million loan. The banks were trying to rid themselves of assets that were categorized as bad assets or sub-performing assets and weren’t lending to buyers of similar types of assets.

 The Savings and Loan crisis that hit at the end of the 1980’s could properly be described as a real estate depression.  Property values started struggling in Texas and then it grew throughout the country.  From a commercial standpoint it was much worse than the downturns in 2001, the so-called Tech Wreck, and worse even than the deep recession in 2008.  In the early 1990’s you could not sell a building because no-one could get financing. The only buyers of buildings were all cash buyers and the volume of transactions just stopped.

 Experience of Recession Informs KBS

 KBS is extremely sensitive to risk. Even though the firm has a sizable portfolio they are a fairly nimble manager of real estate products and have a posture where they flee from risk. If they believe that something risky is going to happen in a marketplace or in a building or looking out two three four years they’ll go ahead and sell assets in that marketplace or sell a building if there is something they don’t like about it.  Indeed, the company modified its investment strategy in 2010 to focus almost exclusively on Class A office buildings in central business districts. Up until that time their investment strategy was really focused on Class B properties where they would put cash into buildings, fix them up, make it a great location for businesses, lease them and then sell them. But what they realized in 2010 was that the only buildings that were leasing were the great Class A buildings. For example, they bought a building at that time in Chicago at 300 North LaSalle which was about 91 percent occupied. Built by Hines, it might have been one of the best buildings built in that decade.

 During that time, the majority of assets in KBS’s portfolio weren’t getting traction on leasing activity and weren’t even having people look at buildings in these primarily Class B suburban office that they held.  In a period of nine months they took 300 North LaSalle, which had over a million square feet, towards 98 percent leased. They had more leasing in that one building than they did in the balance of their whole portfolio. As a result, they modified their investment strategy to focus on Class A and to buy the best buildings they could in locations that they targeted as potential investment opportunities.

 Class A Office Outperforms

 The reason Class A outperforms other asset classes is that they are buildings that complement the principals who run the businesses in them.  In 2009/2010 a couple of things happened. Number one, lease rates dropped in all products and what tenants realized was that they could sign a lease, move into a Class A building at the same lease rate they had been paying for a Class B building. Importantly, and in addition to this, what KBS also found is that principals of companies value their employees and their lifestyles much greater than they did a decade ago.

Buildings located in proximity to residences for employees have become an important driver for employers.  To have a building which would be attractive for a young talented professional to work in that is close to a comfortable place to live really enhances their lifestyle. If they have an option to live in a great CBD whether it's San Francisco, or New York, or Los Angeles, Chicago, Portland, or some other great CBD, if they can walk to work or take public transportation to work or ride a bicycle to work it becomes just a great place to live and a great place for companies to locate and attract wonderful talent.

Recession Resilient

In earlier downturns there was a lot of discussion about large tenants moving out of the CBD and moving into suburban offices, but this is transitioning now because there are so many residential opportunities in, for example, downtown Chicago where people can simply walk to their office, or they can take a train and get out right downtown. There's so much residential development multifamily and condos and apartments just west of downtown Chicago that the downtown core has become increasingly accessible and attractive. Over the last 10 years there has been a substantial change downtown Chicago in the demand for office space.

And KBS is noticing this trend around the country.  For example, markets such as Salt Lake City which institutional investors wouldn't even consider ten years or even five years ago as a primary market, now is a terrific market for investment. There are a couple of major tenants who've gone in and leased space of 140,000 square feet and then expanded for another 110,000 square feet in downtown Salt Lake City. It's become a wonderful market and KBS owns three buildings there that have been very successful because the two key changes there are the development of high quality residential downtown, and rapid transit bringing those who live outside of the CBD the ability to get to a job downtown.

KBS Direct

One of the criteria that the fund applies when looking for core and core plus downtown assets is that there's been a revival in residential developments in the same area. A professional between the ages of 25 and 40 who's talented, who's educated, who has a great background; these folk want to live in proximity to where they work. They're not going to want to live out in a suburban area or even be in a situation where their office is out in a suburban area. Even if they only have a 10- or 15-minute drive to work, they don't want to get in their car to go get lunch. They want to go to the lobby in the building; they want to go out on the patio on the side of the building. They want to go across the street to the mall. They want to go across the street where there are restaurants, or maybe go shopping at lunchtime.

KBS bought a building in Portland Oregon, for example, and one of the most popular things they did was put 200 bike racks at the lower level of the building. Ten years ago, they wouldn't even have thought of such a thing.

Low Minimum

In 2005 KBS formed KBS Capital Advisors and entered into the non-traded REIT business focused on retail investors.  By the third REIT of this kind, KBS REIT III, there was over $1.8bn invested and yet the average was only $40,000 per investor.  KBS is passionate about that because that $40,000 investment may be as important to that investor, to that couple, because this is retirement money for them.  Chuck explains how he and his partners believe that is as important as a pension fund who's giving them an allocation of $200 million dollars.

The idea to go fully retail with KBS Direct started with their seventh fund, KBS Growth and Income. They raised over $70 million through a private placement and started to buy assets in 2016.  At the time, they started looking at the availability of technology for the retail investor who would be able to educate themselves, or deal through a registered investment adviser, to make a decision to invest in a real estate product because KBS had the ability to offer some institutional grade real estate.

Today [at time of recording this podcast] KBS Direct has a portfolio which is a little less in value than $200 million, with four different assets that are scattered around the country.  The investment strategy is to buy top quality buildings in CBD markets and what they found was that through technology investors have been able to educate themselves on a variety of investment types. KBS believes that their transparency and ability to offer this kind of asset either directly to investors or through registered investment advisors with a no load and no commission profile is an attractive option for investors.  One hundred percent of the money that an investor puts in goes right into the real estate and KBS believes that they are the only firm that has done this.

Putting something together like this is not easy because they had to write a number of checks to cover the upfront cost to create the structure, but they think it's going to be a unique opportunity.  Investors have the ability to go through and look at the fee structure compared to other similar institutional caliber investment opportunities and really educate themselves on the fund, the potential risks, and the overall plan for the investment.

The Fees

Chuck explains that the fees KBS takes for operating the fund and the properties are fairly consistent with industry norms.  They get an asset management fee that is based on the equity in the portfolio.  What makes KBS Direct stand apart is that typically, when investments are made in non-traded REITs through an adviser, there's traditionally a commission that is paid. That commission can range anywhere from as low as 3 percent but is typically in the 6-7 percent range, and it may be paid upfront or paid over a four-year period of time.  The fee rewards a broker dealer for all the due diligence they need to do to recommend a transaction to clients. Chuck’s perspective is that they earn that fee which, presumably, hopefully, they are disclosing to their client.  There are, however, some fiduciary rules that KBS believes will impact the market that are going to make for some challenging times for some broker dealers.

The strategy of KBS Direct is, therefore, to utilize technology to provide enough data to the investor so that they can make their own decision on whether to invest. The investor can educate themselves or if not they can get the advice of a registered investment adviser who really doesn't have a commission business.

This approach reduces the cost of investing because it helps to eliminate ‘the load’. There isn’t that 10 percent upfront cost to investors which would be the commission and then the reimbursement for organization and origination costs. Those are costs are paid by KBS Direct, and because it's a non-commissioned product, the upfront load is eliminated. The other unique feature is even though where other REITs paying all those expenses upfront might recapture them later, in KBS Direct’s case they are committed to paying those expenses with no recapture and booking it as simply an expense to create the product. The bottom line is that every dollar invested goes right into the real estate investments themselves and are not lost in fees or commissions.

Yield

[As of time of podcast] KBS Direct is paying a five and a half percent dividend on a purchase price per share of $8.79.  At the end of each year, the fund declares a new net asset value, a new value for the equity in the shares. At that time the share price will be adjusted to whatever the new net value is and should roughly be in the dividend range of five and a half percent per year, paid monthly.  Of course, dividend and period of the yield are not guaranteed and may change in the future.

Importantly, as a non-traded REIT, shareholders can't sell their shares.  These are not

investments for somebody who needs liquidity. Rather it is like an investment club.  Think of it this way: It’s like if two or three people were going to buy a fourplex, or a small office building and hold for a period of time.  There’s no liquidity, you would only be looking at yield and some long-term capital appreciation.   KBS Direct is similar in this regard.  The firm anticipates having a hold period anywhere from a minimum of five years out to as much as 10 years. If people need this money for education, or for other needs during that 5- to 10-year period this is not the right investment for them.

KBS anticipates that the typical investor is going to be $100 to $200 thousand investor who will look to be receiving 5.5 percent on that investment, per year, in cashflow coming back out to them. The firm also anticipates that there may be opportunities to grow the value of the equity of the portfolio over the course of its life. It will be diversified throughout the country and the average size of the buildings the fund will acquire will be probably around $60 to $80 million because these are sizable institutional grade real estate projects.

While the intent of the fund is for longer term hold, they will go back if, during the hold period, if there is a belief that there is an opportunity to realize returns, and may sell assets, reinvesting those dollars into other properties. That said, at a point some years out, maybe four or five years from inception, if KBS believes that is an appropriate time to sell the entire portfolio, they return to investors and ask for their concurrence to liquidate.  At that time, they decide whether to sell the portfolio to one buyer, whether that's an existing traded REIT or other institutional investor, or to sell the assets individually.  It is expected that the fund will have maybe 15 to 20 different buildings in the portfolio and so, if it owns three buildings in Seattle for example, they may sell those buildings as a cluster to one buyer.  However, in KBS’s history, they have typically sold buildings one at a time because they find it's a way to maximize returns for the investors because, while it takes more work to do that, they have found that they are able to negotiate higher prices.

Portfolio Liquidation

At the end of the fund’s lifetime, when the firm believes that it's time to maximize return of the investor, they will go ahead and sell the entire portfolio.  Perhaps there will be 15 assets, of which they might have sold 3 or 4 or 5 of them separately, but ultimately, they will target a 12-month period of time to go ahead and sell the balance of all remaining assets.

At the time when all assets are sold, the investors receive back their initial investment first, assuming sufficient funds available.  Then, if the assets were bought right, there may be some equity growth, which would be a gain in addition to the cash flow that the fund will have been historically paying on a monthly basis.  Of that excess gain, KBS receives a subordinated incentive fee of 15%, and the remainder is paid to investors.  KBS is motivated to maximize returns to the investor, to provide above average returns to investors, because the firm then participates in any excess returns. If they do not generate that excess, then KBS just gets a flat fee, but they’re in business for, and are motivated by, the incentive fees.

Challenges Raising Money from The Crowd

One surprise that surfaced that was the first challenge when they sat down in 2016 and decided they were going to do this was cyber security. It was an area that was new to the firm and they consider themselves fortunate to surround themselves with two or three different professionals to help them go through this. If investors are going to be putting their name, address, their Social Security number into the online platform, that needs to be completely secured.

The other thing the KBS team found novel was that in their business they haven't historically done a lot of marketing presentations directly to investors. That's changed with KBSDirect and with related website communications. Being on a website, there is always the flexibility to change the message daily and to clarify terminology if need be. 

That said, it is easy to just assume people may be very familiar with the terminology used. For example, a young lad approached Chuck, who had looked at the website which had stated that KBS is paying five and a half percent dividend, and his question was simply ‘is that good?’ Relative to a bank deposit interest rate, certainly, but how does that compare against other real estate investments? 

A sophisticated real estate professional can be naive in thinking that everybody knows that 5.5 percent is a good solid return on a core asset in today’s market. KBS continually seeks ways to provide data to investors to help them understand how to compare one asset class against another and how prime downtown office building yield’s fit into the continuum.

One alternative, for example, is to invest in a traded REIT which is a very large business type, but their average dividend over the last year [at time of podcast] was somewhere below 4 percent. Now there are benefits because it is a liquid asset. If somebody wants to buy a hundred thousand shares that in six months later they want to liquidate, with a traded REIT they can sell those shares, and while it is possible to sell KBS Direct shares, it is discouraged because they would probably have to be sold at a discount.

Another term that is important to understand and perhaps little known, is the concept of load.  The KBSDirect offering is a no-load product, and the website has been structured so that investors can research what this means without having to search around for explanations elsewhere. The information is right there as well as a team at the KBS offices who, should investors have any questions, are available to provide answers directly, by phone.  This was another area where the KBS stepped up and has built an infrastructure to be sure that they are really crystal clear with their communications.

Leverage

Traditionally KBS has not applied more than 50 percent leverage on assets and at their low end it is around 42 percent.  On occasion, when they buy a building which they believe offers an opportunity to invest additional dollars for capital improvements, sometimes they will do that through debt. So an example might be that if they bought a $50 million dollar building and thought that the building should have, say, $3 million committed to a new lobby and elevators and parking, they might go to a lender and ask for a 50 percent loan to value, which would be $25 million loan, but then might record a loan in the building that's $28 million dollars.  The remaining $3 million could be held in reserve and not funded at the acquisition, but as time goes on those funds could be used to improve the building.  Ultimately this could mean a 56 percent loan to cost, but the objective would be to create value by putting in the extra $3 million, so the loan to value ratio would remain at or below 50 percent.

Flexibility

Having such levels of leverage also provides flexibility in the future should KBS want to go back and modify the loan.  Whether they want to increase the loan amount or extend the term, there is much more flexibility because the lender throughout the entire hold period is an ally and extremely pleased to have the loan on their books.

Crowd Funding

Chuck thinks CFRE offers a wonderful opportunity although he shies away from the term ‘crowd’ funding for their offering as it suggests somebody who's going to invest a thousand dollars. It may be that in time KBS will market to those type of investors, but for now they are marketing exclusively to larger, accredited investors and registered investment advisors.

There are a handful of different organizations who are actively involved in providing opportunities for retail investors to invest in larger deals with smaller amounts of money. The key, Chuck says, is that investors take their time to research the website of the companies they are looking at investing in, to look at the track records and at the fee structures and to really get into the analysis.  Crowd funding is a wonderful opportunity for investors because the alternative is to invest in a fourplex where, if a tenant moves out or two move out, all of a sudden you have 50 percent vacancy. Looking at institutional grade office buildings is just a different type of investment versus ‘retail’ real estate investing. 

At KBS, Chuck notes, they are giving investors an opportunity to invest in properties that are comparable with the kinds of properties that CalPers or CalSTRS or New York Common or the State of Michigan Retirement System invests in; some of the best institutional real estate investors in the world invest in these types of assets. So why can't a $200,000-dollar investor be able to have that same opportunity or even a $10,000 investor. Now they too can do it because they can get the information online, they can get the data, and KBS is making it available.

* Content of this article is taken from a transcript of the podcast conversation with Chuck Schreiber.  No recommendations or advice of any kind is given or implied.  Please refer to the important disclosures and website disclaimer at the bottom of this page.

Greg MacKinnon is director of research at the pension Real Estate Association, PREA.  As the director of research his role is to provide research in white papers, and data and thought leadership to the association’s membership.  Members are primarily institutional investors in commercial real estate, so, despite the name of pension real estate, members include both pension funds, such as the big public pension funds and corporate pension funds, and also include sovereign wealth funds, family offices, insurance companies, endowments, foundations and large institutions that invest in commercial real estate. Membership also includes investment managers who are putting together funds aimed at institutional investors.

See Today's Episode Shownotes Here

What is a REIT

Starting off just with absolute basics a REIT is a Real Estate Investment Trust.  Essentially the idea is if someone's not familiar at all with REITs but they're familiar with say mutual funds equity mutual funds, then it's a similar type of idea.  In an equity mutual fund rather than going out and picking individual stocks and buying those stocks yourself, you hand your money over to the mutual fund manager in a lump sum and then the manager goes out and picks a good portfolio for you. It's an actively managed fund. It's a similar idea with REITs.  Rather than going out and trying to find particular properties to buy, you invest in a REIT and the management team is going to invest in particular properties.

Now what makes REITs different than the mutual fund is that they are publicly traded on a stock exchange.  REITs trade just as any other stock does. If you want to put money into shopping malls, for example, there are a number of REITs that specialize in shopping malls. All you have to do is to go into a brokerage account.  You can do it online or in person, or however you normally do your stock trading.  Buy buying a shopping mall REIT, you have essentially invested in a portfolio of shopping malls.  Similarly there are REITs that specialize in office buildings, in industrial space, in apartment buildings – all kinds of different things.

So really they function like a stock. It's a fairly easy way for someone who is not really well versed in the real estate industry in general to get exposure to real estate. It is no harder and it costs no more in terms of brokerage fees than buying into any other stock.

The Crowd Fund Real Estate Investor

REIT Fees

Fees are going to be going to be variable across different REITs but the easiest way to think about it is because they are traded stocks, first of all, to actually make the investments you have to pay the normal fee you would pay your broker for any other kind of stock investment which, these days, is relatively negligible especially if you are investing a fair amount of money.

If you put your money into a REIT mutual fund, then the mutual fund managers will likely charge you a certain fee to be in the fund. Those are similar to regular equity mutual funds.  For a passive index fund based on the REIT index, it's probably going to run about 10 basis points a year so 0.1%.

The fee structure is similar to investing any other kind of stock. Now, in terms of how the actual REIT itself is getting paid, it's set up like a regular company. It gets paid the same way any other kind of regular company does.  One thing that some investors will do to get an idea of the kind of implicit fees or costs associated to being in a REIT relative to some direct private market investment in real estate, is that every REIT is going to have an entry for general administrative costs on their income statement.   That is the cost of running the organization. All the money they're making from investments in an office buildings or malls or warehouses or whatever, some of that money is going to have to actually go to run the company and that's going to come out in the general administrative cost.

That obviously varies from company to company and REIT to REIT, but across all REITs it runs about 90 basis points a year. Now, that's always going to go up and down over time and like I said it varies across REITs but you're looking at about 90 basis points as the cost of running the company. You throw in, let's say, 10 basis points a year because you're a passive index fund of REITs because you want to be diversified, and then you're up to about 1 percent, essentially, as a total cost – plus any dollar brokerage fees for actually buying the shares if you're buying shares directly.

So, investing in REITs is not necessarily a high cost or a high fee avenue to get at real estate.

Dividends

For a lot of investors one of the things that makes REITs attractive as an equity is the high dividend yields.  One of the benefits of the REIT structure in general is that REITs are not subject to corporate income tax on any money they pay out as dividends. That makes them distinct from a regular company like General Motors or IBM or something like that. As long as they pay the money as dividends to shareholders they're not subject to corporate taxes; they're passing through the profits from the real estate they hold directly to the shareholders.  One of the rules REITs are subject to, however, is that to get that benefit they are required to pay at least 90 percent of their taxable income each year as dividends.  In short, the concept behind them is that they really should be acting kind of as pass through securities.  There are the investors on one side, and there are the actual brick and mortar buildings on the other side and then between them are the REITs running the buildings, collecting the rents, putting in the capex and that sort of thing.

The profits from those buildings are basically flowing through the REIT tax free to the shareholders.  If you compare them to regular equities there is a substantial difference in the dividend yield, which is what makes it attractive to income seeking investors.  [At time of podcast] the NAREIT index, REIT yields were running about 3.8%, and on the S&P 500 it's under % - so not quite double, but substantially higher nevertheless.  

The Real Estate

Typically REITs are investing in quality real estate although most REITs will specialize in one particular type of real estate, for example in shopping malls, or in strip center retail, office buildings, warehouses.  There are a number that specialize in nontraditional types of real estate such as seniors housing, student housing, cell towers, billboards – there’s even one or two that own prisons. There's a lot of non-traditional or alternative property types that are represented in the REIT world so REITs as a whole are a good way to get access, especially for small investors, to a well diversified portfolio of commercial real estate. It's also a good way to get access to some of these types of real estate that no one's going to go out on their own or buy – like a cell tower, for example.  But if you invest in a cell tower REIT, you’ll be investing in hundreds of cell towers across the country so will be well diversified.

The Liquidity Premium

There is a theory that when something's more or less liquid in that you can buy and sell them at a moment's notice there is a premium to the underlying real estate which is obviously much harder to sell on a moment's notice. So REITs are more liquid than the underlying real estate. The theory says that because more liquidity is an advantage, you should get a higher return where there is less liquidity where you don't have that advantage.

There's all kinds of academics have been trying to find that liquidity premium for years. No one's actually been able to tell if it actually exists or not.  Certainly, liquidity is an advantage, but if you don't mind locking up your money for a longer period of time, you may want to look at directly investing in real estate. A lot of people see REITs relative to direct investing in private market real estate, but because REITs trade on the stock market they are more liquid and they're also more volatile.

So, as with any stock, the price is going to go up and down each day, each minute, month after month, with the animal spirits of the market. So maybe REIT prices goes up more they really should. Maybe they go down more than they really should. You do have a lot more volatility in REIT prices than you see in the values of the actual properties that they hold.  That's the downside of the liquidity argument because they're in a more liquid market.  

One disadvantage of REITs is that when there's a broad market correction in the equity market when the underlying real estate market turns down as well, you can get a big effect on REITs.  That came out in a big way in that financial crisis back in 2009.  The REIT index was down well over 80 percent at one point.  But a lot of that it turned out was overblown. You did you did see a drop in underlying values of actual properties but not nearly to that extent. So a lot of that 80% drop was just people getting carried away in the equity market and selling too fast because they were able to sell too fast.

The underlying direct private market real estate markets a lot more so slow moving and doesn't react all that much to news on a day to day basis. The slower moving aspect is bad in the sense that you have less liquidity but it's good in the sense that you don't have these giant panics that happen one day and then get reversed the next day like you might have in the REIT market.

 Long Term Perspective

A lot of institutional investors place their allocation to real estate as well as to other private market types of assets based on this idea that they are able to be very patient capital and can afford to wait years. They can wait out any downturn in the market and therefore they prefer to go to the private markets because they expect to get a bit higher return.

That said, REITs over the long term have a somewhat higher return than the corresponding sort of direct market underlying real estate. The downside is they had somewhat higher returns but also with much more volatility over time so there is more risk in that regard.  Over the long run there's a very high correlation between REITs and the underlying real estate because, as you would expect, if REITs are being affected on a daily basis by the animal spirits of the market, those things will tend to cancel out over time.

At the end of the day, investing directly in real estate is one avenue to access that kind of investment, and investing in REITs is another avenue to access that kind of investment. And they have somewhat different characteristics and one may be more advantageous for some investors and the other may be more advantages for other investors. But they're both alternative ways to get into real estate so that they both have advantages and disadvantages.

Sara Hanks is, was, a corporate and securities lawyer of thirty plus years before the financial crisis of 2008+ happened.  She was recruited by Senator Elizabeth Warren, who at the time was Chair of the Congressional Oversight Panel for the Troubled Asset Relief Program (TARP), a program set in place to put a floor under potential collapse of the financial system.  Sara started the week that the Dow Jones hit bottom although they did not know that until later.  After working on oversight issues on Capitol Hill, Sara became aware of all of the various pieces of legislation that eventually became the JOBS Act, and, while finding it of great interest, was also around folk at the American Bar Association who said things like, ‘oh my goodness, they're going to defraud my grandmother!’

SEE THE SHOWNOTES FOR THIS EPISODE

Wanting to provide a solution to the defrauded grandmother problem, Sara started talking to a couple of friends she had come to know through the Congressional Oversight Panel and, together with them, set up a company to provide reassurance to people in crowdfunding that the companies were legitimate.

From that point the company expanded and now does all aspects of compliance for online capital raising. Whether it is under Regulations CF, Regulation D 506 (C) or regulation A. and although they did not initially found CrowdCheck as a law firm, because they were securities lawyers by background, people kept asking them securities law questions and they eventually started thinking that they could provide counsel on these matters also. They set up an in-house law firm and provide a complete legal disclosure compliance package for all aspects of JOBS Act type fundraising.

Attraction of the JOBS Act

It was the ability to democratize the capital raising process to permit everyday people to take control of their own financial lives that attracted Sara to the Act.  For early stage companies or projects, real estate included, sponsors could now not just go to people who they always go to for capital but could reach out using the Internet to a broader source of capital, giving people more investment opportunities. Its seemed like a good thing on both sides both for the company or project and for the investors providing it was done in a compliant way and providing that everybody knew what the risks involved were which is where Sara saw CrowdCheck coming in.

The Regs

The easiest of the JOBS Act regulations to comply with is probably Reg D because there is really nothing there.  A sponsor is going out to accredited investors only under 506 (c) where, really, the only rules are do not lie and do not make misleading or fraudulent statements.  A sponsor still has information is presented in a way that new investors understand. Just because somebody is accredited does not mean that they necessarily understand what all the risks are and, from SEC studies, we know that there are some 12 million accredited households in the US, but that only half a million or so regularly invest as accredited investors. There is a big disconnect. There are some accredited folks who should not be investing in anything, and there is a whole new investor class out there who could but maybe do not understand what they are getting into when looking at a Regulation D offering. And the next level of complexity from a compliance and education perspective, is, of course Reg A where both accredited and non-accredited investors can invest alongside each other.

The Sophisticated Investor

When the concept of crowd funding was introduced, the idea of an accredited investor was supposed to be a proxy for someone who either had experience or could buy experience. They were rich enough to be able to hand this over to a financial adviser and say ‘tell me, financial adviser, is this a good thing for me or not?’  It was always an incredibly blunt tool.  The SEC has recognized that for quite some time viz. that the mere owning of various sums of money or earning various sums of money does not necessarily mean that you are automatically able to make investment decisions. On the flip side some folk can be incredibly sophisticated people and yet not accredited, including many SEC staffers among them who are not accredited yet but could make just as good decisions. This could change as leadership at the SEC changes and it is possible that the definition of the accredited investor will probably be expanded at some point in the near future, and these changes could include, for example, adding a level of sophistication by reason of examination.  This could capture people who hold FINRA examinations, for example, or who have business experience as another possibility, irrespective of income or net worth.

Potential Changes to the Act

There is unlikely to be any major change to the JOBS Act, perhaps some minor chipping around the edges but to the extent anything goes really wrong then there could be some pulling back, but even that would take some time. First there would have to be the scandal, everybody would need to know about the scandal, and then there would have to be regulations passed to address them. For the foreseeable future, therefore, at most there will be minor fiddling with the edges of the various provisions of the JOBS Act.

Real Estate Compliance

What CrowdCheck does in the real estate space is really boring (!)  They do the corporate diligence to make sure that the entity that owns the property was properly organized and then the entity that is doing that is issuing the securities was properly organized and that the two of them have a relationship. The standard structure that seen in real estate is property-owning-company, which may be an LP Limited Partnership or it may be an LLC, and then the issuer which is issuing to the crowd, holds interest in the LP or else LLC holds the property.  CrowdCheck verifies that all of those are properly incorporated or organized and that they have authorized the issuance of the securities at both levels and what they very frequently find is that the paperwork around the property owning entity especially can be very sloppy.

For example limited partnership Number Four owns property Number Three, and the issuer saying they are selling interests in property Number Two. There is a tendency sometimes in real estate for successful sponsors to just pull out the last set of documents and mark them up.  Another area that they see is the use of cascading pyramids of limited liability companies all the way up because, of course, one of the things that they have to do is check that nobody who is a ‘bad actor’ is involved in the sponsor.

Sometimes they will see several different layers of LLCs which may have been used in order to disguise the fact that there is a bad actor involved who did not want to be disclosed. CrowdCheck’s rules are that they have to go all the way until they hit a human being or an incorporated company. Anyone who comes to us with a pyramid of LLCs will find that they just go through all of the these.

Platform Stability

As important a protection as they are for investors, compliance services are not mandated and a lot of the platforms have very limited resources and they are not making a huge amount of money.  Compliance services are, therefore for many, a kind of a luxury to a certain extent although one could make the case that not being sued for sloppy paperwork is not a luxury.  Indeed, soon after the JOBS Act was enacted, CrowdCheck probably was working with maybe 12 to 15 real estate platforms – but of those platforms only one or two of them still exist.  The biggest issue that the failed sites faced was one of deal flow; a lot of them had problems getting enough projects. If a site only got one or two sad looking condo complexes their platform, people are going to come along and see that they are the same deals that were there 12 months ago.

Lemon Squeezer

There were three companies involved in a series of discussions with the SEC. Two of them were real estate companies. Sara wrote an article, ‘the lemon squeezer’ article, which came out as a result of a fuller understanding of just how far the SEC would let people go when it came to high pressure, very flashy ads on TV or radio. The issue is that in Regulation A prior to qualification by the SEC – which is the point at which the SEC says no more comments you can go off and sell your securities now – until then an issuer is just trying to solicit interest. During the period up to qualification the issuer can advertise on TV and on the radio. You have to give a disclaimer which you can verbally say telling when the filing has been made with the SEC where that the offering document can be obtained. But until then, an issuer can do these very flashy ads that are almost startling to people with traditional securities backgrounds.

In short, prior to qualification once an issuer is qualified and allowed to take money, the rules change and the SEC says at that point you can only use methods of communication that include the delivery of the offering document which of course you can do if you if you are online – but that cannot do on the TV or radio. So you cannot use TV and radio under present interpretations by the SEC to advertise your company or your real estate project.

Future Changes

During the next downturn, as Warren Buffett says, when the tide goes out you find out who has been swimming without their shorts on, and that is when we will see things start getting dodgy. That is when you start seeing who has not done the paperwork. The tragic thing there is that so many of these platforms are so thinly capitalized that when something goes wrong, just one or two deals go completely wrong, people will start to lose faith.  There will not be anything left for anybody to sue, either on the project or for the investors in the platforms themselves.

The next downturn you will see evidence of some sloppiness and that will lead to probably further extinction event of platforms. It is likely that there will also be some consolidation of the various platforms. Many of them are just too small and they are complete niche players, and somebody might scoop in there and roll several of them up.

With respect to downturns leading to changes in the JOBS Act, this is possible if people actually blame the JOBS Act for things going wrong – there are a lot of people who are very cynical about the JOBS Act, concerned about defrauding grandmother.  However, any future changes are probably going to come from people suing which tends to happen a lot faster than regulatory change.

Introducing Max

Max Sharkansky’s firm, Trion Partners, is in the business of value item multifamily residential real estate. They started out around 2005/2006, right before the recession.  Prior to that Max was a broker at Marcus and Millichap and his partner, Mitch Paskover, was working on the debt side at HFF in mortgage banking. They started buying deals towards the end of 2005 and as Max had been brokering multi-family deals in the San Fernando Valley at the time, they naturally started buying multi-family in the San Fernando Valley. That is where they had access to off market deals and market knowledge, and then from there it just snowballed.

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They bought two deals in 2005, a few more in 2006, and then at the end of 2006 the partners formed Trion.  They continued to buy through the last cycle in 05, 06, 07 and sold most of their portfolio in 2008 prior to the crash.  They saw what was happening with Mitch being in the capital markets and Max being in the transactional markets. Their properties when they saw vacancies starting to  tick up, and rents starting to tick down. They saw what was happening to the market and so they sold out in 2008. As they were selling in 2008 they changed their acquisition strategy from a value add multifamily.  The old model no longer worked so they started targeting non-performing debt secured by multifamily, even though at that time in 2008 there was a logjam in the market and nothing seemed to work. Lenders wanted to sell non-performing debt at 90 cents on the dollar irrespective of the value of the underlying real estate, and Max was looking at deals based on the value of the underlying real estate.

As the market slowly changed, they were able to buy from one local banks and from there they ended up doing about 20 deals during the downturn in 09, 10, 11, 12.  About 15 of these were note acquisitions and deals and five were REOs.  By that time they had a fully built out their management infrastructure and while their competitors were straight buy the note/foreclose/sell because Trion were operators they were buy the note/foreclose/renovate/lease up and then sell. And it was in having this infrastructure that allowed them to buy the REO products as well.  Coming out of the downturn in 2012 they just went back to the value add business and [as of date of podcast call] had approximately 17 properties in their portfolio with an 18th in escrow. Their aggregate portfolio value is around $240 million and they have a gross track record of over $300 million on over 40 deals.

Financing

It was a wild, wild west especially during the downturn. Trion grew very organically during that time. They bought their first few properties with their own capital. Both Max and his partner had been pretty strong producers at their respective firms so they had some dry powder and bought their first few properties using that. Then they started to syndicate out to friends and family and colleagues. Mitch reached out to some of his HFF folks to some of Max’s Marcus folks invested and it grew very organically.

During the downturn it became extraordinarily difficult to raise money so they bought a lot of stuff with high octane debt and their own capital. As they got a little further along and developed a track record and more of infrastructure it became a little bit easier to raise money.  At the time it was still all friends and family and introductions through referral. They had met some family offices who were able to write larger checks and they were using a lot of expensive debt. Indeed, they were buying notes with other debt, putting debt on debt which was very helpful in allowing them to close.

Two Models of CFRE

Max heard about CFRE through the news when the JOBS Act passed.  They started calling around. They did some deals with a RealCrowd, RealtyMogul, RealtyShares and have found them all to have been great to work with.  The whole process has been very successful and it has been a large boon to their business. It has provided access to capital that they would not otherwise have had access to, and it has allowed them to supplement equity capitalizations when they very much needed the capital.

Max has found that there are two basic models by which the CFRE websites operate. There is the LLC model which would be like RealtyMogul and RealtyShares where you interface with the platform directly.  This model is more like dealing with an opportunity fund, where the sponsor interfaces with one originator, call it, or a deal guy. With that person, the sponsor does a walk through, the deal guy does their own underwriting, there is a lot of Q&A back and forth and the process is not dissimilar from an opportunity fund.  In this model, there is no interface with their investors as that all happens behind the platform’s own curtains. Sponsor does not know who the investors are, they do not interface with them before the acquisition, and neither do they interface with them after the acquisition as they are operating:  All communication is with and through the platform. 

The other model is more of the technological platform model, which is like RealCrowd and CrowdStreet. In that model the sponsor is effectively paying the platform to post their deal on the site.  They still vet the sponsor who still goes through a process of sorts, and when a deal is posted on the site there is a flat fee paid to the platform, not a percentage of how much they raise.  In this model, the sponsor interfaces directly with investors.  Investors, in this scenario, will contact the sponsor based on the posting and with questions about the DD materials. Max has had a lot of dialogue, and Q&A with investors this way, and has even met people on site at properties. Their first property raise through RealCrowd was in 2013and they have investors who have been with them since then doing multiple deals. Even though the process is different, either model works very well.

CFRE Site Input to Operating Agreements

There can be input to operating agreements from the platforms but it generally depends on what portion of equity they are taking. If the deal requires a check of $10 million plus and the platform/investor is taking $1.5 million, they are really not going to have much input into the operating agreement.  On the other hand, if they are raising $4 million and the investor is taking $2.1 million then they are absolutely going to have some input on the operating agreement. This is not dissimilar to an opportunity fund or any JV type partner that would go in and mark up the operating agreement and go back and forth before coming to a final contract.

There is a time and place for both models and Trion has used both very successfully. With regard to other sponsors, it really depends on their business as a sponsor and how they want to grow and what they want at a particular time on a specific deal. If they have a deal and do not want the brain damage of talking to a lot of people just do not have the time, then going with the LLC model might make more sense. Here the sponsor will only interface with one person in the raise and the platform gets paid when the money is raised.  If the sponsor has a business where they are trying to grow out their Rolodex of high net worth investors and have come to the conclusion that this is the way they want to grow their business for years to come then perhaps the marketplace model is better suited.

Marketing

In both models, the platforms do the bulk of the marketing. The sponsor does very little.  The sponsor might participate in webinars that would be a form of marketing, but these are coordinated and produced by the platforms.  In these, the sponsor will discuss the investment and give investors an opportunity to dial in and listen to the dialogue and the Q and A about the investment and then they can submit their questions at the end of the webinar.  Beyond that, though, sponsors typically are doing much of the marketing.

Terms

Platforms did not start out guaranteeing to sponsors that their raise would be successful, but it seems that the industry is moving in that direction.  Fundrise is active in the preferred equity, mezz space and they do guarantee a certain amount but that is a little bit of a different business than the raises that Trion has done.

Transparency

Max thinks that the opportunity to invest equity in deals through crowd funding is a great improvement for investors over the way it used to be.  There is a lot more transparency so some of the more egregious terms that you would see in the old days are not really there as much anymore.  For example, back in the olden days you would see much lower preferred returns and much higher promotes.  Back when Max started in the old cycle it would not be uncommon to see 50:50 after a 6% pref. and today that is a thing of the past. It is a relic because people have transparency and they have a window into what other sponsors are charging and what is market. 

Trion has adopted a cookie cutter approach on preferred returns and promote. For the most part they take a 70:30 split after an 8 pref. and that has worked for them – although some sponsors charge a little bit more.  Typically Trion does not do waterfalls but other sponsors will.  Other sponsors do but Max and his partner prefer to keep it simple. They do not charge an asset management fee because they self-manage.  Some sponsors will outsource their management so they do take an asset management fee. It really depends. It's all case to case, and there is not necessarily a right or a wrong way. There is a very broad spectrum of how to operate.

Platforms do not generally have input into the operating agreements, or attempt to leverage controls that a sponsor has over their deals primarily because, for a sponsor doing a syndication, they need to have controls.  In this regard it is very different from the private equity model where the PE firm will have input into key decisions in the deal, and Max has seen some control layers with some of the crowdfunding groups in the LLC model if they have a substantial portion of the equity, say 60 or 70 percent or more of a deal because they own so much of the asset. 

The Fremont Deal

Trion purchased a deal that they fully financed and then backfilled using RealtyMogul.  It is an 88 unit in Fremont California which is in the East Bay and the Bay Area. Many people have heard of Fremont because it is the home of Tesla auto manufacturing. Tesla is one of the hottest cars out there and it is a rapidly growing car company and because of that there has been an extraordinary amount of growth in Fremont not just because Tesla but also because of AMD some of the other local employers. If you look at it on a map, the town is very strategically located as the gateway to Silicon Valley.  The town has an awful lot of overflow from Silicon Valley and the peninsula and Trion loves the market and we love everything about the real estate with regards to the asset itself.

The deal presented an incredible value add opportunity and is very typical of what Trion buys.  They bought the asset from the family that bought it from your original developer in 1966. Their basis was nothing; the debt was nothing, and they had been operating the building for occupancy for decades, with little capital put back in.  Trion will spend twenty $25,000 per unit on interiors, fully upgrading the interiors.  They will tear everything out, and will put in brand new kitchen cabinetry, high gloss very European looking, quartz countertops, stainless steel appliances, full wood vinyl plank flooring, washer dryer in every unit – which is a huge selling point for renters.  There will be all new fixtures, all new finishes in the bathrooms, tubs, vanities… basically the units will be like brand new units and they can deliver the finished units to the market place 25% below what a renter would be paying for a brand-new class A property.

The project thesis is to stabilize the building at a low 6 percent cap rate on cost and exit five years from inception at a high four cap which is where properties were trading at time of purchase. The company will grow the rents organically once stabilized at around 2.5% to 3% per year.  The project was underwritten to a five-year hold, with a deal level 19% IRR and an investor level IRR around 17%.

Trion paid it $26.5 million for the 88 unit asset, which works out at about $300,000 per unit and $300 a foot because the average unit sizes are right around 1,000 square feet.  At time of purchase, the price per pound was one of the lowest that had traded in that market in the prior couple of years.

With regards to the structure with their investors, the deal is a standard Trion formula of 70:30 after an 8% pref. They do not take an asset management fee as they self manage for which they take a property management fee.  They have their own crew so they also take a construction management fee.

The minimum investment when they were going directly to their own investors was $50,000 but on the CFRE websites typically that is lower.  The Fremont deal was a very large raise for Trion at a total equity of $10.5 million, and they started syndicating the equity with $50,000 to $200,000 investors. They also had a few larger investors who took up some allocation but they were not able to fully fund by closing so the partners put in the shortfall and then went to CFRE to backfill.

It took Trion about 45 days to finance the deal, which included 20-25 investors, and then another few weeks to conclude the CFRE tranche – which, typically in using the marketplace crowdfunding platforms, Trion expects to gets 7-10 investors for a given deal.  Max will usually meet the new investors, the CFRE investors, before the close. It can be something as simple as a few e-mails or sometimes he has had them come to his office. There have been times where he has met them on site at the property if it is in L.A. or if the property is in the Bay Area and they happen to live in the Bay Area he might meet them there.

Mitigating Downturn Impact Risk

One of the things that Trion does that really helps them hedge risk is low debt.  They do not put an extraordinary amount of debt on their properties. Fremont as an example is levered to about 68/69% percent of cost. Once they refi out of it they will be right around the same leverage at 65/70 percent of the new value based on the increase in NOI.

Real estate doesn’t kill people; debt kills people.

Recommending CFRE

Max is a strong advocate of CFRE.  He thinks sponsors would be crazy not to do it. Whether they are a young sponsor or an old sponsor, a groups that has been around for a few years doing it, or a group that has been around 25 plus years doing it. It is a phenomenal supplement to a sponsor’s investor base and anyone would be crazy not to do it. It is a win, win, win, for all involved.  Max has not personally invested in other sponsor’s deals in CFRE because he needs to use all the capital that he has for co-invest and in keeping their own deals but otherwise would certainly consider such investing.

Easy for Some

Max’s Trion is a very niche investor. They are not jack of all trades and masters of none. They do not buy five different asset classes all over the country, but rather focus on buying value add multifamily 60s and 80s vintage in four markets; San Diego, L.A., Bay Area, and Portland.  Their business model is simple and Max finds that he does not have to explain real estate concepts to investors because it is a fairly straightforward business. It is the business of apartments; they are taking an older apartment, fixing it up, and making it like a new apartment.  They explain the details to investors and they try to keep it as layman as possible.  It is not, as Max says, rocket science.

Looking to the Future

Having been founded only in 2013, CrowdStreet’s growth trajectory has been very rapid reaching the $200 million milestone of equity placed just four years later in 2017 and exceeding 70,000 investors in the same year.  The company focuses on bringing institutional quality deals with a diversity of both asset types as well as risk profile so that investors can create a truly diversified portfolio of commercial real estate.  The platform plans to incorporate easy to use tools to compare and contrast the offerings in a transparent for way for member investors who have multiple investments on the marketplace to be able to view their portfolio in a very constructive manner.

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Though impossible to predict, the company attempts to remain cognizant of the inevitability of a real estate market recession and how to address investor anxiety understanding that no-one wants to be the last one in on a deal, so to speak.  Being conscious of leverage rates that developers are using and where are soft places in certain markets, CrowdStreet tries to give a little bit more clarity of what the outlook looks like at any point in time, from an overall economic as well as from a real estate perspective.

Tores’s background is squarely in the Internet and software space for the last 20 years of his career and in bringing technology into industries that have not adopted the Internet and software for the betterment of their customers as well as the operating efficiencies.  He also has a background in financial services, though he does not like to confess to this, and early in his career started in banking. This gave him a good appreciation for lending and for the financial institutions and the financial services and consumers.  It served him well when he met Darren Powderly his co-founder at CrowdStreet some years later.  Darren comes out of the commercial real estate space and was a partner at a well-known firm in the Pacific Northwest.  He was looking for a co-founder who had built Internet and software based businesses before in order to facilitate his vision for a marriage between technology and an industry that traditionally has not adopted technology to really transform real estate investing.

The partners met in the summer of 2013 and Darren had already come up with the concept of CrowdStreet and the idea of democratizing access to commercial real estate investing.  The whole idea of CrowdStreet emerged out of the Great Recession of 2008 and the idea that that too much capital is sitting in too few hands could have some negative implications.  This tallied with the passing in 2012 of the JOBS Act which was created by Congress and the President at the time, to further decentralize finance by updating regulations that had been around for over 80 – the securities laws.  Subsequent rulings, Title 2 of the JOBS Act and Titles 3 and 4 further helped to solidify what was going to happen.  By the time Tore met Darren in 2013 those other things had yet to come out, but Tore felt that Darren had a great vision about how to reform finance and as their skillsets were complementary, they teamed up and launched CrowdStreet in April of 2014.

One of the largest challenges they faced early on, and it is not uncommon when trying to transform and disrupt and industry, was that there is a lot of education needed initially. The legislation and the securities laws had been changed but there were still a lot of questions and ambiguity about it. In the early days of the company, they had to do a lot of evangelizing and a lot of educating of commercial real estate developers, operators, and investment firms who were intrigued by the idea but really had more questions than they had answers.  Tore found CrowdStreet was to be part of a subset of a subset people out there sharing knowledge and information, and many times connecting them to other experts whether it was attorneys who worked on the SEC in legislation to enable this to happen, or whether it was some of those early adopters who had taken the plunge and were the innovators.  So that was really one of the biggest hurdles which was really getting the industry to understand that this new opportunity was possible; that it was legal and that it would actually benefit their business as well as benefit many consumer investors across the country.

The way of traditionally doing business for sponsors, the commercial real estate developer who is going out and acquiring either an existing asset, it could be a senior housing facility and office multifamily complex storage facility or whatever their specific asset type and geographic focus was, was very different from what had become possible.  For decades the way they have traditionally done it was they would put together a private placement, they would do a Reg D 506 (B) offering with a traditional form B filing, and they would go out to those individuals who they knew and had a substantive relationship with to raise their capital.  Usually that equity amount that they were looking for was anywhere between $3 million and $8 million because their project value was in that midmarket $20 to $40 million range.  So these guys were flying underneath the radar of getting a big institutional check of $10 or $20 million, but they had definitely built up a network of high net worth investors that they cultivated and built a relationship with for years.  So they had a great way of going out and probably financing between five and ten acquisitions each year, sometimes doing ground-up but a lot of times it would be value add to an existing asset.

What CrowdStreet has to share with these developers was that Title 2 of the JOBS Act, which was passed in September of 2013, had created what's called the Reg D 506 (C).  This said that you can do that private offering but now you can make it public and so you can actually generally advertise. Developers, for the first time since 1933, could solicit investors from the general public and therefore could use the Internet to promote their offerings – in  way, to securitize offerings with the caveat that all those investors have to be verified as being accredited investors. There can be an unlimited number of those investors however, with the extra step of needing to have a verification process.  The CrowdStreet marketplace was set up as a medium to go and advertise and they have now attracted thousands of accredited investors to register on the platform because they are looking for access to great sponsors with great deals.

Key Benefits

One of the key benefits for sponsors and is the ability to reach investors outside of their immediate geographic location. Sponsors have traditionally built up relationships in the off-line world with investors and many times the way gain new investors with their deals through referrals and word of mouth, but it only goes so far and is usually confined to a geographic region. So first and foremost, what sponsors really like is the fact that by putting their offering on the marketplace like CrowdStreet, they are making their deals available to a wider population of investors who could be in Seattle, Washington, or in New York City or in San Diego, or Los Angeles, Florida; all over the country looking at their offering at 10:00 at night. sitting on the couch sipping a nice glass of wine with their spouse and looking at their offering and deciding whether they want to invest.  Many times in the off-line world sponsors have one on one meetings with investors that are very time consuming, so the efficiency of online is really important to them. The second key aspect that's tied to that, is not only the acquisition of new investors and the efficiency by which they can do that, but by facilitating the mechanics of investment itself. By automating and streamlining the fundraising process from review of the information entirely at the fingertips of the investor, through the actual investment itself, deciding how much an investor wants to put in, to signing documents and then funding their investment and then post fund raising.  Everything is automated on the CrowdStreet platform.  In addition to this, another thing that sponsors like is that the ongoing communication with investors is done through an online channel which brings with it many more efficiencies and the capability that now that they have maybe up to 50 more investors that they are working with, they can actually do it in a very efficient manner.

One way that this online communication is facilities is, for example, how they distribute K1's. Most deals are set up as an LLC, which is a traditional format and the format is no different when they are putting their offering online.  As they bring investors in they distribute capital to them on a monthly or quarterly basis based on the cash flow. At the end of the year, because it is an LLC structure they have to distribute K1's. In the traditional way, they either have to mail those out or if they get electronic consent they can e-mail it out with a password protection. But e-mail channel is always not always the most secure and so one of the ways that CrowdStreet not only makes it more secure but also more efficient is by having what they call an investor room when they log into CrowdStreet.  When log into their investor room investors can see the performance of their investment they can see all of their executed documents and then when the sponsor comes to that wonderful tax season where they are trying to distribute hundreds if not thousands of K1's they can simply drag and drop and the K1's which get uploaded automatically into each individual's investor room. The individual investor will get an email communication, not with an attachment because of security concerns, that if they log into their secure investor room, they have access to a secure K1 document.   This minimizes security concerns caused by sending a PDF document over an unsecure channel, and improves communication by sending documents to many with literally one click of a button instead of having to do individual one to one communications.

Alleviating Concerns

Many times when sponsors were raising capital the ‘traditional’ way, they were faced with a lot of email exchanges and a lot of phone calls so they come from a world where investor relationship management could be pretty cumbersome because it was usually a manual process.  One concern sponsors have is that when they bring their offering online that now they will be fielding calls by vastly more investors and going to have to answer a lot more e-mails.  Tore understands this concern from his perspective of having brought industries online to seeing what can happen in those circumstances.  The consumer that comes to a site and gets exposed to a brand and a company through an online channel, does not generally want to take that relationship offline. Consumers do not go to Amazon.com to buy a product because they want to call the company and learn more about the product; they want to go review and see everything and read about everything about that product online and be able to make a best educated decision without dealing directly with the company.

Part of CrowdStreet's responsibility is to make sure that when they take all of a sponsor’s offering materials, they digitize them and put them into a Web environment that is really easy for an investor to access whether it is the sources and uses information, or the table of the deal economics or other due diligence materials.  Many times before questions even start coming in via email, the CrowdStreet investment team helps to coach sponsors to think of all the Q and A things that are going to happen and prepare ahead of time to put the answers at fingertips of the investor from the outset. Of course, this does not guarantee that investors will not pose questions, but what CrowdStreet does is to run webinars so that for every offering, investors get invited and can register to join a one hour webinar with the sponsors talking about their deal.  During this time the sponsor fields questions and when you have 100 or 200 investors participating, part of that community aspect is that an investor can pose a question during that time and the other investors have the benefit of listening to the response.  This, Tore sees, as being an enhancement compares to the off-line world where usually that would have to be done many times in a one on one relationship that investors used to have with the sponsor.  Not only is communicating with so many investors simultaneously beneficial to sponsor, but it benefits the investor also.  Here you have created a community where other investors can get better educated and they can learn by hearing from other investors. So, there are lots of benefits; sponsors can minimize the noise factor by spending an hour talking about a deal that is recorded for other investors to listen to later; and investors learn from the crowd of other investor questions. 

Confidentiality and Privacy

Sometimes sponsors express concerns about confidentiality of information and there is a fine balance between how much a sponsor wants to publish and how much is behind a firewall.  CrowdStreet implements a confidentiality agreement that investors have to agree to click through which adds that extra degree of security and comfort about what a sponsor might want to expose.

Direct Contact

One of the criteria CrowdStreet looks at when determining if a sponsor is proper for the marketplace is have they worked with investors in the past. How have they done from a performance perspective for those investors from the perspective of demonstrating experience in fielding questions.  That said, the CrowdStreet investor relations team functions like a concierge service where if they can play air traffic control and if a question comes in that they know is contained in a particular document, they can point that out to the investor so that it does not even have to go across to the sponsor. But obviously there are questions that they are not in a position nor legally can they field about the deal.  If it is not a factual document piece, they will escalate to the sponsor only those questions that are required. CrowdStreet also allows investors the ability, through the online channel if they have feedback or key questions, to submit that question directly online. Then the sponsor can choose at their leisure when they have time available to respond to it or ask CrowdStreet to send them a document or other information. 

Crowd Sourced Questions

Sharing these questions and answers in an open forum is something CrowdStreet has looked at: How to further expose these community aspects for the betterment of the investor community but also for the sponsor. There is a little bit of concern for all of this to be open in a complete forum environment. Today the questions that get posed by the investors are going directly through the channel directly to either CrowdStreet’s Investor Relations team or the sponsor's Investor relations team and there are some privacy concerns with making all questions fully open. One has to be very cautious about for both the investor as well as for the sponsor, but if CrowdStreet gets consent on both sides perhaps full exposure is possible and the platform is looking at how can they provide a more forum environment that both sides feel comfort in and that they can gain more benefit by exposing more.   It is a is a sensitive matter. People are investing and it is not as easy as looking at a review on Amazon about a product, for example. You are talking about people spending thousands of dollars investing into deals. It's a whole different level.

Deal Structure

Since the advent of crowd funding real estate, from a deal structure perspective on the distribution of capital on a current basis, CrowdStreet has not seen sponsors change the structure of their deal to align with online investor requirements for having cash flow. Most sponsors have already come up with their waterfall structure before them come to the platform. They have come up with what their anticipated current yield is on a particular investment and that has not changed much. Maybe sponsors have become more conscientious about the fact that that the online investor with whom they have yet to build a relationship does like a current yield, but investors do understand that certain deals will not have a current cash flow to it –  whether it is a ground up development or whether it is a redevelopment.  Sponsors are very clear from the onset that it could be maybe an 18 month timeframe or 12 month timeframe until there is any current cash flow from a project. Investors know that maybe on that redevelopment there is no current cash but that there is a higher IRR potential that is maybe over two years instead of over seven years. What CrowdStreet has seen is that investors like to create a diversified real estate portfolio where they can pick and choose from projects that are cash flowing currently versus those that might be more realized on the back end.

One of the structural changes that is very significant and could not have happened if we had not moved to the online world is the ability for sponsors to take a lot lower investment size because again this goes back to the education when CrowdStreet was first working with the sponsors in 2013 and 2014. Typically, sponsors were taking $100,000 or $250,000 checks from their high network investor network in the off line world.  When Tore talks to sponsors about bringing their project online, he requests that their minimum investment size be $25,000 which is, well, a 10x difference in many cases to what a sponsors usual minimum investment might be.  You can imagine, again going back to that conversation about the customer experience and how much contact would a sponsor have with investors, because now they are looking for $25,000, sponsors are concerned that they cannot be on calls all day with these investors. So, it took a little bit of time for sponsors to understand that this does not happen.  Indeed, at a CrowdStreet sponsor conference, someone talked about how he had 30 new investors come in through the CrowdStreet marketplace, and there was a little gasp at the implied additional work this amount of new investors might burden a sponsor with.  But their concerns were ameliorated with the sponsor told them that he had conversations directly with only two or three new investors and these were putting in a lot higher than the minimum amount. This sponsor’s personal experience was that he did not have to have one on one conversation with many investors and so adjusting their perception of the impact on their time of crowd funding that sponsors have to get used to. Once they try to fund this way once or twice they realize the huge advantage of growing their investor base, this way, beyond their local markets.

Aspects of Education

Another aspect in the education process is to really let investors and consumers across the country understand, number one, why this way of investing was suddenly available for an industry that for decades they could not get access to. Before, investors had to get a personal invitation to meet the sponsor from somebody who had invested with that sponsor, possibly many times.  And then, even if they got invited, they didn't want to put in $250,000 dollars, perhaps having $25,000 or $50000 to put to work or wanting to spread it around to many deals.  The second big question from investors is often how do sponsors get on the CrowdStreet platform.  So Tore and his team are very up front with their investor community about the vetting process that their investments team employs.  They have a team of eight people who come out of the private equity real estate space for a real reason; because they are used to screening sponsors and they are used to screening the deals themselves.  CrowdStreet does not underwrite the deal, but they do have a detailed process around the vetting so that investors know more about the sponsors.  To be clear, CrowdStreet is not doing due diligence per se in the traditional sense but they are very clear about the vetting and the background checks that go on behind the scenes on the sponsors before they actually show up and they have found that investors appreciate that.

What Tore is seeing is that once someone has invested in one of the projects and they have become accustomed to the process, over 60 percent of investors become repeat investors on the CrowdStreet marketplace.  Of that repeat investor base the majority of those have three or more projects in which they have invested.  They are starting to realize that they can now create a diversified commercial real estate portfolio through the online channel. Traditionally the only way they could get diversification was either investing locally with a developer they knew or they could go through a REIT get that diversification.

CrowdStreet primarily has single assets in their marketplace but also have funds, special focused funds, that can be in a specific asset type, as well as having full blown REITs that are listed.  CrowdStreet likes to offer investors that type of choice because they might want to put some capital into a REIT where they can automatically get diversification even if it is focused on a particular asset class like senior housing or multifamily or office; they are getting some diversification across the assets in that fund. However, sometimes because of the fund structure there might be a higher fees structure and consequently also lower potential returns, but the portfolio is de-risking some of that by buying diversification and that is the tradeoff.  With the single asset investment the investor has more exposure to maybe a specific geographic region or specific asset type as well as obviously the specific sponsor who is managing the deal.

Challenges

For Tore, coming from a tech background and migrating into the real estate world also had its own learning curve. Having worked in many different industries and coming at it from a technology perspective, whether it was health care education publishing world he had worked with many different verticals and industries. Figuring out where their biggest frustrations are and what are the biggest obstacles that industry participants are facing was the first step because it is always unique across the industries.  Dealing with investor and sponsor adoption of and trepidation with leveraging the Internet there was this early concern that the offline consumer is not going to take online. Initially, Tore took things for granted and had to back up a little bit and understand better about the world that sponsors come from, learning about their pain points on investor relationship management and in the fund raising processes.   He also spent time with Darren and with customers understanding more about their world and how CrowdStreet could solve problems for them because at the end of the day the ultimate objective is to help both the investors as well as the sponsors and to do better for both of them.

Employee Investments

The policy at CrowdStreet is that anybody who is qualified can invest in any of the projects on the marketplace. There is no special treatment given because it is the open internet out there, and people can register so the company does not want to say no to an employee – but there is no special treatment given and they make sure that there is nothing extra that they get.

Prefunding Deals

To date, most of the sponsors have not asked CrowdStreet to prefund a deal. The company took a different approach from other platforms some who did go that Special Purpose Vehicle model where investors are pooled into an SPV, usually an LLC., and take balance sheet capital to supplement that fund raising. CrowdStreet took a very much a road less traveled approach.  It is also a road that takes longer until there is investor base that has thousands of investors. You cannot stand up straight with a sponsor and say that there is a high degree of confidence of selling the equity portion without that investor base.  In many cases, sponsors will explain that they are listing a sliver of the equity because they have their own current base of investors. That said, CrowdStreet did take a pretty significant pivot as a company back in early 2015. They learned from those sponsors that were using the marketplaces that not only did they love the capability to instantly get in front of thousands of investors across the country but they also saw the capability of the technology platform.

In response to this, in 2015, CrowdStreet launched a software as a service product. It is a white label version of the same software they use to run their our marketplace.  As of today’s podcast, CrowdStreet has 85 customers using the software on their own Web site under their own brand to manage their own investors and to create a more online innovative way of fund raising and investor relationship management.   Of these 85 companies, fully two thirds of them solely license the software, called Sponsor Direct, and they are going it on their own; they are perhaps not quite ready to try a marketplace and, for the time being, want to keep their deals private. But a third of our SaaS clients today do put select deals of theirs on the CrowdStreet marketplace in order to grow their distribution. These clients are open to more general advertising and they are seeing the benefit of adopting both approaches.  They are using the software on their website and are running their investors through it. They have one dashboard and they can see their fundraising process both how it is running on CrowdStreet marketplaces as well as how they are doing with their own investors.

Back to the Future

When Darren and Tore got together in 2013, the passion, the vision of democratizing access to commercial real estate investing was baked into their idea of how they could transform real estate investing to make it accessible to make it transparent to make it efficient.  Right now they are just scratching the surface and one thing that particularly excites Tore, is the that the market has not opened up yet for the non-accredited investors to participate. This is a stair step thing; it does not happen overnight but one sees a lot more sponsors being receptive to doing a Reg A plus filing, or a Tier II where they can raise up to $50 million and they can do it through a general advertising and they can make it available to non-accredited and accredited investors at the same time.  Tore thinks that is one of the one of the phenomena that is going to happen over the next three to five years where people will be able to put in as little as $1,000. You cannot do that without using automation as technology.

Tore also sees another potential major shift in the market.  At the end of the day commercial real estate is still an illiquid asset; in many cases there is no current cash flow. You could be in an asset for the next three or five years before realizing gains. Tore thinks it will be interesting to see how taking what has  traditionally been an illiquid investment and turning it liquid – and this is why publicly traded REITS have an advantage.  But because they also might have a lower return because you have a liquidity premium built into that investment because you can you can trade it on a daily basis. Tore sees things like block chain that might create an ability to securitize commercial real estate holdings and make it easily transferable and mark to market in a way that makes this investment type more liquid.

From Single Family For Sale, to Senior Housing

Global Senior Housing, the company that Nick Walsh co-founded with his father, develops senior living projects in the western United States. Before forming the company and moving to San Diego, they had developed residential subdivisions in Idaho. Despite being relatively new to the to the senior housing space and having only a small company, they currently have projects in Texas, Arizona and Idaho.

Listen to this episode in the shownotes, here.

Nick’s path brought him from the last downturn when they started looking at what asset classes they could get into to develop projects that was less cyclical than the residential industry – that they had been involved in in Idaho.  Through an associate who developed smaller senior housing projects like cottage type products or projects where there are multiple smaller buildings on a site, they were introduced to the space.

They figured that senior housing is a lot like the hotel industry in that it is operations intensive and felt that as long as you get a good site and line up good financing partners, the operations really is what makes and breaks the success of a project. So going into the senior industry they wanted to partner with a successful experienced operator who knew what they were doing and leverage off their experience versus trying to start a new operating team themselves.

Their Idaho based operating partner had a building prototype that they had built before and were confident operating.  Nick came on to partner with them to raise the capital and to find and acquire sites so they generated parameters that they use to look at demographics in the supply and demand in certain areas.  They started by focusing on Texas and canvassed the whole state looking for the right markets that were underserved for Assisted Living and Memory Care and that had the right demographics for a project to build.   That is how they found their first project and that project, which is in Houston, they funded by crowdfunding the finance.

Nick had not done a CFRE deal before having adopted more traditional financing routes in their residential subdivision business in Idaho.  There it was really localized and they knew a group of investors that understood the residential market and were happy to finance their deals.  Going down to Texas to do senior housing, they knew that they needed to expand their pool of investors and preferred private syndications for projects of this size where they were raising equity under $5 million.  Under that level they feel like syndication is the best option and so wanting to expand their investor based, they started looking at the crowdfunding platforms as the quickest way to achieve that goal.

Initially, Nick came across the idea of crowd funding when he was talking to a few attorneys at real estate conferences who were starting to put together PPM Reg D crowdfund deals at the time that the JOBS Act was getting approved and they were formulating the rules for that. There was a lot of buzz in the industry about crowdfunding as a way to raise money. 

Selecting the platform that they were to use was a process even back then when there was probably 20 or 30 companies out there already.  Nick started his search process by looking at who was doing ground up development. A lot of the platforms were in their infancy and most were doing deals with existing income streams so finding those doing ground up narrowed the field down to just a handful.  Adding the extra layer of wanting to do a senior housing deal narrowed things down even further.  Nick looked at each platform and who had raised done a successful raise on a senior housing project before, and that is how he landed on the company that they ended up partnering with , CrowdStreet.  They had just completed a successful raise for a larger skilled nursing developer that Nick had read about in a senior housing publication and that is what prompted him to call them.

Early discussions addressed the inexperience of Nick and his father in the senior housing space and that is where their joint venture with their operator partner came into play.  They were able to leverage off their partner’s experience in the industry and bring land development and construction as their role in the joint venture.  At that point in time they already had a project entitled now so they were raising equity for an entitled project and their role for the rest of the project was to manage the financing and manage the construction of that building and rely on their operator’s resume in operations which helped with their approval with CrowdStreet, as well as with the equity investors they reached out to.

Interestingly, when Nick first approached CrowdStreet he approached them with a different project that they turned down because the market was a tertiary market in Texas and they explained investors would not likely be interested in such a location. This allowed Nick to bring another in a major metro; something more attuned to what investors were looking for.  Most investors were looking for a city that they knew that they felt comfortable and that is why the project in Houston met the criteria.

The underwriting requirements that CrowdStreet looked at, of course, included the sponsor group; who the operator was and who the developer was.  They had a third party market study that justified the demand in the market for the building that they were going to build. Beyond that, one thing that they really liked about CrowdStreet was that they looked at the deal structure and did not really mandate the  deal structure like some other platforms do, but instead guided them through what would be successful.  Nick had to put up the fees for the raise whether they were successful or not, and they found that CrowdStreet did not want a blemish their reputation with a raise that was unsuccessful.  After the upfront fee, there is an annual maintenance fee for use of the software which sits on the Global Senior Housing website under the investor link.

From the investors perspective,  they are dealing directly with Nick and his company and not with CrowdStreet.  This was a differentiating factor from a lot of platforms that appealed to Nick.  Some platforms operate like equity shops where they will actually fund a deal and then backfill all the raise with investors and sell it later on. CrowdStreet is more of a marketplace where they are really just a middleman between developer and investor. They are exposing a project to their pool of investors but when it comes down to it, investors are calling the developer to ask questions that help them decide whether they want to invest or not.  It was the direct investor contact that Nick was looking for. He wanted to build his company’s investor pool and build those relationships with the investors direct so that when they went and did the next deal they would be there.

The process with CrowdStreet was as follows.  Nick’s company was given a checklist of documents that they needed to submit for the raise before they went live.  They were assigned a designated investor relations person as well as customer relations person who checks in from time to time to make sure thes sponsor has everything that they need to communicate with investors effectively and to make sure everybody is happy.  If an investor has a question sometimes they contact CrowdStreet and CrowdStreet will connect the sponsor, but sometimes they may just connect with the sponsor directly by either email direct telephone call.

CrowdStreet’s role with Global Senior Housing was solely that of a middleman marketplace that gets paid a fee to broadcast the project to their investor network.  They had no input into the agreements or structure of the deal that Global was proposing, and no rights to intervene should the project falter at any point for any reason.  The operating agreement, inside a private placement memorandum with a subscription agreement, was one that Global generated and then put out to investors on a take it or leave it basis.  Investors dealt solely and directly with Global in this regard.  In some cases, investors would say ‘hey, I like this deal if you had a higher preferred return’, or ‘I'd like this deal if you were putting in more sponsored equity,’ and they would still invest, even without modifications, and some would go in a different direction. Most understand that at the point the deal is being syndicated and is posted on the marketplace, it is really a take it or leave it proposition.

Once the deal went live, the total raise took about 75 days before the last dollar was deposited into escrow. Total amount raised was $1.2 million on top of which they had about another $300,000 in sponsor equity that Global principals were placing into the project.  The $1.2 million of outside equity came from 44 investors.  There was a range of investments sizes and this was one thing that CrowdStreet helped structure.  Global initially wanted to come in with a $50,000 minimum but CrowdStreet said that they thought the deal would be a lot more successful if the minimum was set at $25,000. In the end their investors ranged from some at $25,000 and up to $100,000.  While Nick did a little marketing on their own primarily to investors in Idaho who wanted to get into the senior living space, the majority of investors came from CrowdStreet's marketplace.  There were many investors from Texas since the project was in Houston, but overall there was a wide range of geographical dispersion with most from the West coast or the western states and a few from the northeast and East coast.

Every investor was accredited and CrowdStreet ran all of the accreditation processing for the investors. Of the investor pool, probably half were real estate professionals who understood the background and the real estate industry and who just wanted to diversify into crowdfunding projects. The other half were other professionals and family trusts who were taking their money from stocks and diversifying into real estate through crowdfunding.

The biggest challenge, Nick found, was the way the timing worked on the raise.  It started really quickly after launch, with probably half the money they needed raised in the first 20 days or so.  Then it slowed down because when a project is placed on the marketplace it comes up first so everybody sees it at the top of the list.  Once more projects get posted, Nick found that his project dropped down and he thought that perhaps it took someone a little bit longer to find their deal.  He felt that an important consideration when selecting a site to list a deal on was to look at how many deals are posted.  If there are none, that might indicate inactivity; but if there are too many there might be a concern that one’s own deal might get caught up in the wash and not really get the attention that it needs to complete the raise.

Another challenge to raising from the crowd was that Nick found himself spending a lot of time on the phone with potential investors; a lot of time answering e-mails; a lot of time with each potential investor so they could vet out the projects.  It took up a lot of time and energy and so Nick advises sponsors that that if they do not have someone in their company who is fully devoted to investor relations to the raise to field those calls, then the process could probably bog you down. 

One handicap Nick found with the process was due to the compressed timeline from launch to completion of the raise; it was a very condensed period of time. They were unable to post the project until they had entitlements and were ready to start construction – a CrowdStreet requirement.  Their traditional methodology on other projects was that they would start talking to folks throughout the entitlement process, giving them six to 12 months to gather the investor group together.  CrowdStreet, on the other hand, looks for products that are ready to go because they do not want to post a project and have investors commit, only to have to then wait for the entitlements which could be an extra three to six months down the line.  Investors want to place their money immediately; they are not going to be around in six months or have those funds to invest in six months.

Most appealing to Nick about the process was in their ability to increase their investor pool and work directly with investors. They have now talked to some investors who have already told them that they want to invest in more deals together. It was a good way to expand their investor pool and Nick liked the idea of giving people, through crowdfunding, the idea that no matter where they are they have the ability to do their own research and invest in a real estate project.  Perhaps they did not have any experience in senior housing but they were still able to own a piece of a project.

While the project did require that Nick devoted considerable time to it, he understands the attraction of going to a private equity fund where there is just one person to deal with who is asking all the questions. Crowdfunding real estate deals may not be for everybody.  Global found, however, that for raises of under $5 million in equity, it is hard to catch the private equity fund manager’s attention.  Even if they could, another issue with private equity is that the capital is more expensive.  With CrowdFunding, the sponsor can get less expensive capital in terms of both the kinds of payouts that investors expect, but also with the deal structures where control remains more firmly in the sponsor’s hands. Remember, there is no negotiation with crowdfund investors; the sponsor can structure the deal however they like, and investors have a choice to invest or not invest. With private equity groups they are going to negotiate with the sponsor, take more of the project through a larger percentage of the backend and in the operating agreement they want certain management controls that the crowd does not demand.  These kinds of controls range from more stringent reporting requirements or audited financials for instance, all the way to management decision making controls on certain things like when the sponsor can sell or refinance, or restricted budgetary controls.  In short, compared to the crowd, a private equity group takes more of the management out of the sponsor’s hands.

Another difference, Nick found, was that whereas private equity funds will not require distributions until the deal has been completed, with crowd funding Global has to distribute every quarter and preferred interest check.  This, CrowdStreet explained to him, was very important and started from the very inception of the project.  Indeed, Global had to raise a little bit more money to begin with in order to be able to make these distributions.  The strategy on the Houston crowd funded deal is for a a three year recapitalization and a five year sale. The most advantageous exit for Global, however, would be to develop and sell a portfolio of these cottage style product across Texas, way 8 smaller projects versus just trying to go out and sell one-off as each are completed.

Those in the Houston deal may be the only ones crowd funded.  Subsequent to the CrowdStreet raise Global Senior Housing partnered with a Dallas based equity group who syndicates their investors. It is a similar situation with where the money is coming from private investors, but their partner did the syndication work and came in as a co-owner.  They brought their own money and so the distinction between them and CrowdStreet was that they are syndicating in a similar way but they are also putting some risk equity in the deals as well.  The money was more expensive and while the benefit of not having to do the syndication work themselves cost them quite bit in ownership, Nick felt it was worthwhile.  This has allowed Global to scale more rapidly.  They were able to partner with a group that provides programmatic equity for multiple projects as well as one that understands the local markets they are active in.  For example, they have been supportive of the project that Global originally took to Crowdstreet that was not approved because it was in a tertiary market. Their new equity partner is in Texas, understood the market; the manager was able to drive down to take a look at the site and approve the investment. 

Going forward, however, Nick does have at least one crowd fund project on the horizon.  They are looking at an acquisition, a reposition project in Austin, Texas. They found that when investors looked their other project and/or sign up on CrowdStreet, they indicate which markets they have in interest investing in.  Austin popped up on a lot of lists for a lot of investors and so that is one potential deal that has in place cash flow and that is in Austin.  Deal size is $1.3 million of equity so maybe that will be the next crowd fund raise that Global decides to do.