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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
[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.
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.
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.
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.
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.
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.
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.
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.