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.