The Real Estate Crowd Funding Review
Ian Ippolito came from the world of tech entrepreneurship. He had run a couple of companies and started some companies, some more successful than others. He had a few failures but over the years he had built up a bunch of different companies. In 2013 Ian sold a company called VWorker. It was an online marketplace that was sold to a company called Freelancer. He enjoyed a nice exit and found it was time to move from being a tech entrepreneur to his new job, managing the finances of his family. He had to really get up to speed and had always been investing while an entrepreneur, but his job was his primary thing and he had invested passively in a whole bunch of things but had never really gotten down deep.
So at that time he really needed to get serious so he took a look at his entire portfolio and just redid everything because his risk was totally off. He had neglected a bunch of things and so started looking at stocks and bonds and traditional investments which were OK. But he also wanted to branch out to other things including branching out to peer to peer lending. Ian looked at Lending Club and Funding Circle which do business loans, and that's what led him to real estate crowdfunding. When he discovered it he thought, wow, they're taking the idea of lending to peer to peer lending which is a good one but a lot of times is based on an asset that's not collateralized so you don't have any protection or if the person defaults on the loan they're gone. But now we're putting it into real estate so if you're doing debt it might be collateralized or you know you've got equity and then you've got this tangible piece of property behind it. And he was really intrigued by it.
This was in 2013, when Ian began in CFRE and at that time there weren't that many sites but they exploded really quickly. Everyone was really excited about the idea. It was kind of like a big explosion and then it kind of winnowed back and then another kind of growth spurt. But back then there were some of the names that people are familiar with today. One of his favorite sites was FundRise and Patch of Land was around back then. A lot of the sites changed over time or changed their business models or maybe they changed their underwriting or whatever but those were some of them back then.
Beforehand Ian had owned some rental properties so had knowledge of what being a landlord involved. He had invested in a couple of passive deals with varying success and had gotten into a one deal right just before the Great Recession. He invested passively with a syndication and just the bad timing didn't understand what he was getting into and didn't understand how to evaluate the terms of the deal. Looking back, it was something he never would have gotten into. Thankfully he didn't lose any money but it took about 12 years to break even. It wasn't something he wanted to repeat and he decided when he got into CFRE that he was going to do a lot more research to learn a lot more about what was going on inside and kind of up his game.
He came across a deal, did some research and contacted the sponsor directly. It was investment in residential real estate and that was their business model. The minimum was pretty high – in the hundreds of thousands and came with a beast of a PPM. It was just a huge thing. He took it to and attorney because, well the thing you do is when you get these things is you need to take them to an attorney to evaluate them. And this is really important. He learned how difficult it is for people starting out because he didn’t know who to bring it to so he asked around who's a good attorney that understands real estate. And the guy he chose to take a look at it, after charging him all of the usual fees and everything, told him ‘if you trust this person it's probably going to go ahead if not don't let me read it.’
This wasn't what Ian was looking for. He wanted someone would had evaluated 100’s of these and could tell him that the terms look good or don't and so the experience was a kind of a wakeup call because he had to educate himself. It was hard for to find that type of expertise he needed to get to do it. He found everything to be interesting but it was overwhelming because he there were debt funds, and equity, and they're investing in senior housing, or they're investing in apartments as well. What's the difference? Some are value added, some are opportunistic. It was really difficult at the beginning to piece together the relative risks and so he needed to create a coherent overall portfolio strategy and just going through the platforms and just taking it deal by deal which maybe is the way most people do it and that was the way he was doing it was just not working.
He wanted to understand what he was getting into; yes, the return looks great but how much risk taking and of course the sponsor doesn't tell you. So Ian took some time to figure out which investments he wanted to go through and thought maybe a good shortcut would be start with the platform's first because there were so many at that point and it had exploded and he thought he could find the ones he liked. That way he could weed out a whole bunch to start with and once he found the good platforms, I could start digging into the deals. So that was the way he looked at the different platforms. And there was nothing out there on the internet that would explain it which would have been the easy way. He realized he was going to have to figure this out himself. He had his research assistant help out and together they contacted every single one of the platforms, talking to the people involved. He talked to other investors asking how was their experience on the platforms.
He looked at their legal setups. If they go bankrupt what's going to happen? So just looking at what are their fees and comparing them to the other ones. So he started looking at all of these different things and it was just really for himself, putting it together over a couple months until he felt pretty confident that he had found those he liked and those he didn’t. Then people started asking him for it and then another pretty soon he found it was too much answering individuals and so he just put it out on a Web site. And that's how it all got started.
In the Beginning
To get going he just started reading and read as much as he could. And he found that after reading 30 or 40 PPMs you start to see patterns that are occurring over and over again. And then you notice something that's a little bit different; No, that's not super great of a term or you know that's pretty questionable or he’d find deals where investors were liable for a lot more than actually the money they were putting in or whatever it is. He went into a whole bunch of these things and just started looking over and over again and seeing which ones he liked and which ones he didn't.
To learn about the art of real estate, Ian went online. He wished there had been some source back then that put it all together into one place but unfortunately there was not anything like that. So he did it the way that he had learned to do his stock market investing and his mutual funds. He read everything out there and digested it, repeating over and over again each investment doing the same thing over and over again until, eventually, he figured it out.
Since the Beginning
There definitely has been lots of change in the industry in just a few short years. There was kind of the initial explosion where everyone was trying to get into it and people were raising a ton of money from venture capital. And there was an explosion of platforms and it was a very exciting time. Then there was kind of a period where if you remember there was a scandal with LendingClub and there was a financial accounting scandal. And maybe they did some things that were improper. And when that happened all of a sudden the entire Fintech space was no longer as desirable to investors. All of a sudden these companies that were raising a ton of money couldn't raise their second round or the third round. So a bunch of companies started they were laying off people massive layoffs or they were shutting down. So there was a kind of a contraction.
What we're seeing right now in the last year and a half is like another expansion that's being done in a different way because of that VC capital is no longer flowing in. Instead people are actually turning to the newer crowdfunding rules that allow crowdfunding platforms themselves to raise funding for themselves versus with the investments. And we're seeing a new round of expansion to the ones that are successful on that. Sites like Fundrise and you've got Groundfloor raising millions for their own corporate development. This is a great way for a company that maybe had trouble with the VC market or VCs aren't the best thing for a company that is not going to explode and because it pushes companies to do that. So this is kind of like a slower growth model. It seems like there's a lot of appetite for it. People are buying up these shares left and right with all these deals filling up very quickly.
Of course, investing in equity in the platform is a speculative investment where it's not a real estate deal where people are going to get income coming in on a regular basis. You're hoping for some sort of exit at the end or maybe the platform was sold to somebody else and maybe did an IPO. And then at that point then the person hopefully is going to see a return on their money.
Deal quality has not been totally positive. The deals earlier on were much better. They were higher yielding and were taking less risk and as the cycle has aged the risk has been ratcheting up the yields have been going down. Each quarter it’s been getting a little bit worse and worse. So a deal that would be considered maybe a good deal in 2018 would probably be a deal that maybe would not be such a great deal earlier on. There's so much money right now that's just chasing not enough deals. And you know definitely it has deteriorated.
For example, you would find on a particular platform you could find conservatively underwritten debt deals so that maybe 65 percent loan to value or less first position a residential flip or something. And that would be yielding double digits. Now to get something conservative like that is very difficult unless it's some sort of more speculative like some sort of huge construction project or something that's not going to be double digits, most likely going to be maybe like 9 percent or something like that or eight and more likely even less. The other way that there was a change just on the debt side. It's just that back then prices were cheaper. So because prices were cheaper it just made all the underwriting that much easier. Now prices have gone up but we've had a really good run now as a result of the great performance of all those old investments. Now a lot of the properties are really expensive. So it gets harder to find the good deals.
Finding the Deals
Ian does a bunch of things to find deals. He subscribes to all the crowdfunding sites and is constantly having new deals come to him. Just at this stage we are in the cycle you know, it's not going to last forever at some point it's going to end and there's going to be a downturn. And for Ian what he wants to be in at this stage of the cycle is a very experienced sponsor who's gone through a downturn and not lost money. And it's difficult to find it on a crowd funding site. Probably 95 percent of investments if not more. So he ends up networking with people, going to investor groups and talking to other investors. A lot of the deals just don't work out, but looking for them is Ian’s job, basically working on the investments so he spends a good portion of his day doing that.
The Real Estate Crowd Funding Review
Ian created this place where he puts the ratings of the different platforms out there so everyone could see them. Once he did that people were like hey what about the non-accredited platforms that were springing up. So he I did a ranking of those that up there and then just started talking about things like real estate news as it were coming in and blogging about it; Here's my opinion about this or my views about that. And that kind of grew to a following. There are about 1600 or 1700 people who subscribe regularly. The site is getting maybe 7000 or 8000 visitors a month. So it's quite a few people are starting to come follow.
And then what's happened is he wrote something a little bit negative about one of the sites and it was an investment on a site and he felt that they were being very deceptive in their marketing and felt they were giving a guarantee that they couldn't give. There's no such thing as a guarantee really on investing. There's always risk. Anyway he wrote about that and they threatened to sue him. They looked up every single address he’d ever been at. And they sent their threats to it. They went all out and they said you need to take this down and it sounds like well you know this is a political thing as Ian was doing it for free he thought well he was going to have to shut it down or find some other way to get the information out there or do something else. So he created a private investor only forum on the Web site and vets the people that come in to make sure that they are truly investors and not associated with the platform and then that way the people themselves feel free to share information. Whether it's positive or negative. But to share it freely.
Power of the Crowd
Every single time someone asks a question it's helpful. It may be something Ian’s thought of before but a lot of times it might be something that puts him in deeper or maybe at first he thinks that's an annoying question but then he thinks about it and realizes, no that person has a great point and he digs in deeper. That kind of give and take is really important and investors on their own are kind of in a little chamber and so to have other points of view is really powerful.
Ian thinks that with certainty that there's going to be a downturn coming up eventually and he suspects that we're closer to the next downturn than we are to the last one. He is positioning the real estate crowdfunding review with this in mind and focusing on the investments he’s interested in which are these conservative investments, sponsors who have experience doing multiple cycles who have not lost investor money or maybe they are debt funds that are very conservatively underwritten. Maybe they are real estate funds which is maybe a little bit too boring for some people but for Ian it's perfect for this part of the cycle. So a lot of the focus is on those kind of things a very conservative mindset trying to preserve principle not trying to extend too much and with the idea that hey after the downturn maybe there's going to be some opportunities there. And have some cash and some dry powder might be a really good thing.
Rethinking Real Estate
Dror Poleg has spent the bulk of his career, a little over 10 years, in China developing institutional real estate. There he developed around thirty million square feet of shopping malls space, offices, about twenty-six thousand apartments and some serviced apartments. Together with a Dutch Israeli fund some of these assets were sold to institutional investors, and they were partners with BlackRock in most cases selling other projects to private equity funds in Asia and to a REIT in Asia. His experience is, therefore, across the whole real estate development process from beginning to end; buying land, developing large projects, leasing them and then either selling or stabilizing them. He has consistently brought in financial partners and taken assets all the way to being owned by an institutional investor once they become mature quality assets. He arrived into the real estate world from the world of online development and design – digital design of all things. He was partner of a digital design agency in Israel which is where he is originally from, and then worked in Australia, in China and through helping real estate developers on some projects he gradually got sucked into the business from the marketing side to the market research side to the presenting to investors and government to leading the leasing of commercial assets and then finally to really just handling the big deals.
Today Dror operates a small consultancy based in New York City advising large scale real estate owners and operators and private equity firms on innovation in real estate. He covers anything from understanding long term trends that are driven by technology such as, changes to the nature of work, how people get married, or education trends, autonomous vehicles different things that impact the real estate industry, longer term to more immediate terms such as different technologies and tools and business models that they can implement today in order to produce more value out of their assets, up to really looking at the underwriting of specific deals that involve some innovative components mostly co-working, flexible office, co-living, or anything along that spectrum. On the other side of his business he works with startups that are focused specifically on the real estate industry. This includes anything from modular construction, building management systems, different sensors and IOT, to kind of more communal ventures and operating systems for a whole neighborhood.
He does not have a typical client having worked with clients in Japan, in Turkey, in the UK, in New York, on the West Coast, in China. It is really diverse. His clients range from startups to very large owner operators companies like British Land which is a company with about $25 or $26 billion of assets under management, as well as some smaller real estate companies of around $5 billion assets under management and above, and some funds that are either based in the U.S. or based out of Hong Kong.
Private equity in Real Estate is, basically, using private money as opposed to public money in order to fund the equity or to acquire and operate real estate projects. Similarly, REITs are public equity that allow retail investors to own a piece of a real estate portfolio, and private equity mostly refers to funds that are managed in order to acquire and generate as much value as possible out of, usually, large scale real estate projects. These funds are usually capitalized by institutional investors or high net worth individuals.
For a private equity fund the clearest division is between what is called the general partners, people that are actually actively managing the fund and its assets and are also partners in the fund and the limited partners. The general partners sometimes put in some of their own capital into the fund and the limited partners are people that bring money into the fund but do not have any managerial responsibility and thus no liability in some ways, at least in terms of their legal exposure. Limited partners do, of course, have liability in terms of being able to lose the money the invest and have no control over, or limited control over, how the general partner manages the fund.
These limited partners are often institutional investors. People that have a lot of money to allocate are not necessarily real estate specialists, so like a pension fund, an insurance company, a sovereign wealth fund, people that manage a lot of money and have huge portfolios where usually a very small percentage of them is allocated to real estate. The general partners are the folk who manage the fund. They are usually property professionals or private equity real estate professionals that have experience of actually running an asset.
It's an interesting because the daily life of a fund manager is changing in line with technology. Most of these funds originally have relatively small teams. If they have several offices or focus on different geographies they might have a handful of people in each area. That would mean, several general partners who are really the ones managing the fund, and then a few analysts. Sometimes, depending on the type of assets that they invest in they would have additional people that have operational capabilities or specific expertise, let's say in shopping malls or, office leasing. People that can help when you do due diligence on an asset or when you oversee the people that are operating the actual asset then you can kind of know when you know things cost too much, or you can leverage relationships that you have for other assets in order to make that specific asset better. But part of what is changing now is that real estate as a whole is becoming much more operationally intensive. And if in the past the operators were almost like commodities, and the owner could just hire people to do certain tasks, today more and more you see that the good owners, which means a good fund managers, are people that have unique operational expertise as well, or unique relationships and in some cases even unique technology.
The vast majority, or a lot of the time of the fund managers, is dedicated to raising funds, and some would even say that their main skill is the ability to raise funds, so more than actually picking the right investments, and definitely the traditional fund, the ones that are still leading the market today are. Their success is very much attributed to the relationships that they have and that they've built over the years with the investors so their ability to raise capital. When they set up a new fund they go and try to raise money for it, they usually have a target. They either rely on their direct relationships, they can rely on companies that are called placement agents, which are companies that assist limited partners so institutional investors and high net worth individuals who allocate their own capital into different funds. Placement agents are another type of middleman. They're theoretically familiar with all the different funds around the world. There are other third-party companies that grade some of these funds assuming that these funds have a track record. When institutional investors are looking for investment they may have placement agents to assist them and they have third party bodies that, that give them feedback or kind of rate the type of funds that they about to invest in.
The general partners go to institutions and the institutions there are individuals who are responsible for huge amounts of assets that they have to deploy and they have to allocate a certain amount. An institutional private equity will fund to raise $50 or $100 million from any individual institution, and that will typically be based on the relationship, probably with, maybe just one guy at the institution that they have, whose job it is to allocate those funds. Now at the institutions they're going to have investment committees and whatever else they're out to authorize the divestments.
So relationships matter but it is definitely not one guy's decision. There are investment committees. These institutional investors to begin with have their own mandate and very strict criteria in terms of their risk profile. Sometimes geography, sometimes type of asset, sometimes the holding period. The fund has to feed all of these. Another thing to note, is institutional investors also vary in terms of the size of the team and level of expertise that they have. If you start at the top you have some sovereign wealth funds like JIC from Singapore, or the Canadian pensions which have very relatively large and very professional real estate teams. They really have their own knowhow and ability to evaluate funds. They also invest in assets directly because of their capabilities, and on the other hand you might have, we can call it poorer institutional investors that manage a lot of money but have very small teams and very small budgets in terms of their own overhead. Something like the Illinois pension management board or institution which operates with a very small team and really relies completely almost on other people's opinions and feedback when they decide how to invest.
How Fund Makes Money
The second that they close the fund, basically once they're done raising the money, they're already starting to make money, in theory. So, the compensation models for these funds is along the lines of what is called 2 and 20. They take a certain percentage, 2 percent, but these days probably less, one and a half or one percent of the total funds raised per year as a management fee and 20 percent or, less these days, in a carried interest profit which is the added value that they create through those assets, so, 20 percent from the upside.
Depending on the strategy of the fund, there are four main strategies that private equity funds look at, starting from core investment which are really the most stable best quality asset in the center of main cities. Core plus which are assets of the same kind but that might have some, some very limited value add potential such as leases that are lapsing or renovations or certain little things that could improve them, then complete value add which are assets that are still relatively good and developed but have some more major potential for value creation. Either the occupancy is quite low and there is room to change things or there's one tenant that has issues that could be replaced or needs some type of negotiation skills that the existing owner can't handle or several leases that are lapsing within the next year or two that the new buyer assumes that he could find better people for that will pay significantly more, or sometimes on the financial side, restructuring, refinancing of different kinds that can ultimately create a higher return for the new equity. The last category is opportunistic investment, which entails significant more risk. This includes anything from ground up development, taking distressed asset and repositioning them; basically doing things that are riskier and targeting much higher IRR, towards a 20 or higher.
Fund managers do not typically execute on the business strategies themselves although sometimes they might. Sometimes they cooperate with others. They go and look for deals, like the rest of us in some ways. They use brokers, all the large broker firms like Cushman and Wakefield, Jones Lang LaSalle, CBRE, Savilles, Colliers. They have their own capital markets team or kind of investment brokerage and people that tend to these types of clients and try to find them opportunities. They also leverage their own relationship, again, through their own network, looking for opportunities to invest in. Some funds also specialize in sourcing deals and they have unique sources for whether its different types of foreclosures or other similar large investors that own certain things but need to liquidate for certain reasons. They buy or sell from other funds that are focused on different strategies.
Let's say, there's one fund that has an opportunistic strategy. It owns an asset that was under development and once the asset is almost stabilized it can sell the asset to another fund that has let's say a value add strategy and can take that asset from 80 percent occupancy to 96 percent occupancy, at which stage you could sell it to a core plus fund or to a core fund that could just buy it as a stable asset for a much higher price and not bring much more value but just enjoy the yield, which is what institutional investors ultimately want. Institutional investors don't want to take a very high risk. In a perfect world they would just buy you know something that brings in 5 percent a year or 6 percent a year, and not have to do anything to it and just be happy. But it's getting harder and harder to find assets like that especially when you have so much more new money to allocate each year.
One of the projects Dror developed in China was a shopping mall. It was still a new mall not fully stable yet at around 80 or 85 percent leased. About 80 percent of the space that was leased was already open and operating. They received an investment from a fund that is owned by BlackRock, which is more known for managing other investment products but they also have like a, small about 10 billion dollar real estate private equity business and they bought 50 percent of the holding company of Dror’s mall, and became their partner. To do that though they arrived at the deal through a broker, in that case through Jones Lang LaSalle. They spent, a lot of time several months, doing due diligence ahead of agreeing to a deal, looking both at the market at large and specifically, at the project and everything the operator/developer could tell them about it including assessing them as managers, so spending a lot of time with the team. They challenged them on the rent roll and on each specific tenant that they had; Why did we give them these terms? Why not those terms? Blackrock looked at underlying assumptions about the additional space that will be filled et cetera. Once they became partners, they sat on the board, they had a seat on the board of the project, and in the operating agreement which was signed when they invested, they also defined certain key decisions that they have a say about, or even a veto on. The original company remained operating the asset but major decisions such as major capital investments, changes to more than a certain percentage of the tenant mix and other things had to be approved with them or by them.
The most contentious issues are things that are purely financial. For example, if the management team wants to refinance the assets. If they want to sell a piece of their ownership. What to do in case there is an opportunity to sell the whole project. What to do if they buy the whole project and the managers don't own it anymore. What are the responsibilities in terms of operating it and ensuring that there is a successful and smooth transition. Mostly these type of things are very common to any type of kind of merger or acquisition elsewhere.
Triggers that could allow the investor take over the project included terms of not performing as had been projected. Although the investor does not want to run the project, at the end of the day, they invested in an asset that they assumed that they're almost unable to operate, without their partner. But the terms allowed for them to bring in a third party. Part of the assumption is that they're taking a big risk and that they trust you and if they wouldn't, they probably wouldn't go into the deal to begin with especially with something like a shopping mall or a hotel which is very operator dependent.
The investor can, de facto, replace certain people in management. In an extreme situation they can replace the manager completely as operators of the assets, who would remain their partners in ownership until there's a new buyer but who would have to cede the actual operation to another operator. There may be a budget approval procedure each year with quarterly reviews. During that process, if they want to make life difficult for the manager in terms of how they spend money on a project they can make it difficult.
There are bad boy clauses, key man clauses. These limit what the manager can do if they have some really talented person there that the manager might want to move to another new project that's something that they may not be able to do. There's all sorts of things. In China mostly the bad boy was about indemnifying investors in case the manager did certain things like bribing or doing something that is illegal, locally or internationally. These terms are very similar in the US too. The investor’s goal is to be completely indemnified as much as possible from anything that the manager does but on the other hand they want to have as much power as they can get away with, in balance with the previous point.
Promote & Fees
Deal structures can vary. In some cases, the sponsor could be a straight up partner, or it could be a 50/50 partnership. In those cases there's no waterfall and there's no promote. Basically, both own the asset. If the asset does well, both make money. In that case it also means that probably the 50 percent that the private equity fund owns, or was sold to it by the sponsor who originally brought in the project. So assuming that the sponsor already made some money already, on that piece of the deal on that half and when they both sell in the end, they're going to make more money.
Other structures, have a promote which is very similar to how it works in smaller deals. The sponsor can get sometimes a small piece in the beginning just for bringing the deal. Something between half a percent to 2 percent, which sometimes is expected to be reinvested or kept as part of the deal. Then upon exit or other major financial events such as refinancing there's a promote structure that means that once the returns for the private equity investors meet a certain hurdle, and that depends on the type of the asset. It could be 5 percent 8 percent, 12 percent 15 percent. Then the rest of the returns are split between the two partners. Whether it's 80-20, 70-30, 50-50, or even with a few different steps and a more complex waterfall.
Impact of CFRE on Private Equity
There are several ways in which crowdfunding impacts private equity, both directly and indirectly. First and foremost, technology means that access to information is being democratized, so, suddenly everyone can know almost anything, both about investment opportunities and the investment details of specific opportunities. Also, they can know a lot about the market, like today. Definitely in development markets in a place like New York City almost every building that you look at, you can find online. You know how it is performing, who are the tenants who bought it before who bought it later, if there are any violations or complaints. You have access to rich information that previously only people with unique expertise, or with unique relationships, had access to. Technology does that and crowdfunding contributes to that and benefits from that.
Second, it democratizes access to capital. Which means that developers or sponsors today, that have a good deal or a track record. They can go directly to people with money and raise money from them instead of relying on private equity funds or larger investors. They can pull together resources from smaller investors and still get larger and larger projects done. As is happening. Which means that to an extent it poses an alternative to private equity funds. Not a significant one yet but a growing one. It empowers, in a way, the flight of talent, from, big funds, and big developers. So. If in the past someone was managing, working for a private equity fund and they were doing really well, they could maybe go and find a job with a similar fund. But today, there's actually an alternative for that person to say 'Hey I'm actually really good at finding those deals. I have relationships with developers and maybe even with the government. I know the market better than anyone. Why don't I just go and syndicate myself?' They can then put themselves out there and raise money through crowdfunding. It's incentivizing executives to go at it alone albeit in a limited way
CFRE also does things that in some way benefits the larger private equity, real estate funds. Crowdfunding is mostly focused at the lower end or the lower part of the market and, in a sense, it makes the market much more fragmented than it was because it empowers a lot of small players which means that those funds that are really large and usually have unique operational capabilities as well are only getting bigger, and it's harder for medium size funds, or for medium sized operators to compete with them or gain leverage when facing them. If we need an example, we can start with the retail world because their dependence on the operator is most obvious. You can have companies like Simon or Westfield which have unique operational capabilities. They're proprietary brands they have proprietary technology they have proprietary relationships with tenants. And they have their own fund management business so they can raise money. And they leverage their network and their scale to benefit all the different assets that they own. To the extent that if someone just buys one shopping mall, it would be very hard for them to compete with these guys, in terms of their leasing capabilities marketing capabilities, and asset management technologies etc. And when the middle and bottom of the market is getting more fragmented, it means it's harder and harder for people to climb out of that space and compete with those really large operators or fund managers. Another example is Blackstone. These guys manage more than $100 billion of different real estate assets most of it is office, and they're investing in startups and companies that specialize in operating office space and in technologies that optimize the way energy is used, and the way space is marketed etc. And unless you're a very large, it's hard for you, as an owner of one asset or five assets or even 20 assets, to compete with them. This is going to get harder and harder.
Impact of Tech on Real Estate
Technology at large, meaning not one technology but different technologies together, are creating dramatic changes in the real estate industry, starting from the way they impact the way people work, the way people raise their families, the way people move or don't move, the stability of jobs in general the fact that even people that are doing well and are educated and experts, don't have 20 or 30 year careers with the same company which means that, they are less likely to stay in the same place less likely to take a mortgage, sometimes less likely to even want to own anything. Technology is impacting real estate this way which is indirect but it's very significant.
More directly, technology is basically redefining all the basic tenants of real estate value, starting from the meaning of location, and the value of location, and the meaning of visibility and accessibility. The meaning of regulation. We've seen in the past few years, the technology redefined each one of these aspects because of, you know, ride sharing, autonomous vehicles, remote working, online marketing, which means that you get your lead not by being in the most prominent location but actually most of your tenants come through online channels and other channels.
The fact that disruptors can leverage the crowd to undermine regulation and rules. If you look at what, for example Airbnb has been doing. The hotel industry was assuming that since Airbinb was illegal, it's not going to compete with them but they've seen that Airbnb has so many users that depend on it, and love it, both the people that lease space and the people that are guests, that governments in many cities basically succumb to or had to adjust regulation, in ways that people couldn't imagine before. Technology is undermining all of these things and that boils down to maybe the most important point which basically means that real estate as a whole, even the most stable asset that people assumed previously, that are valuable forever, just because they are where they are so they have inherent value. These assets are becoming destabilized to the point where unless they're operated very intensively and very creatively and probably, reinvented and readjusted constantly, they do not retain their value. To cite an example, if you look at office buildings in central Manhattan, that until a few years ago people assumed that they can just buy them and they'll have a stable yield and it’s a very boring business. Today they are competing with people like We Work in the building becomes dependent on its operator. If we look at retail, retail on Fifth Avenue again, until a few years, the safest bet on earth. No longer safe. A hotel next to Disneyland. Likewise, Airbnb suddenly comes over, partners with a local developer, and starts competing with your hotel and create new supply that is not zoned as a hotel even, sometimes, basically serves your potential customers.
That's the ultimate impact of technology really destabilizing what real estate means. This has immense implications to the institutional investors which means immense implications for our own pensions and our own savings for the future, what we can assume about the returns that we're going to see. Something to keep in mind.
From Zero to 300 Million
When he formed Patch of Land, Jason Fritton hadn’t had any career experience related to real estate. It was an aspirational, ‘somewhat naive goal’ of his to start a real estate company, as he describes it, and he came into it with absolutely no knowledge beforehand. Jason’s background is more on the technology side. He had worked providing solutions on the telecommunication side for very large public sector clients and had done very well with that and had built a nice company that he owned 100 percent of. Unfortunately, in 2008 and 2009 when the financial crisis hit, he learned the mistake of having just a few clients or one very large client and when that client went away his company went away with it.
This was an extremely painful experience. He lost everything and wanted to do something again because, as he says, “once you start a company that does well that is what you're going to do for the rest of your life. It's in your blood at that point.” Jason had to take a day job in deciding what else he was going to do next. He wanted a company that had thousands of very happy loyal customers and clients. He had known the CEO of a company that was doing crowdsourced graphic design and who was just blowing up the entire industry and doing very well and this gave Jason the idea that this kind of company was the future. He felt that this is how things are going to move because we're so interconnected today that the ability to be able to reach out to people that you didn't have any sort of previous relationship with, and to be able to focus their resources their skills and their experience into what had previously or what would otherwise be very difficult project was very powerful.
Jason sat down with a scratch pad on his couch one day and asked himself ‘how would this type of thing work in a big scalable fun sense?’ Driving his inspiration that day, was that one of the biggest things that was really traumatic to him about losing his company beforehand was that he lost his house and a lot of people really take for granted just how nice it is to have your own place your own piece of the planet your own patch of land – which is where he came up with the name. Real estate resonates with people. Deep down everybody wants to feel like they have some corner of the earth that is theirs.
Even though he didn't know anything about real estate at the time, around 2010 which was the depths of the market, he went and took a look at the auctions out in Chicago to see what type of opportunity was there. What he found was that there was always just the same group of 12 guys at this particular point that were bidding on good properties. These were smart guys. Highly experienced guys. Wealthy guys. Always the same small group of people that were on a first name basis. It was a very insular group.
At one of the first auctions he went to there was a property that came up nearby where Jason was living. The current appraisal on it was $300,000 dollars. By today's standards after the recovery it is probably worth $600,000 or more. But back then that appraisal was $300,000 and minimum bid on it was $20,000.
And nobody bid on it.
The clique of regular buyers who all knew each other were highly experienced and at all those auctions they were bidding on the big properties and multimillion dollar properties and small properties, that Jason considered to be the bones of real estate, were a little bit beneath their attention at that point. Not only that, but because it was the depths of the housing crisis nobody else had the money because banks weren't lending. Private lenders really had massive liquidity problems and the usual real estate professionals didn't have access to the capital. So this great property went back to the bank or was abandoned and in this Jason saw a real opportunity. He went to his attorneys and to a bunch of mentors that he trusted and told them that this was what he wanted to do.
And without exception they told him that it was a great idea and there's something that they would be really excited about it but that if he did it, he was going to go to prison. They were worried about public solicitation over the internet but Jason, who describes himself as being a stubborn guy always trying to find solutions to complex problems, found out there were a couple of Congress people that were cosponsoring what became the crowdfunding exemptions to what became the 2012 Jobs Act. He worked to advocate for the passage of the idea and once the President indicated his willingness to sign the bill Jason put together Patch of Land full time in an incubator space out in Chicago.
Now the company has gone from that little tiny company built from his couch to one with a run rate of about a third of a billion dollars in annual lending, and climbing rapidly to half a billion by the end of 2018. Jason started from not knowing anything about real estate and now has reviewed billions of dollars worth of opportunities.
How POL Grew
Jason says that the growth of the company is down to one thing, that “begins and ends with a lot of hard work and determination.” When the company first started he was fairly new with the idea of providing access to real estate to people who may have no prior experience whatsoever and the goal was to allow people to invest in real estate from two minutes flat from their phone from their couch from their pajamas if they want to and that was exciting to the wider public. They started doing some press demos and Jason put together a small team in the Chicago incubator space and got a minimally viable product out doing just the absolute minimum of what they would need to be able to get business done in a very minimal sense. They started doing some tech demos and started to get a little bit of press about this. It kind of grew organically at that point. It wasn't something where they just took off and the Wall Street Journal picked up on them. It was very homegrown.
“Every entrepreneur has huge dreams or you wouldn't be an entrepreneur to start with,” says Jason, “And of course along with every huge dream comes every bell and whistles you can think of that's going to great for your customers. A problem is if you go that route right from the very beginning you end up with this development paralysis essentially where you never get the product perfect. It's not exactly what you envision in your head and you delay launching until the opportunity has passed you by.” To overcome this issue he and his team wanted to put together a basic framework online that would allow people to review good real estate opportunities and then place a commitment within them. That was the base of the problem they were solving. They wanted a thousand people to come together and to put a little bit of money into an opportunity to make a big opportunity happen that wouldn't have been possible with these folks individually.
The minimum viable product that they developed was really just providing the ability for somebody to view a real estate opportunity online, review the due diligence, for POL to upload docs and everything to show why it was a credit worthy, good project and then be able to place a small commitment fractionally and have that tracked. Once they had accomplished that the story became real because for an entrepreneur what you're trying to do may be very clear in your head but one of the biggest challenges to getting something off the ground is communicating that to other people and getting them to believe in it. Consequently, you have to be able to show somebody relatively quickly and to be able to show the wider public relatively quickly what your idea is. What exactly is the value of it. With their MVP, they were able to show that someone was able to come into a deal and put a tiny little bit of money into real estate and be able to own real estate across the country and that they can do it from their phone.
That was enough to get some articles written about them even though they hadn't done any business at that point, it was enough to be able to say “hey, look at these guys over here. They have this kind of cool little idea,” and it blossomed from that because you never know who's looking at those type of articles. And somebody else who was looking at other marketplace lending companies at the time all of a sudden saw this and said “OK I've got real estate experience and this makes complete sense to me” and that person was Carlo Tabibi, Jason’s co-founder. He has a very prominent powerful family out in Beverly Hills and he's done hundreds of millions of dollars worth of real estate on several different continents. Carlo came to Jason told them that if they were willing to relocate to Los Angeles he would put in a few hundred thousand dollars worth of seed capital to get the company started. So they started from this very simple idea, without actually having done any actual business to getting the right person to believe and that took them to the next level.
At that point, however, Jason could not move his entire Chicago team because they had families and lives in Chicago. So just Jason and Carlo who started up the business in Los Angeles. Jason moved to L.A. and put another team together and did that very slowly because they did basically all of the work themselves to begin with. They worked 16 hour days every single day, seven days a week to try and get the platform ready in anticipation of launch. He arrived in Los Angeles in September of 2013 and launched the Web site with their first little tiny opportunity in October of 2013. They were set to go speak at a trade show so launched their first project and jumped in the car to go out to Las Vegas to do the presentation.
The deal was only for a $100,000 project and they expected it to take 30 days to fund. It funded in hours and that presented its own problem because they didn’t want to have dead space up there where they didn’t have anything new for investors to get involved in and then see them lose interest. So while in Vegas they had to crunch to find a new a new opportunity to launch from there. From there they picked up speed and really operated in kind of a beta sense. When you have a real estate investment company where the founder doesn't have a whole lot of real estate experience they wanted to take things slowly. Working with other people's money, they were cognizant of that and respectful of that, so they operated most of 2014 in a beta stage while they put the system together.
They wanted to build a platform that was scalable. Essentially a lot of real estate companies are real estate lenders are built around a few men and women that have been in real estate for a very long time and have a big book of business and they operate off of that that book business but they really don't have the ability to grow far beyond that without finding other men and women who have that type of book of business themselves and getting them to come to their company. Jason wanted a system where they could generate the book of business internally with a very strong conversion funnel on externally developed leads and then be able to have a strong group of smart people internally that they would train up into their products and into their system that could convert and close the leads and be able to handle clients respectfully, efficiently, and with a positive experience. They spent 2015 and 2016 building that system.
Patch of Land was financed through a few hundred thousand dollar seed round provided by Carlo in Beverly Hills. Then the company raises a Series A. They went the traditional venture capital route which Jason found to be exhausting. You have to convince very smart people that not only do you know what you're talking about directly but that what you're building has the ability to grow into something that's 100 times the size of what it is today and to be able to do it in a relatively quick timeframe. He found that at the same time as it was very challenging, it could also be very discouraging because most VCs will take a look at a hundred different companies before they give one Yes. Which means that say all things equal a company may get ninety nine no's before they get one Yes assuming they ever get a yes.
In addition to the VC community, they also went to Wall Street.as well as to family offices and that's eventually what allowed them to get a lead for the A round. They found a very prominent family office that was also involved with other marketplace lenders like Avant and Ondeck and other companies in different asset classes that had experience with it. They promised a good amount of capital to begin with and then Jason went out to his crowd. The nice thing about building a crowdfunding marketplace lending type company is you end up with a great deal of very happy customers, assuming you're doing your job right. They tend to have significant resources of their own and the entire baseline idea still stands whether it's funding real estate or funding a company that a small amount of capital from a whole lot of people adds up very quickly.
They were able to produce the Series A with a very sophisticated lead from a big family office and then fill it out with clients and who were the best investors because they know what you do and they've had an experience working with you and they're happy with who you are. That's a big advantage that POL has even today. If they ever get in a position where they need capital they have thousands of investors in the platform from whom they can potentially raise capital as long as they can show that they have a good plan for making them a positive return on their investment.
The Series A round raised a little over $23 million and was built from a combination of debt and equity. Some was a straight cash infusion and then an additional amount, a larger amount was POL’s first prefunding line. When they create an opportunity with a real estate developer they have to move fast and can fund a deal on a property in 46 states in as little as a couple of days. But to be able to do that they can't and go have it staged up on the Web site and go out to investors and have them wait for their money to come in. That's not really workable. They found that they had to be able to use thei own capital to fund the property to begin with and so depending upon how quickly they scale, if they’re doing $20 or $30 or $40 million dollars a month, they have to have that amount of capital available to fund deals to begin with. Once funded, they can then take it out to investors. Much of the Series A was earmarked for that capacity.
Another part of the A round was used to reinvest in the company. They needed staff, they needed offices, they needed marketing materials, they needed marketing channels, they had trade shows to attend and they needed press releases. Most people don't realize how quickly money goes when you're a new company. It's a huge achievement to eventually get to be cash flow positive.
Finding the deal flow from developers or generating the investor base presented respective challenges. Sometimes one drove the model, at times it was the other depending on the stage of the company’s growth. Initially they had a decent amount of opportunities to be able to fund but they had no investors. So they had to get new investors on board because you can't promise a real estate professional you're going to fund their deal when they may have earnest money down on it if you don't have the investment backing to make it happen. At the same time how do you get those investors if you don't have deals. So there's a chicken or egg argument early on. They needed capital just like any small company to make these opportunities actually happen and it can be difficult advertising for this type of opportunity. They had a constraint in capital initially both on the warehouse lines for prefunding and as well as just investment capital from investors.
Deal size was also a constraint. They can't do a $10 million deal if it's going to take two years to be able to fund while sitting on a Web site. And then once they started getting a lot more attention they started to grow organically on the investment side. They were producing around an 11 percent return backed by solid hard asset that was worth more than the investment to start with. So that was a very appealing product. And once their investors started to see a good return on their investments and be able to get their money flowing in every single month they would tell other folks and it would grow very organically from that. Eventually you get to the point where that balance started to tilt towards having too much money and not enough product and then we had to take internal capital and market back out and find out how to reach out to what can be a very insular group of real estate professionals to be able to get the opportunity to work with them and then it goes back and forth depending on what stage of the company you're in. Today they have billions of dollars worth of capital commitments and can fund pretty much as much as they can get in as far as solid opportunities are concerned as long as there are good opportunities. They get a lot of applications from folk who have big dreams but really don't have a good plan for how to make their project happen and, naturally, they can't fund those. As of the date of recording the podcast, they were constrained on the deal flow side as opposed to the capital side.
Currently, POL only works on construction opportunities with real estate professionals on non-owner occupied properties. A lot of what they do can be called a fix and flip or a fix and rent or a refinance to rent. They deal with folk who know what they're doing in real estate. POL goes back to their investors and are able to say this person has a reasonable expectation of being able to pull off this project primarily on single family residential and small multifamily although they are now branching into small balance commercial as well in the $1 to $5 million dollar segment. They are also doing new construction in specific markets and they are going to be expanding aggressively as they continue to develop skills and making sure to adequately underwrite additional markets for that type of product. They also want to move into long term investments.
To date they have been constrained on doing long term because they have been working with the crowd and the crowd doesn't want their money tied up for five years or seven years or 30 years but that's 85 percent of the market. So it's absolutely a priority for POL to get into that market. As they have grown they’ve developed credibility have been able to engage and interest billion dollar Wall Street firms. Those firms take a look at the loan tape and their underwriting criteria and the viability of the company itself and they've been able to do a forward flow for this type of product. For the longer term product they are currently negotiating and expect to have something in place by year end 2018.
The new products will be along the lines of a 5/1 ARM for a rental portfolio and not owner occupied. They don't want to move into owner occupied opportunities at this point simply because of the regulatory environment is extremely burdensome. When they started this they started because there was a massive fragmentation. There was a failing in this type of industry where the banks wouldn't lend on these types of opportunities but there is a huge market and hundreds of billions or even trillions depending upon how far out in the asset class you go. But the banks didn't do a good job with it. So there's a huge opportunity. The banks do generally a pretty decent job with residential mortgages but Jason believes that POL is in a much bigger market that is so huge that even if he is able to scrape together a tiny bit of market share he figures they will be doing very well.
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.
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.
Sara Hanks is, was, a corporate and securities lawyer of thirty plus years before the financial crisis of 2008+ happened. She was recruited by Senator Elizabeth Warren, who at the time was Chair of the Congressional Oversight Panel for the Troubled Asset Relief Program (TARP), a program set in place to put a floor under potential collapse of the financial system. Sara started the week that the Dow Jones hit bottom although they did not know that until later. After working on oversight issues on Capitol Hill, Sara became aware of all of the various pieces of legislation that eventually became the JOBS Act, and, while finding it of great interest, was also around folk at the American Bar Association who said things like, ‘oh my goodness, they're going to defraud my grandmother!’
Wanting to provide a solution to the defrauded grandmother problem, Sara started talking to a couple of friends she had come to know through the Congressional Oversight Panel and, together with them, set up a company to provide reassurance to people in crowdfunding that the companies were legitimate.
From that point the company expanded and now does all aspects of compliance for online capital raising. Whether it is under Regulations CF, Regulation D 506 (C) or regulation A. and although they did not initially found CrowdCheck as a law firm, because they were securities lawyers by background, people kept asking them securities law questions and they eventually started thinking that they could provide counsel on these matters also. They set up an in-house law firm and provide a complete legal disclosure compliance package for all aspects of JOBS Act type fundraising.
Attraction of the JOBS Act
It was the ability to democratize the capital raising process to permit everyday people to take control of their own financial lives that attracted Sara to the Act. For early stage companies or projects, real estate included, sponsors could now not just go to people who they always go to for capital but could reach out using the Internet to a broader source of capital, giving people more investment opportunities. Its seemed like a good thing on both sides both for the company or project and for the investors providing it was done in a compliant way and providing that everybody knew what the risks involved were which is where Sara saw CrowdCheck coming in.
The easiest of the JOBS Act regulations to comply with is probably Reg D because there is really nothing there. A sponsor is going out to accredited investors only under 506 (c) where, really, the only rules are do not lie and do not make misleading or fraudulent statements. A sponsor still has information is presented in a way that new investors understand. Just because somebody is accredited does not mean that they necessarily understand what all the risks are and, from SEC studies, we know that there are some 12 million accredited households in the US, but that only half a million or so regularly invest as accredited investors. There is a big disconnect. There are some accredited folks who should not be investing in anything, and there is a whole new investor class out there who could but maybe do not understand what they are getting into when looking at a Regulation D offering. And the next level of complexity from a compliance and education perspective, is, of course Reg A where both accredited and non-accredited investors can invest alongside each other.
The Sophisticated Investor
When the concept of crowd funding was introduced, the idea of an accredited investor was supposed to be a proxy for someone who either had experience or could buy experience. They were rich enough to be able to hand this over to a financial adviser and say ‘tell me, financial adviser, is this a good thing for me or not?’ It was always an incredibly blunt tool. The SEC has recognized that for quite some time viz. that the mere owning of various sums of money or earning various sums of money does not necessarily mean that you are automatically able to make investment decisions. On the flip side some folk can be incredibly sophisticated people and yet not accredited, including many SEC staffers among them who are not accredited yet but could make just as good decisions. This could change as leadership at the SEC changes and it is possible that the definition of the accredited investor will probably be expanded at some point in the near future, and these changes could include, for example, adding a level of sophistication by reason of examination. This could capture people who hold FINRA examinations, for example, or who have business experience as another possibility, irrespective of income or net worth.
Potential Changes to the Act
There is unlikely to be any major change to the JOBS Act, perhaps some minor chipping around the edges but to the extent anything goes really wrong then there could be some pulling back, but even that would take some time. First there would have to be the scandal, everybody would need to know about the scandal, and then there would have to be regulations passed to address them. For the foreseeable future, therefore, at most there will be minor fiddling with the edges of the various provisions of the JOBS Act.
Real Estate Compliance
What CrowdCheck does in the real estate space is really boring (!) They do the corporate diligence to make sure that the entity that owns the property was properly organized and then the entity that is doing that is issuing the securities was properly organized and that the two of them have a relationship. The standard structure that seen in real estate is property-owning-company, which may be an LP Limited Partnership or it may be an LLC, and then the issuer which is issuing to the crowd, holds interest in the LP or else LLC holds the property. CrowdCheck verifies that all of those are properly incorporated or organized and that they have authorized the issuance of the securities at both levels and what they very frequently find is that the paperwork around the property owning entity especially can be very sloppy.
For example limited partnership Number Four owns property Number Three, and the issuer saying they are selling interests in property Number Two. There is a tendency sometimes in real estate for successful sponsors to just pull out the last set of documents and mark them up. Another area that they see is the use of cascading pyramids of limited liability companies all the way up because, of course, one of the things that they have to do is check that nobody who is a ‘bad actor’ is involved in the sponsor.
Sometimes they will see several different layers of LLCs which may have been used in order to disguise the fact that there is a bad actor involved who did not want to be disclosed. CrowdCheck’s rules are that they have to go all the way until they hit a human being or an incorporated company. Anyone who comes to us with a pyramid of LLCs will find that they just go through all of the these.
As important a protection as they are for investors, compliance services are not mandated and a lot of the platforms have very limited resources and they are not making a huge amount of money. Compliance services are, therefore for many, a kind of a luxury to a certain extent although one could make the case that not being sued for sloppy paperwork is not a luxury. Indeed, soon after the JOBS Act was enacted, CrowdCheck probably was working with maybe 12 to 15 real estate platforms – but of those platforms only one or two of them still exist. The biggest issue that the failed sites faced was one of deal flow; a lot of them had problems getting enough projects. If a site only got one or two sad looking condo complexes their platform, people are going to come along and see that they are the same deals that were there 12 months ago.
There were three companies involved in a series of discussions with the SEC. Two of them were real estate companies. Sara wrote an article, ‘the lemon squeezer’ article, which came out as a result of a fuller understanding of just how far the SEC would let people go when it came to high pressure, very flashy ads on TV or radio. The issue is that in Regulation A prior to qualification by the SEC – which is the point at which the SEC says no more comments you can go off and sell your securities now – until then an issuer is just trying to solicit interest. During the period up to qualification the issuer can advertise on TV and on the radio. You have to give a disclaimer which you can verbally say telling when the filing has been made with the SEC where that the offering document can be obtained. But until then, an issuer can do these very flashy ads that are almost startling to people with traditional securities backgrounds.
In short, prior to qualification once an issuer is qualified and allowed to take money, the rules change and the SEC says at that point you can only use methods of communication that include the delivery of the offering document which of course you can do if you if you are online – but that cannot do on the TV or radio. So you cannot use TV and radio under present interpretations by the SEC to advertise your company or your real estate project.
During the next downturn, as Warren Buffett says, when the tide goes out you find out who has been swimming without their shorts on, and that is when we will see things start getting dodgy. That is when you start seeing who has not done the paperwork. The tragic thing there is that so many of these platforms are so thinly capitalized that when something goes wrong, just one or two deals go completely wrong, people will start to lose faith. There will not be anything left for anybody to sue, either on the project or for the investors in the platforms themselves.
The next downturn you will see evidence of some sloppiness and that will lead to probably further extinction event of platforms. It is likely that there will also be some consolidation of the various platforms. Many of them are just too small and they are complete niche players, and somebody might scoop in there and roll several of them up.
With respect to downturns leading to changes in the JOBS Act, this is possible if people actually blame the JOBS Act for things going wrong – there are a lot of people who are very cynical about the JOBS Act, concerned about defrauding grandmother. However, any future changes are probably going to come from people suing which tends to happen a lot faster than regulatory change.
Max Sharkansky’s firm, Trion Partners, is in the business of value item multifamily residential real estate. They started out around 2005/2006, right before the recession. Prior to that Max was a broker at Marcus and Millichap and his partner, Mitch Paskover, was working on the debt side at HFF in mortgage banking. They started buying deals towards the end of 2005 and as Max had been brokering multi-family deals in the San Fernando Valley at the time, they naturally started buying multi-family in the San Fernando Valley. That is where they had access to off market deals and market knowledge, and then from there it just snowballed.
They bought two deals in 2005, a few more in 2006, and then at the end of 2006 the partners formed Trion. They continued to buy through the last cycle in 05, 06, 07 and sold most of their portfolio in 2008 prior to the crash. They saw what was happening with Mitch being in the capital markets and Max being in the transactional markets. Their properties when they saw vacancies starting to tick up, and rents starting to tick down. They saw what was happening to the market and so they sold out in 2008. As they were selling in 2008 they changed their acquisition strategy from a value add multifamily. The old model no longer worked so they started targeting non-performing debt secured by multifamily, even though at that time in 2008 there was a logjam in the market and nothing seemed to work. Lenders wanted to sell non-performing debt at 90 cents on the dollar irrespective of the value of the underlying real estate, and Max was looking at deals based on the value of the underlying real estate.
As the market slowly changed, they were able to buy from one local banks and from there they ended up doing about 20 deals during the downturn in 09, 10, 11, 12. About 15 of these were note acquisitions and deals and five were REOs. By that time they had a fully built out their management infrastructure and while their competitors were straight buy the note/foreclose/sell because Trion were operators they were buy the note/foreclose/renovate/lease up and then sell. And it was in having this infrastructure that allowed them to buy the REO products as well. Coming out of the downturn in 2012 they just went back to the value add business and [as of date of podcast call] had approximately 17 properties in their portfolio with an 18th in escrow. Their aggregate portfolio value is around $240 million and they have a gross track record of over $300 million on over 40 deals.
It was a wild, wild west especially during the downturn. Trion grew very organically during that time. They bought their first few properties with their own capital. Both Max and his partner had been pretty strong producers at their respective firms so they had some dry powder and bought their first few properties using that. Then they started to syndicate out to friends and family and colleagues. Mitch reached out to some of his HFF folks to some of Max’s Marcus folks invested and it grew very organically.
During the downturn it became extraordinarily difficult to raise money so they bought a lot of stuff with high octane debt and their own capital. As they got a little further along and developed a track record and more of infrastructure it became a little bit easier to raise money. At the time it was still all friends and family and introductions through referral. They had met some family offices who were able to write larger checks and they were using a lot of expensive debt. Indeed, they were buying notes with other debt, putting debt on debt which was very helpful in allowing them to close.
Two Models of CFRE
Max heard about CFRE through the news when the JOBS Act passed. They started calling around. They did some deals with a RealCrowd, RealtyMogul, RealtyShares and have found them all to have been great to work with. The whole process has been very successful and it has been a large boon to their business. It has provided access to capital that they would not otherwise have had access to, and it has allowed them to supplement equity capitalizations when they very much needed the capital.
Max has found that there are two basic models by which the CFRE websites operate. There is the LLC model which would be like RealtyMogul and RealtyShares where you interface with the platform directly. This model is more like dealing with an opportunity fund, where the sponsor interfaces with one originator, call it, or a deal guy. With that person, the sponsor does a walk through, the deal guy does their own underwriting, there is a lot of Q&A back and forth and the process is not dissimilar from an opportunity fund. In this model, there is no interface with their investors as that all happens behind the platform’s own curtains. Sponsor does not know who the investors are, they do not interface with them before the acquisition, and neither do they interface with them after the acquisition as they are operating: All communication is with and through the platform.
The other model is more of the technological platform model, which is like RealCrowd and CrowdStreet. In that model the sponsor is effectively paying the platform to post their deal on the site. They still vet the sponsor who still goes through a process of sorts, and when a deal is posted on the site there is a flat fee paid to the platform, not a percentage of how much they raise. In this model, the sponsor interfaces directly with investors. Investors, in this scenario, will contact the sponsor based on the posting and with questions about the DD materials. Max has had a lot of dialogue, and Q&A with investors this way, and has even met people on site at properties. Their first property raise through RealCrowd was in 2013and they have investors who have been with them since then doing multiple deals. Even though the process is different, either model works very well.
CFRE Site Input to Operating Agreements
There can be input to operating agreements from the platforms but it generally depends on what portion of equity they are taking. If the deal requires a check of $10 million plus and the platform/investor is taking $1.5 million, they are really not going to have much input into the operating agreement. On the other hand, if they are raising $4 million and the investor is taking $2.1 million then they are absolutely going to have some input on the operating agreement. This is not dissimilar to an opportunity fund or any JV type partner that would go in and mark up the operating agreement and go back and forth before coming to a final contract.
There is a time and place for both models and Trion has used both very successfully. With regard to other sponsors, it really depends on their business as a sponsor and how they want to grow and what they want at a particular time on a specific deal. If they have a deal and do not want the brain damage of talking to a lot of people just do not have the time, then going with the LLC model might make more sense. Here the sponsor will only interface with one person in the raise and the platform gets paid when the money is raised. If the sponsor has a business where they are trying to grow out their Rolodex of high net worth investors and have come to the conclusion that this is the way they want to grow their business for years to come then perhaps the marketplace model is better suited.
In both models, the platforms do the bulk of the marketing. The sponsor does very little. The sponsor might participate in webinars that would be a form of marketing, but these are coordinated and produced by the platforms. In these, the sponsor will discuss the investment and give investors an opportunity to dial in and listen to the dialogue and the Q and A about the investment and then they can submit their questions at the end of the webinar. Beyond that, though, sponsors typically are doing much of the marketing.
Platforms did not start out guaranteeing to sponsors that their raise would be successful, but it seems that the industry is moving in that direction. Fundrise is active in the preferred equity, mezz space and they do guarantee a certain amount but that is a little bit of a different business than the raises that Trion has done.
Max thinks that the opportunity to invest equity in deals through crowd funding is a great improvement for investors over the way it used to be. There is a lot more transparency so some of the more egregious terms that you would see in the old days are not really there as much anymore. For example, back in the olden days you would see much lower preferred returns and much higher promotes. Back when Max started in the old cycle it would not be uncommon to see 50:50 after a 6% pref. and today that is a thing of the past. It is a relic because people have transparency and they have a window into what other sponsors are charging and what is market.
Trion has adopted a cookie cutter approach on preferred returns and promote. For the most part they take a 70:30 split after an 8 pref. and that has worked for them – although some sponsors charge a little bit more. Typically Trion does not do waterfalls but other sponsors will. Other sponsors do but Max and his partner prefer to keep it simple. They do not charge an asset management fee because they self-manage. Some sponsors will outsource their management so they do take an asset management fee. It really depends. It's all case to case, and there is not necessarily a right or a wrong way. There is a very broad spectrum of how to operate.
Platforms do not generally have input into the operating agreements, or attempt to leverage controls that a sponsor has over their deals primarily because, for a sponsor doing a syndication, they need to have controls. In this regard it is very different from the private equity model where the PE firm will have input into key decisions in the deal, and Max has seen some control layers with some of the crowdfunding groups in the LLC model if they have a substantial portion of the equity, say 60 or 70 percent or more of a deal because they own so much of the asset.
The Fremont Deal
Trion purchased a deal that they fully financed and then backfilled using RealtyMogul. It is an 88 unit in Fremont California which is in the East Bay and the Bay Area. Many people have heard of Fremont because it is the home of Tesla auto manufacturing. Tesla is one of the hottest cars out there and it is a rapidly growing car company and because of that there has been an extraordinary amount of growth in Fremont not just because Tesla but also because of AMD some of the other local employers. If you look at it on a map, the town is very strategically located as the gateway to Silicon Valley. The town has an awful lot of overflow from Silicon Valley and the peninsula and Trion loves the market and we love everything about the real estate with regards to the asset itself.
The deal presented an incredible value add opportunity and is very typical of what Trion buys. They bought the asset from the family that bought it from your original developer in 1966. Their basis was nothing; the debt was nothing, and they had been operating the building for occupancy for decades, with little capital put back in. Trion will spend twenty $25,000 per unit on interiors, fully upgrading the interiors. They will tear everything out, and will put in brand new kitchen cabinetry, high gloss very European looking, quartz countertops, stainless steel appliances, full wood vinyl plank flooring, washer dryer in every unit – which is a huge selling point for renters. There will be all new fixtures, all new finishes in the bathrooms, tubs, vanities… basically the units will be like brand new units and they can deliver the finished units to the market place 25% below what a renter would be paying for a brand-new class A property.
The project thesis is to stabilize the building at a low 6 percent cap rate on cost and exit five years from inception at a high four cap which is where properties were trading at time of purchase. The company will grow the rents organically once stabilized at around 2.5% to 3% per year. The project was underwritten to a five-year hold, with a deal level 19% IRR and an investor level IRR around 17%.
Trion paid it $26.5 million for the 88 unit asset, which works out at about $300,000 per unit and $300 a foot because the average unit sizes are right around 1,000 square feet. At time of purchase, the price per pound was one of the lowest that had traded in that market in the prior couple of years.
With regards to the structure with their investors, the deal is a standard Trion formula of 70:30 after an 8% pref. They do not take an asset management fee as they self manage for which they take a property management fee. They have their own crew so they also take a construction management fee.
The minimum investment when they were going directly to their own investors was $50,000 but on the CFRE websites typically that is lower. The Fremont deal was a very large raise for Trion at a total equity of $10.5 million, and they started syndicating the equity with $50,000 to $200,000 investors. They also had a few larger investors who took up some allocation but they were not able to fully fund by closing so the partners put in the shortfall and then went to CFRE to backfill.
It took Trion about 45 days to finance the deal, which included 20-25 investors, and then another few weeks to conclude the CFRE tranche – which, typically in using the marketplace crowdfunding platforms, Trion expects to gets 7-10 investors for a given deal. Max will usually meet the new investors, the CFRE investors, before the close. It can be something as simple as a few e-mails or sometimes he has had them come to his office. There have been times where he has met them on site at the property if it is in L.A. or if the property is in the Bay Area and they happen to live in the Bay Area he might meet them there.
Mitigating Downturn Impact Risk
One of the things that Trion does that really helps them hedge risk is low debt. They do not put an extraordinary amount of debt on their properties. Fremont as an example is levered to about 68/69% percent of cost. Once they refi out of it they will be right around the same leverage at 65/70 percent of the new value based on the increase in NOI.
Real estate doesn’t kill people; debt kills people.
Max is a strong advocate of CFRE. He thinks sponsors would be crazy not to do it. Whether they are a young sponsor or an old sponsor, a groups that has been around for a few years doing it, or a group that has been around 25 plus years doing it. It is a phenomenal supplement to a sponsor’s investor base and anyone would be crazy not to do it. It is a win, win, win, for all involved. Max has not personally invested in other sponsor’s deals in CFRE because he needs to use all the capital that he has for co-invest and in keeping their own deals but otherwise would certainly consider such investing.
Easy for Some
Max’s Trion is a very niche investor. They are not jack of all trades and masters of none. They do not buy five different asset classes all over the country, but rather focus on buying value add multifamily 60s and 80s vintage in four markets; San Diego, L.A., Bay Area, and Portland. Their business model is simple and Max finds that he does not have to explain real estate concepts to investors because it is a fairly straightforward business. It is the business of apartments; they are taking an older apartment, fixing it up, and making it like a new apartment. They explain the details to investors and they try to keep it as layman as possible. It is not, as Max says, rocket science.