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National Real Estate Forum

The Real Estate Crowd Fund Project. Providing you with the tools you need to raise money and invest in crowd funded real estate deals. Crowd-funding, typically associated with business start-ups and 'donation' sites such as Kickstarter, has benefited the real estate industry more than any other. Listen to the National Real Estate Forum podcasts where industry leaders, Founders, CEOs, VC's, sponsors and investors share their insights. For the first time since the advent of the internet, you can now raise money and invest in crowd funded real estate deals online. Download the free primer (pdf) at NREForum.org, listen to the podcasts, and become an expert in raising money and investing in crowd funded real estate deals online.
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Now displaying: Category: crowd funded real estate
Jan 14, 2018

Humble Beginnings 

Chris Loeffler graduated Cal Poly, San Luis Obispo, and started his career at PricewaterhouseCoopers as an accountant going down the corporate path.  An opportunity came to him, during the 2007-2009 economic downturn, to start buying and selling auction properties at trustee sale auctions and basically flipping homes.  He would go to auctions on a daily basis and bid on properties every day.  Together with his partners, Chris would drive the properties in the mornings from 4:00 or 5:00 o'clock until 10 o'clock when the auction started.  They would inspect the properties to make sure that they were not gutted or had cracks in the foundation or other critical deal breakers. And then he bid on them at auctions all day long.

Find this episode in the shownotes here.

Using his own small remodeling company, he would then do all of his own remodeling in-house and would renovate the properties, before listed them for sale via his in-house retail brokerage.

At the time Chris’s financing came from anybody who would talk him.  He did not have any family money or any startup capital or formal venture funding or anything like that. He literally would meet people through the random circumstance of life and tell them what he was doing and ask them if they wanted to flip a home and tell them how it worked and go from there.

Chris tells of a time when he had put a non-refundable, $10,000 check down as a deposit on a property at auction.  He had 24 hours to pay for the property in full, in cash, or lose the deposit.  As he had bought two or three homes already, and only had enough money to fund two, he found himself in a bind with $10,000 on the line.  That afternoon, he met somebody at a Starbucks at 4:00 o'clock, told him the story, and the next day had a new investor who wrote a $50,000 check that helped close on the third home.

Fast forward nine years later and Chris’s company, Caliber, has become a sophisticated real estate private equity company. They are consistently raising capital into different funds with different profiles; long term for growth, short term for a fixed income, or for the mid-term for a little bit of combination of both. The funds operate independently of the deals so they are always raising capital in the funds because they know that they can deploy it eventually.

Caliber is also a company doing real estate deals across the board.  They do hotels, apartments, office buildings, commercial properties, self-storage facilities, single family homes, and all middle market.  The company has built itself up to about $300 million in assets under management and has learned sophisticated ways to raise capital from accredited high net worth investors and their wealth advisers.

One aspect of that is that they are conducting a Regulation A+ listing where they are permitted to raise up to $50 million per year while being, in contrast to Regulation D offerings, not restricted to accredited investors only.  Indeed, Caliber has found that non-accredited investors are typically a little easier to work with and offer better deal because they have a lower level of expectation for a return on a $5,000 investment than a deeper pocketed, accredited investor.

What makes Caliber especially different in the crowd fund real estate space is that they are operating in many ways like one of the market place platforms, but are actually the sponsor also.  Caliber is the real estate manager, is actively the developer, actively buys the deal and conducts the deal making structure and  finance, the do the construction and construction management; everything.  They are not an intermediary, and not a platform. Caliber is a developer with truly vertically integrated platform.  By taking this broad role, Chris finds that they can get very close to the deals and that sometimes that can give them a competitive advantage in the marketplace.

Finance

Caliber has a $100 million commercial asset fund that is a bigger fund than they could do under Reg A, in addition to a Reg A for the parent company. They are seeing competitors who have started to create child funds for $100 million, $200 million, $billion funds and for which they will create a mini new company.  That company will be taken through all the Reg A requirements, which are not that difficult, and they will raise $50 million into that offering.

The only purpose of that company is to buy a piece of the larger accredited investor fund and so in essence provides the non-accredited investor, for the first time ever, a legal way to invest just like an accredited investor would.  They might pay a small spread in fees or something like that versus what the accredited investor spends, but at the end of day individual investors, who otherwise would not get access to these types of wealth building tools, can now get access.

For Caliber, their Reg A+ offering is effectively turning them into being a public company.  They will file a 10k at the end of the year and a mid-year report; no need, under Reg A+, to report four times a year. The reporting requirements give investors a lot more transparency into the business in comparison with investing into a private company which is something of a tradeoff.  But the cost to maintain that reporting can still be manageable and, either way, running $50 million of other people's money, Chris figures is going to be just the same type of external audits and hard core financial reporting that he would need to do anyway if they remained a private company.

What Caliber is using the Reg A offering for is as a bridge to take the overall company, the parent company and take it public.  This entity acts as the general partner and has their equity and their interest and all of the assets that they own.  It holds all the control positions they have and all of their funds as well as their operating companies; their real estate company, brokerage,  property management, construction, development. All of these businesses are rolled up into a single entity, and that entity is doing the Reg A+ offering to raise up to $50 million to become a public reporting but non-trading company.

As a result, for the first time ever non-accredited investors can own a piece of Caliber. The second phase of this will come at the end of 2018 when they plan to list the stock on the Nasdaq and become a NASDAQ traded company.

Deal Types

Caliber looks only to middle market deals.  These are assets that are typically too big or too complex for a handful of doctors to get together, open an LLC and buy.  They are not typically $2 million, $3 million deals that are small enough that a couple of people can get together and buy.  On the larger side they buy assets that are smaller than $40 or $50 million in check size to do the entire deal which are usually properties that are approaching the size that institutions like a REIT, like a public REIT or insurance company might buy.  Caliber does not want to compete with people who have money that costs almost nothing to deploy, and they don't want to compete at too low of a scale with smaller investors who are really scrappy and can afford the time to be able to work the deals at that level.

 

Criteria

Chris stays away from asset classes that are hyped up, although that can change over time. For example, there is a lot of hype around assisted living and student housing and apartments currently.  Having said that Caliber are doing student housing projects and have looked at assisted living projects, so there are always exceptions that prove the rule.

Caliber has an underwriting model that they think of as being elegant and simple. They want to buy an asset where they are getting better than 20 percent discount to market; for less than they we believe the asset is inherently worth.  In addition, they want to see that after completion, the asset can exit at a 10 cap. What that means is that if they buy an asset for $500,000 put $500,000 renovation into it, by the time they are done with the transformation it will make at least $100,000 a year in profit – or a 10 percent cap rate or a 10 percent rate of return.  Then, last but not least, they look for properties with a story. Every deal with a story has the ability to transform the property in some way shape or form so it it is a real deal you can you execute on the plan.

Challenges

The culture of the real estate industry is that a lot of real estate entrepreneurs are pursuing a lifestyle business. If they get good at it and know what they are doing, even in a very small shop they can make a really nice income.  And as they build a reputation over years and years with about 20 or 30 investors which is pretty easy to manage, you can build into a multimillion dollar business. It is not as easy as it sounds, but it is not so difficult once you understand what you are doing.

The problem is if you want to build a real company into a real enterprise that is going to be something beyond something that is just there to serve your needs and your lifestyle. It is a path that is very difficult. There are no banks that view you especially as a small real estate investment company as a lendable entity.  They might lend you money on your real estate assets but they will not lend you the money to build your business. As you build your business you are going to make bad hires you are going to pick the wrong software, waste money on a strategy that does not work, and will be doing this on a fixed income from fees upfront and along the way, but with most of your money comes from the profit.  And you might not see that profit for three to five years.

For Chris, every year for nine years his partners and he have had a look at each other and said, you know, do we want to make money personally or do we want to build the company.  Those, for Chris, are mutually exclusive things. As the company goes public that will allows him to be able to get beyond the main hurdles that stop a company like Caliber from being able to function the same way as if they, for example, manufactured toasters where they would be much more supported in the community in terms of lending relationships and equity capital.  But for his type of business there is really no clearly defined path for growth and a lot of regulatory risk; a lot of execution risk that goes along the way.

Once the company goes public, Chris is confident that the world will change for Caliber. They will become a lendable company and it will be a lot easier to raise capital. But that has been a 10 year process with a lot of risk along the way

Community – The Impact of Crowd Funding

The real estate industry has been due for change for a long time.   If you look at around at our neighborhoods in our communities, there is a reason why you see so many Walgreens in why you see so many strip malls that look relatively the same. And yet when you look at going to these retail outlets where they do look very different is where there are local restaurants and local shops. Why are they these places always packed? 

The answer to that, in Chris’s mind, is that everything in real estate at a large scale has been driven by the public capital markets and institutional capital investing into deals. And what does institutional capital like? They like do the same deal the same way the same time a thousand times across the country so that they can put $2 billion into the strategy to keep it efficient for everybody.

But what real estate is local. It is hyper local. It is one thing on one corner on one street that is different from different corner 1,000 feet away. So what people really want is the local coffee shops. They really want the local shopping experience. And they really want that kind of experience in an office space and in retail etc. and because of that, these crowd funding mechanisms are the thing that will bridge that gap. People are going to start investing in their own communities.  Indeed, 60 to 70 percent of Caliber investors are Arizona residents and they love investing in projects that they can drive by and see that they own a piece of that hotel or the self-storage facility. And in addition to that developers are going to be able to say “you know what, I want to build this really quirky, weird mixed-use type deal here on this corner. I'm going to put a sign up on my property and offer it out to the community to support my project by voting with their dollars. And so all of those things are changing the real estate business because that capital is cheaper than the normal sources of capital. And it is allowing me to build a project that's frankly more profitable.”

Chris thinks it incredibly useful to have local investors for everything. For finding additional investors, for assistance through entitlements, knowledge and support at neighborhood meeting.  When you have somebody who owns another business that is well respected saying that they support the project is fantastic.

Most CEOs of private real estate companies and in the investment business generally avoid talking to their investors pretty much at all costs and when they do they have very structured communications so that they do not have to be in a situation where they said or did something wrong. Chris’s philosophy is the only thing that gets them in trouble with their investors is not having a relationship with them. If something goes wrong and he cannot lean on the fact that they know they are trustworthy people and are just working through a problem because real estate problems occur, then you know that is the big issue.

If you are in the real estate investment business and you think that the most important thing in the business is the deal, Chris thinks you have lost sight of what really matters. It is the relationships; the investors, and it is all about making them happy. If you have good quality equity investors and good relationships Chris Loeffler is confident that the deals will almost always be there.

Jan 9, 2018

The 19th Hole

After graduating Penn State, Adam Hooper started his career as, of all things, a class A PGA golf professional.  Finding that not quite as glamorous as he had initially anticipated, he followed in his family footsteps and, around the year 2003, took up working a regional commercial brokers firm in central Oregon.   It was a really good market and the time and Adam got to ride that wave up, finding that as he was active in a small enough market he was able to gain some experience in little bit of every type of real estate. 

Take a look at the shownotes to this episode here 

In 2008, Adam started his own firm with a partner and focused on single tenant deals nationwide, getting into some of the equity placement transactions, helping developers raise capital for their deals.  Realizing that there was a need for helping people capitalize their projects, in late 2011, he moved down to join a firm in the Sacramento area as a partner where he got a lot more experience sourcing joint venture equity.  The deals he was working on were sub-institutional size i.e. in the $15 to $20 million range, with $5 million to $7 million of equity.

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In one particular deal, he was raising capital for a prolific syndicator with a great track record, great background, and very deep capital relationships.  A sister building came up nearby with very similar project metrics, and of a similar acquisition size. It made sense for the sponsor to capture some economies of scale and this other building also.  The problem was that the sponsor was tapped out of immediate capital sources and reluctant to dedicate time away from his business and his family to go on a roadshow for a month or so, to syndicate another 4, 5, $6 million of equity.

What Adam was noticing was that this was a fairly consistent issue for sponsors and when in April 2012 the JOBS Act was passed, he had a few deals in the hopper with similar fund-raising limitations.  Noticing that sites like Kickstarter and Indiegogo and a lot of other companies were raising capital on a donation basis, it occurred to Adam that there was an opportunity to morph the Kickstarter model to real estate syndication. 

What they realized was the single most important impact that the JOBS Act had was that it lifted the ban on advertising private securities and it allows sponsors to openly advertise their deals online.  While real estate was ever the intended recipient of the legislation, this fact alone has made it one of the biggest beneficiaries of it. 

The way it works is like this.  Ever since the Securities Act of 1933, if a sponsor did not have a pre-existing business relationship with someone, he was prohibited from soliciting an investment from that individual.  You could only offer the opportunity to invest in your deal to people that you already knew. You could not go to a new group of investors that you did not previously know but the JOBS Act lifted that ban completely. 

It was a fundamental shift in how the capital markets can function and access on both sides of the sponsor, investor equation.  To be able to use the internet in place of what has always been a one on one conversation, or a meeting over lunch or dinner or playing golf, is a radical shift for real estate syndication.

Adam believes, however, that while the need for the one on one conversation has been removed by regulations, the need for a ‘relationship’ has not.  The distinction is that while the law now says that you can simply advertise online to attract investors, the nature of the real estate business mandates that you still have to build that relationship with the investor – just today you have to do it in a different fashion; one dictated by online marketing methodology.

In a real estate transaction of any kind, there is always going to be, always should be, a connection between all the stakeholders; the investors and the manager, the manager and the tenants, the tenants and their customer that they are serving.  When Adam and his partners were thinking about how to set up their platform, they were really trying to think of how they can amplify both sides of any real estate relationship. 

In practical terms, on RealCrowd, it is a direct relationship.  As an investor, when you come in, you communicate directly with the real estate manager.  When you choose to invest, you are executing the subscription documents directly from that real estate manager.  RealCrowd does not block that connection, they do not aggregate people into our LLC, and they do not try to obfuscate that relationship between the investor and the real estate manager – a process that you see on some other platforms.

RealCrowd’s ethos is to make it as easy as possible for a sponsor to raise capital, and one of the ways to do this is to dispel some of the myths that sponsors have.  One of these is the concern that by advertising on the internet, the syndication process will have dramatically changed also. In RealCrowd’s experience, the average investment is around $70,000 per investor per deal.  This can range is high as a $120 to $130,000 on some deals.  They like to explain that what they do is no different from that which a sponsor would otherwise be doing anyway if they were syndicating their own deals.  They are still syndicating, they still get to set whatever minimum investment amount that they want whether it is $25,000, $50,000 or $100,000.  They will still follow the same regulatory processes, form the same subscription documents, with the same structures that they are used to.  It is just that now they have this new avenue to reach 25,000 plus members.  And to address the concern of any sponsor worried about having to deal with too many potential investors; Adam has yet to hear anyone complain that they are getting too much attention and need to dial it back.

Fees

RealCrowd functions solely as a marketplace – and one that is completely free for investors.  They charge real estate companies a flat fee for using the platform and the technology to distribute their deals.  One of the exemptions under the JOBS Act for operating a marketplace such as RealCrowd is that a broker-dealer license is not required provided no performance based commission is charged. 

While crowdfunding real estate deals might be seen as a kind of fringe experiment by some, it is, in fact, becoming a meaningful source of capital.  In the early days RealCrowd would consider deals that raised $500,000 to $750,000 as a pretty good result.  This increased to projects raising upwards of $5 million on a regular basis, and the trend is only upward – including a debt fund that has already raised about $25 million through the platform. 

The biggest challenge that the industry currently faces – and likely will face for some time – is one of education.  There is little appreciation or understanding within the retail investor based of the idea of a risk adjusted return.  What does risk adjusted mean versus just choosing the highest number in terms of total returns.  Since the industry’s inception just four years ago, the market has been only on an upward tick.  It has been hard to lose money.  However, the real estate market is obviously cyclical and we are deep into the current cycle.  If the sole decision point that people are basing their investment decision on is what deal has the highest return, without any appreciation for the risk associated with achieving that return, that is setting the whole industry up for a bad time.  For example, if the expectation is set for a senior debt position that you are going to get a 12 or 13% coupon and it is being billed as an ultra-secure investment, you have to understand that these hard money loans are hard money loans for a reason – meaning there has to be an explanation of the inherent risks.  You must be taking on some risk to get to 12 or 13% coupon into debt instrument.  Unfortunately the expectation on what an acceptable return is has become askew from what a traditional healthy real estate return is and should be. RealCrowd has been in a battle from day one that real estate should be viewed on a long-term basis.  Consequently, one of the bigger challenge that Adam sees, is how can to help people or give them tools for education. 

Another barrier is one of accessibility and the related idea that investors have a certain degree of sophistication.  An investor must have a fairly high level of sophistication to be able to look at a portfolio allocation or to choose between 10 or 12 different deals – or more if one is looking across multiple platforms.  You must have a high level of sophistication to make good decisions as to what is best for your portfolio.  Now that real estate investing has been made available at a scale never before possible, facilitating that level of understanding of the options available is an objective RealCrowd works to meet.  Through providing people with the tools to look at risk is to make that more accessible through education and to help make them comfortable lowering the sense of intimidation with choosing deals.  RealCrowd works to look at how to take the person that does not really know a lot about this asset class to have some fundamental understanding to enable them to make the right decisions towards putting some percentage of their money and to allocating it to this asset class in a responsible risk adjusted way. This educational function, Adam believes, is going to be the key to see large scale consumer acceptance in this industry.

 

The Future

Tapping into the retail investor base has always been seen as the holy grail of capital raising.  If you can efficiently access this phenomenal amount of wealth that is not playing an institutional capital market, and if you have an efficient way to access that, that is a game changer.  RealCrowd, and the broader industry, is getting to the point where they are already seen as a viable source of capital and it is only going to grow.  The game has not even started yet, to coin a baseball metaphor.  In fact, Adam thinks we are still just setting the foundations for what does the industry will look like in 5, 10, 20 years from now.  RealCrowd is setting the foundations today so that when the consumer becomes better educated, they can capitalize on capital flows in the hundreds of millions or billions of dollars through the platform.

Dec 20, 2017

A Woman’s Voice for Women

AdaPia d’Errico has recently moved into an advisory role with AlphaFlow.   She is a special advisor with the company, still working closely with them on influencer marketing and business development and promoting the company and its brand.

Read these shownotes and listen to the podcast here.

That said, AdaPia experienced a big shift driven in part by the #MeToo movement.  She found it galvanized her in a way she never could have imagined.  It led her to make a decision to dedicate herself to empowering women to develop their inherent leadership traits and to overcome a lot of the barriers that are not only external societal and cultural expectations, but also largely internal: The voice of the inner critic or fears or things that tends to hold women back.  She chose to work more closely with a lot of women on empowering them to step into their leadership roles that they have inherently and at the same time to work with companies to help them understand how to bring those leadership traits out in the women in their ranks.

 

This has been very strong for AdaPia in terms of the direction that she wants to take for herself and for her business. Having been an executive for the past several years in very male-dominated industries, AdaPia really understands the impact that she has had as a person, as a woman, on the company culture, on the direction, on the productivity, on the values and very much on the culture of the company. She finds that effect is prevalent with many women who are in management and leadership positions in companies, and she believes it is important that, as a society, we continue to develop more women and work with management teams, who tend largely to be men, to develop that further.

 

Why Real Estate is So Male Dominated

 

We can relate this gender bias to the STEM disciplines: science, technology, engineering and math.  There has been some great research done by McKinsey who have noticed that women are underrepresented in STEM disciplines and that as math is a critical skill in real estate finance, you find men disproportionately represented.  It goes back all the way to when we raise our children. Girls are told that they should be nurses or teachers or something in the humanities. They are not encouraged to study sciences and they are often told that they are not good at math. Consequently, they are literally directed in other places, in other disciplines.

 

Women in Fintech

 

From what AdaPia has seen in real estate crowdfunding and, more broadly, in fintech, there are quite a few women; still underrepresented, but there are more than one sees in real estate development for example. There is Eve Picker at SmallChange, and Jilliene Helman who founded RealtyMogul.  Both are real pioneers - not only in the industry, but as women in the space. But this is more centered on entrepreneurship and technology than it is necessarily on real estate per se, and there are a lot of women out there starting companies, who need encouragement. 

 

It is, perhaps, something of a generational shift that is occurring in the sense that real estate crowd funding is a new industry that is emerging during an era of tremendous cultural change in America. For the millennial generation where gender is less of an issue than prior generations, and because crowdfunding real estate is also a new industry, it fits well with a new view of how culture and society should be.

 

Indeed, there are a lot of societal trends being driven by the millennial generation and they are far more focused on values, and their values are around inclusion, and specifically with real estate crowdfunding, for example, access and abundance of information and sharing and knowledge.  Companies that have a social mission or that are mission-driven, that are purpose-driven companies are going to survive the next generation or the next wave of changes in business.  Their successes are going to be driven by millennials for whom having a sense of purpose is very important to them.

 

Goals and Aspirations

 

AdaPia has been consulting for years and that was how she initially got into the real estate industry when she first discovered Patch of Land – and what drew her to them was that they were purpose-driven. They had a social mission – their slogan was ‘building wealth, growing communities.’ For AdaPia, the heart and soul of the company was built on that and real estate crowdfunding was built on the premise of being an industry that was creating more access; it would increase the flow of money to people and projects who needed it and who were revitalizing neighborhoods.

 

Now AdaPia has taken step back and has asked herself what does she want to do with the rest of her career, and with her life. She loves working with entrepreneurs. The favorite part of working with them is in helping them actualize their vision. She remains focused on purpose-driven entrepreneurs, and, especially, with female entrepreneurs. She also enjoys working with companies who use her insights and expertise to help them understand how to navigate the gender disparity that is in organizations.  She assists them to bridge some of the gaps that have occurred since #MeToo, where sometimes people – men – are a little bit afraid to talk to women now in the workplace. Of course, it should not be this way; it is the opposite of what we want as a society. We do not want any distinction between the genders and AdaPia’s mission is to assist her clients to build inclusive, balanced work environments and cultures.

Dec 17, 2017

CFRE – An Educational Challenge

AdaPia D’Errico became involved with real estate crowdfunding around 2013 when she joined the three founders of Patch of Land. It was about three months after they launched and was really the beginning of real estate crowdfunding industry. Patch of Land, a Los Angeles company, was one of the first entrants into the real estate crowdfunding space and, for AdaPia, her industry expertise comes from having been a core part of that team. Their she helped bring not only awareness and demand generation to the platform, but also to raising awareness around the opportunity of real estate crowdfunding to the general public.

Listen to this episode and read the shownotes here 

Indeed, informing people and really talking about the opportunities they have in crowdfunding real estate is very much an educational process.  It really comes down to telling people about it in terms of what it is, what the benefits are, and what value it can bring to them.  One must create a good sense of understanding and awareness. Crowdfunding has a complicated regulatory and legal framework.  You can wrap it in very technical language with a lot of nuances and it can get they can get really overwhelming quite quickly.  It is far better to provide digestible information that helps somebody understand what they are looking at and talking about.

AlphaFlow puts investors side by side with a registered investment advisers (RIAs) simply because they are both looking for the same thing; good risk adjusted returns.  The company tries to help them understand what they want and how they can invest to achieve their goals.  First, they consider their investment profile and risk tolerance as well as other portfolio goals that one should be looking at if one is a financial adviser before making an investment on behalf of a client.  Then it is really about explaining to them the opportunity in the very simplest terms – for example, here is an investment that yields this return.  You get X amount based on an investment of this size. At the end of it you receive this yield times the amount of dollars in invested plus you get your principal back.

 

At AlphaFlow they actually go a little bit further and talk about overall portfolio with investors and RIAs.   This is in contrast with non-regulated, non-registered companies that cannot have those kinds of conversations.  It allows AdaPia and her team to have a broader conversation with investors which is really fabulous because that allows them to help understand the investor better.  Consequently AlphaFlow can fully explain the benefits of their product and how it can fit within a client portfolio.

 

Acquiring Loans

 

AlphaFlow purchases loans from lenders; private money and bridge loans that are sometimes called hard money loans. The company talks to lenders who provide these kinds of loans to borrowers. The lender has a direct relationship with the borrowers and knows them well.  This pool of lenders has little interest in the technology or the analytics where the algorithms are or the investment management style around which AlphaFlow operates. Rather, they look at AlphaFlow as a partner that is creating a secondary market for the loans they originate. From AdaPia’s perspective, she looks at the lenders from the perspective of how they underwrite, how they manage, how well they know their market, how well they understand their borrowers.   Ultimately, if AlphaFlow is purchasing the loans they are taking on the risk. Consequently it is extremely important to understand the process of how a lender underwrites and truly who are they lending to.

 

Robo Advising

 

The AlphaFlow model involves implementing a complex algorithm on their portfolio to create optimal investment strategies for clients and investors.  It can be easy for somebody to mistake what they as robo-advising.  Certainly, this is what some of the big guys like Vanguard and Schwab are doing.  They take certain principles of rebalancing and asset allocation and even tax loss harvesting and automate investment strategies around them. When you invest in one of these kinds of portfolios, you fill out a questionnaire about your risk tolerances and goals and capital available, amongst other things. This is often a big questionnaire at the beginning of the process. Then, when it comes time to invest your money, the process is basically constructed for you to allocate assets across your portfolio automatically. This is where the ‘robo’ comes in; there is no human interaction in terms of putting the whole thing together. It is not a financial plan. It is a portfolio of investments robotically compiled which is not the way AlphaFlow operates.

 

The Algorithm

 

AlphFlow has a team of very experienced portfolio managers who are actively working with lenders to identify deals and who also actively manage the selection and purchase of the loans that are purchased. These folk are highly skilled and actively management the real estate portfolio that AlphaFlow acquires. They utilize a suite of data analytics – for which they have attracted venture backing that is used to continue to build out the tools that enable portfolio managers to make better decisions, to better understand the markets, and to better underwrite the loans on properties in their portfolio.

 

When an investor makes an investment, let us say they put in a minimum amount of ten thousand dollars, within a few days it gets spread across 80 to 100 loans across the AlphaFlow portfolio which is constantly rebalanced  on a daily basis. Rebalancing is done with the company’s proprietary algorithm.  This is where the idea of a robotic function comes in; on the back end where AlphaFlow has some sophisticated principles at work terms of rebalancing money to optimize the investors’ portfolio according to individual risk tolerance.

At a basic level, AlphaFlow adopts a moderate risk profile portfolio wide where loan to value, being the most recognized indicator of risk, does not exceed 75 percent of the total weighted average.  No loans are purchased from borrowers who are first time borrowers because experience is so massively important. Instead, loans are acquired from borrowers who have worked with a lender multiple times, and who has a good track record of paying back

 

Fees

AlphaFlow charges a 1 percent asset-under-management fee (AUM). There are no performance fees but they do have a right to charge other fees which could arise should a loan go into a default scenario.  These fees would cover legal proceedings and things like that.

 

Tech Meets Real Estate

 

In thinking about real estate and technology, Zillow and Trulia are real estate companies truly centered in technology.  There are also leasing technologies, and agent technologies, and then there is this real estate investment technology from which crowdfunding companies emerged as a result of the JOBS Act.  This Act made it possible for companies to seek funding from individuals at scale using the Internet. 

 

Client Base

 

Currently, AlphaFlow only accepts investments from accredited investors, but they also are seeing some institutional activity, interest from financial advisers and registered investment advisers and from family offices. They even have an endowment investing in the platform. The company does not offer a liquidity option so it is not, as yet, possible to trade invested funds although they are looking at ways to configure the platform to solve that problem.  As a result, investors must basically leave their money invested for the duration of the loan which, for the most part, is a 12 month term.

 

Looking Ahead

 

Certainly with housing prices going up, margins for borrowers have been coming down in certain markets but globally, and not every market in the U.S. has peaked. AdaPia sees that some are just getting started. There are still pockets of opportunity having the expertise and the insight and the foresight into those markets becomes really important.  AlphaFlow only looks at the markets that they have identified as being risk mitigated. Some of the data that they look at as is really based on historical pricing of the underlying asset.  Part of their analytics suite allows them to look at the worst-case scenarios. They stress test markets against the worst housing market downturn – which as everyone knows was the 2008-2010 market. 

 

That said, AlphaFlow looks at a 25 year period to identify the worst the market got and that is where they are basing their comfort level on the loan to value. Ultimately you have to look at every loan from the worst-case scenario which is that they may have to own that property at some point and sell it. That is why they are looking at what the lowest price was in any 12 to 18 month period over the last 25 years. From this they gain a different understanding of in the worst case and what they can sell it for and in order to recover principal.

 

The company is more interested in protecting the downside than necessarily in maximizing yield at least for their current moderate risk portfolio. Over time they would like to take on higher risk, higher return portfolios but that is a different game and a different investment altogether. For now their focus is on not losing principal.

 

AlphaFlow has started with the single family private money loans as an asset management platform. There are many opportunities in real estate and different kinds of real estate investment so ultimately the company wants to take the expertise that they are building in the single family residential space and apply that to other segments of the market. For example, looking at multifamily, or small balance commercial loans, or even potentially looking at equity project and are natural extensions of the current model. As the company builds its reputation and its information database and analytics they expect to look at evaluating other property types and other investment opportunities for investors.

Dec 11, 2017

Crowd Funding Real Estate – Intersection of Money, Morality and Justice

Amy has always been intrigued by the intersection of money, morality and justice and originally entered the law profession as a human rights attorney.  Moving to Los Angeles some years ago, she became general counsel of a fledgling company at the time called 'Patch of Land', which is now one of the leading real estate crowdfunding platforms. 

See the Shownotes to this episode here

The company was formed at the end of 2013, when the first of the JOBS Act Regulations became effective.  The key component of the Act is called Regulation D 506 (c), which allows people to go out and raise capital and tell everyone about it. The legal term is general solicitation, but it is basically advertising.  You can raise as much as you want, but only from accredited investors.  Patch of Land started doing deals, and at the time Amy joined there were the three founders and one independent contractor.

Amy’s belief in human rights has evolved quite a bit over the last few years and one of the reasons that she joined Patch of Land was because she was looking for something at the intersection of money and morality.  The company was democratizing access to capital to a class of people that traditionally struggled to get it. Perhaps they were underbanked, but usually they are fix and flip developers, and banks do not lend to them.

For investors she thought that they were democratizing access to investment opportunities that they had never had before. On a personal level, Amy is aware of being female, Asian and relatively young, and that people did not look at her and think "Oh, there's a real estate investor, let me approach them about the opportunity". The best deals usually go to people in an 'old boys' club' - a certain age, gender and race, and they do not look like Amy.

Seeking Efficiency

Her personality has always been geared towards efficiency, and she sees the legal industry as one of extreme inefficiency.  One even incentivized by inefficiency.  She believes that if technology can be introduced into the legal industry then access to justice can be increased, transactional cost for business will come down, and a lot of good can be done.  Today we are in the nascent stage of how tech will affect the real estate industry and Amy sees processes that are inefficient and that could be streamlined and digitized.   She has always looked for ways to do things more efficiently, and being a legal counsel and part of a start-up at Patch of Land gave her a lot of license to reinvent the way practice could be.

Crowd Funding Real Estate Platforms

Every real estate crowdfunding platform is different: some are broker dealers, some are sponsors, others are listing aid companies. Some do commercial, some do equity, some do debt.  The vast majority of real estate crowdfunding platforms have their own standardized forms that they try not to deviate from, because doing so increases the transactional cost.  What usually happens is that the lender will negotiate terms with the borrower, who can then accept them or go to another lender. If they accept the terms, they issue a note and fund the loan, and there is very little negotiation.

On the investor side, when the platform is syndicating the debt out to its investor base there is no negotiation. The first part is about real estate and lending laws, and the second is securities law – you are dealing with investors.  Under these laws, all investors have to be treated equally.

Some Platforms Pre-fund Deals

Each of the crowdfunding platforms do things differently. Some, like Patch of Land, will prefund the loan, and they usually have a credit facility and they get paid back when they syndicate it out. Others will not refund the loan, but will put the terms out to the borrower and then put it out to their investor base for funding of the loan. It is riskier from the borrower's perspective, because it might not be funded.  Sometimes these platforms will decide to make a contribution of capital if a loan is 50% funded, syndicate the debt and then get paid back.

The platforms are not incentivized to invest in bad loans - they want to invest in good ones so that their investors make good returns. When they have their own money in, that says a lot about their confidence in the deal.  We are seeing a trend in crowdfunding as a whole, where if a platform performs a lot of due diligence and is able to curate and choose the good opportunities, the investors start to put their trust in the platforms rather than the sponsors.

An important component of the process today is that now we have the internet and everybody on the Internet talks. For example, real estate crowdfunding investors talk about their investments, and if these are not performing, they warn everybody else. News travels fast online, and people talk when they are unhappy.

From a regulatory perspective, what makes this challenge is that you have got a lot of unsophisticated investors looking at a very sophisticated and complex industry - real estate. Then you are adding the tech layer to it. You may have a great platform with fantastic deals, but if the platform fails, that is another layer of risk that you never had before in real estate.

Real Estate Democratized

An emerging trend is the democratization of real estate crowdfunding platforms, so instead of large, venture capital-backed platforms, we are seeing the rise of tiny real estate companies putting out their own platforms. They are not raising money for other people, but are offering investment options on their existing websites. When someone clicks on this, they are taken to a white label site that has already been built, meaning that the cost of technology to build a platform has decreased. That means that real estate developers are now able to move from getting support from their immediate contacts to involving the local community.

Bootstrap Legal

Amy remains focused on economic justice and efficiency. With the cost of legal counsel so high, any wanting to do a small deal meant that hiring an attorney did not make sense for them.  Instead, they were downloading random legal documents from Google and trying to draft something useable themselves, which got them into trouble.  So much of the USA is powered by small businesses, and they employ a lot of people. And yet there is an injustice when they try to raise capital. They cannot afford to pay for help and when they do it themselves they can structure things incorrectly, which does lasting damage to their business. There are actual cases where start-ups have inadvertently giving away 80% of their company.

Indeed, there is a lot of inefficiency in how law is practiced, and injustice because legal services are priced too high. If we can integrate technology into law, we can bring down the transactional cost of a lot of legal services so more people can afford them, and then grow their businesses and employ people.

Lowering Costs, Speeding Transactions

Starting in the real estate sector, BootStrap Legal is creating software that will automate highly complex legal documents that people need in order to raise capital. These are the legal documents you need for a real estate syndication, real estate private equity fund or a real estate crowdfunding deal. Traditionally, this would have cost anywhere from $10,000 to $25,000, but with Bootstrap Legal the cost is significantly less.

Amy is not only lowering the cost, but is also speeding up the transaction. If you go to an attorney, you would usually wait two to four weeks for the first draft of your documents, but at Bootstrap they are turning them around in 48 hours. This can give real estate investors more time to raise money.

The process Amy is employing at Bootstrap originally was intended to integrate AI (artificial intelligence), but she has found other creative ways to get to where she wants to be.  Amy likes to think of it as 'AI-Lite.'  There are a lot of rules and it is an expert system, but the idea is that the user goes in, and answers an adaptive questionnaire. The system asks what type of regulation they are trying to use and who they are raising capital from and the type of real estate.  Typical clients are real estate syndicators, investors or sponsors - basically anyone who is trying to raise capital for a real estate project.

Legal Counsel for All

Although Bootstrap has started off with real estate, she has her sights set higher. Amy is primarily focused on changing the user experience around how they interact with legal services which currently centers a lot around the attorney.  If it could be centered around the client, everyone would be happier. In particular, moving away from the billable hours system would be better for all. You can make things more efficient by decreasing transactional costs, and clients would be happier. In this way, and through Bootstrap legal, Amy wants to have an impact on creating more jobs and levelling the playing field for all.

 

Nov 30, 2017

The First Regulation Crowd Fund Real Estate Investor

Bill wanted to invest in real estate deal but did not have enough money to do so.  That was until he came across the SmallChange website.  SmallChange had a list of all their currently ongoing projects and they updated it with what the type of project was, and was it open to accredited investors or non-accredited investors.  Not being a millionaire (accredited investor), Bill realized that SmallChange was speaking to him and may give him the opportunity to invest in real estate that he had been looking for.  Being tech-savvy, Bill set up an alert so any time the SmallChange website page changed he would know about it.  In fact, he was waiting for the first moment a project that was aimed at non-accredited investors went online, so that he could invest.

See the Shownotes Pages for this Episode

While Bill was searching for a way to invest in real estate, he was primarily focused on completing his Ph.D. at Cornell in chemical engineering.  He was looking at deep biological topics known as ‘systems biology’ and he was approaching the subject more as a theorist trying to understand how the different cells in the body coordinated with each other to grow new blood vessels.  His research helps explain how the leopard gets its spots and he had spent about 5 years working on this, engaging in other hobbies and interests.  One of these was and remains real estate and urban development and he takes pleasure in understanding how to get things built in society.

Having a family that was involved in real estate back around the time of the dot com bubble in the early 2000s helped acclimatize Bill to the jargon around real estate. His father had acquired a bunch of houses in Portland Oregon and this gave Bill a foundation of education about the financial side of real estate investing – how a mortgage works and what kind of market conditions impact investing.  He came to realize that it is a hard thing to find a piece of land that you really, in a neighborhood you like and then to build something of your own because, in Bill’s mind, every place that is cool has already been built up.

This sense of limited supply in areas that interested Bill drew him towards learning more about the infill process and what it takes to change the fabric of a preexisting city as opposed to starting from fresh.  His process of discovery brought him to the StrongTowns which is a kind of a think tank about how to balance balanced budgets of municipalities particularly in the smaller cities and smaller towns of the U.S.  There is a large infrastructure burden in all these towns because everyone is so automobile dependent and addicted to a low density lifestyle.  This creates a financial burden because tax receipts are too low compared to how much these towns have to spend on infrastructure.  One of the major remedies for this is to add more infill development.  And it was through the StrongTowns website that Bill came to hear about SmallChange and their whole philosophy towards gradual in-fill.  SmallChange, and by extension its founder Eve Picker [listen to Eve talking about SmallChange and her path to crowdfunding real estate here].  Bill sees Eve has having a really important piece of the puzzle of how to resolve infill challenge because she provides the financing.

There is a big difference between wanting to buy a house for yourself and to build it or renovate it and investing in somebody else's deal.  For Bill, the whole idea of infill whether it is him or someone else doing it is sort of an underappreciated economic opportunity.  Bring fresh out of graduate school an in his first job, it is kind of absurd to think that he would be funding his own real estate deals unless he was in the business and was a professional real estate developer.  Instead, investing in a deal on the SmallChange website has given Bill a way to make a little bit of money based on what he describes as his ‘armchair understanding of how valuable infill can be’, and it also provides him with a good chance to learn a lot about the infill process itself. The architect developer on the deal Bill invested in, Jonathan Tate, has been very good about filling the investors in on what the plans are, whether there are legal things that need completing, financing mechanisms and so forth.  For Bill, it is an interesting educational process as much as it is an investment.  A novel take on the oft-cited learn-by-doing approach.

Adding further value to the transaction for Bill is that a primary motivator for him is that the deal has a kind of a social conscience in that it is doing good for the community in which it is located.  This is part of the return to Bill that cannot be measured in monetary ways.  Had he wanted just a financial profit, he could have just as easily picked up a real estate REIT that went out and built greenfeld houses in Arizona somewhere.  If making money were the primary driver there are better ways to do it like, perhaps, investing in the stock market.  Bill is expecting around a 10 percent overall and the project will take around a year to complete, maybe a bit longer.  For him, the return is comparable to what he would get on the stock market, ‘but way more fun!’

But for socially conscious investors like Bill, the investment was as much about the project and the almost the aesthetics of the kind of building of which he wanted to more built.  He has invested in two beautiful little houses that he himself would love to own but cannot afford today.  He longs for the day when there are more homes like the ones he has invested in and by helping Jonathan build the models in New Orleans.  Bill sees it as being in his own self-interest in a way because, perhaps, a home like that will be available when he can afford to buy one himself.

Researching the Deal

To figure out a market that is thousands of miles away from him, Bill did his homework. He studied all the documents about the deal on the SmallChange website and that are readily available to anyone with an interest in investing.  He went on real estate sites like Zillow and looked at what is available on the market right now and what that has to do with proximity to transit and jobs.  He likes the neighborhood where the deal is situated.  You cannot find a single family home in this area because everything is either a duplex or a mansion so the only way to buy and live in a single family home in the area is if you are willing to spend a few million dollars.  So the little ‘starter homes’ that Jonathan Tate is building and that Bill invested in really fits in this niche of being highly desirable detached product in this neighborhood. It is high quality construction and small but still something that a family could afford.

1st Regulation CF Real Estate Investor

The foundation of credibility came from the SmallChange website and from Eve who is a thought leader in the space. Adding to this is that Jonathan Tate has a very established practice.  Having been the first person to invest in this deal, Bill Bedell holds the title, unless proven otherwise, of the first Regulation Crowdfund, the first non-millionaire, real estate investor.  If he could Bill says that he would invest in every single deal that comes my way as long as it looks as high quality as the first one.

 

The $2,500 Home

Bill has a novel perspective for what it means to be able to invest in deals like he did on the SmallChange website.  He sees it as a way to build wealth.  Many people see buying a home as the best way to do that, but, for someone like Bill, coming up with the thousands of dollars necessary for a down payment to be able to do that might simply make entering the real estate market practically impossible.  The way Bill sees his $500 investment in the Jonathan Tate house in New Orleans is as though it were the requisite down payment needed to buy a house.  If a down payment would usually be 20%, then, the logic goes, his $500 investment just bought him a $2,500 home.

This works well because it means that anyone can have a Harvard educated architect – as is Jonathan Tate – doing the heavy creative and development work and the investor can just get his or her returns from that without having to do the work themselves.  Crowdfunding offers a huge opportunity to investors like Bill Bedell, and Eve Picker has realized that there is a space to kick start, to borrow the metaphor from the original big crowdfunding website, to kickstart some projects that were not traditionally attractive to banks.  In this way she is using crowdfunding to show that these kinds of deals are viable and as sort of a line of evidence that there is real enthusiasm behind this kind of development.

Nov 25, 2017

SmallChange

Eve Picker is an architect by training and fairly early on in her career she was always very interested in cities and took herself off to New York City to Columbia University to do a Masters in Urban Design because she was interested in the design of cities and not of just buildings.  After she moved to Pittsburgh she found herself living in an area that was in need of revitalization.  She became involved in creating a community development corporation and went about the business of using nonprofit dollars to try and revitalize the neighborhood.

See the Shownotes to this Episode

It was a natural step for Eve to move into doing real estate development herself and she started doing projects her own.  They were always in neighborhoods where she felt she could make a difference, but, disconcertingly, she found that they were generally really tough to finance.  Remarkably, one of her more challenging projects actually 12 different sources of financing on it.  And yet Eve felt that these were areas in inner city neighborhoods that were in the greatest need of change and consequently innovation would be important if she was to have an impact.   Then came along the bank meltdown of 2007/08 restricting still further her access to capital, and Eve found that banks became even more conservative than already they had been.

She did not have a group of equity investors; her partners were often the city of Pittsburgh who wanted to see grittier areas revitalized, and with the cutting off of finance she was unable to any longer do the kind of socially impactful development work about which she was so passionate.  She laments that she was “stopped cold in [her] tracks, and so when she heard about the JOBS Act and crowd funding she found it especially fascinating because she thought she could create a tool, a way for developers like her to raise funds for projects.

Eve saw the JOBS Act and crowdfunding as an opportunity to actually help developers like her raise funds in a different way; to raise a very critical piece of funding for their projects and that is precisely what she is doing.  Eve thinks of SmallChange as being a mission driven business that wants to make an impact.  She has created a ‘change index’ on the website that keeps her true to this mission, whereby deals are measured by the amount of good that they can bring to a community.

Although Eve formed a crowdfunding portal, she prefers to think of her business more as a financial technology platform.  She has moved from being a developer to helping to create a financing tool.  She has a real estate equity crowdfunding platform that, at its core, puts investors together with real estate developers online.  Registered with the Securities and Exchange Commission and a member of FINRA the financial regulatory agency, Eve’s site is one of only a very few in the real estate space that has gone through a highly regulated process of approval to be able to use the brand new security tool called Regulation Crowdfunding – or Reg. CF for short.

The securities law that allows for this has only being active for just over a year and it is really the first time that unaccredited investors – the average man and woman in America – have been permitted to invest.

On the SmallChange platform, while there are investment limits based on income and net worth, anyone over the age of 18 can invest in a real estate project and that is really a ground breaking difference in the world of real estate finance and development.  Developers can set the minimum investment amounts very low and indeed on the first offering [check the podcasts with Jonathan Tate, developer, and Bill Bedell, investor from that deal] the minimum was just five hundred dollars and probably about a third of their investors invested in the minimum for that project.

Eve is passionate about her business and talks of being ‘in love with regulation crowd Crowdfunding [because] it's a way for people who live in cities and neighborhoods to really engage in a meaningful way in the built environment around them. And it's clear that for the first time that they've been given that opportunity.’

Getting Your Deal Funded

To get your deal funded on the SmallChange website you will need to start thinking along the lines of how you would be presenting were you to take the deal to a bank for a loan – only without the bureaucracy and institutional frigidity.  Put together a quick high-level summary about the project where it is, why you want to do it, how you think it will work and a set of numbers, a budget an operating budget, a project budget and demonstrate that it all makes sense.

Depending then on precisely what are you requirements, you will review the three potential securities regulations that apply – Regulations D, CF, and A+ – and will be advised which probably makes the most sense for you.  Once you have decided which format to go with, you will be guided through the preparation of a disclosure document or an offering packet.  This typically involves a restatement of what the deal looks like and includes how you are going to pay investors back, how investors are going to make a return, a review of market comparables that make sense… Basically everything a bank would ask for.

What sets SmallChange apart from any other platform is that no other funding portal offers Reg D and Reg A+ offerings also but Eve went about structuring SmallChange to be able to offer all three.  Once you get into the weeds, so to speak, of presenting your deal online via SmallChange, you will see that the use of what can only be described as truly plain English.  Eve is particularly fond of this aspect of disclosure.  She likes rules that are meant for the lesser sophisticated investors and that is what she has built her platform around.

Challenges

There are many more people out there who are not even aware of the possibility that they can invest in these incredible deals; not even aware that they are permitted to invest. This is hardly surprising since 97 percent of the population was indeed not able to invest in this way until the middle of 2016. The biggest challenge SmallChange faces – and other similar sites – is probably getting enough eyes on them so that they can grow quickly enough and offer enough opportunities to people.

One compounding challenge to resolving this is that Regulation Crowdfunding has very strict advertising rules, whereas the other regulations do not. Of course, you can never promise anything in securities any way because there is always a risk to invest so you have to be careful about your language no matter what.  But Regulation Crowdfunding is especially strict because the intention is that everyone sees the same information at the same time on the Web site and so how that information is disseminated is very strictly governed.

SmallChange Deal Flow

SmallChange is very active in places where there is a lot of change going on. Like Los Angeles where there are some really big zoning changes and similarly in the Hudson River Valley where there is a lot of movement out of New York and Brooklyn.  They are also finding activity in Newark and New Orleans where there are a lot of creative architects.   [Of course, SmallChange does not limit it range to just these areas so if you have a deal that you think might make sense, contact me a the link at the top of this page and I will gladly provide feedback for you on your deal]

SmallChange makes money in Reg CF offerings by charging transaction fees to the developer, typically a 5 percent commission on whatever the site raises.  [Again, if you process the deal through the NREForum we can probably assist you get a decent discount on this fee].  Although the site can accept it in lieu of the fee, it has not yet been given common stock or anything in exchange for funds, though this may change. In Regulation D because the site is not a broker dealer it is not permitted to charge a commission so instead negotiates a fee with the developer on a case by case basis.

Pursuant to Regulation Crowdfunding rules, SmallChange is not permitted to talk directly to unaccredited investors although communication is permitted through social media.  But the unaccredited investor is a group of people who is ready and waiting for this kind of investment opportunity. It is very different talking to an accredited investor who is going to invest a larger amount of money. That kind of investor is used to investing in a more traditional way and, in some ways, the those conversations are actually more difficult because for them it is a very new way to invest and they use to conversations around investment that may not happen in the same way in crowdfunding.

The Unaccredited Investor

Eve is finding that unaccredited investors are coming to crowdfunding real estate joyfully. SmallChange’s first investor, Bill Bedell wanted to be the first one to invest in a Regulation Crowdfunding deal. [listen in to the next podcast episode to hear Bill talk of his motivations for investing].  The accredited investor is often motivated by things that go far beyond money and, so far, it appears that there are geographical variations in how the accredited versus the unaccredited investor thinks and acts.  Talking first of the Regulation D deals, the accredited investor only.  There it seems that think the tendency is more to invest in your own city, whereas the unaccredited investor looks to influence change in neighborhoods anywhere that they can. In fact, the first Regulation Crowdfunding offering, which was in New Orleans, attracted investors from all across the country. It was a first-time opportunity for people to invest in real estate and they were interested in the project and they invested from places as from Indianapolis to Florida, from Boston to Los Angeles. 

The Change Index

If you want to raise a million dollars from both accredited and unaccredited investors it might make sense to do a side by side Reg CF and a Reg D offering, which SmallChange is alone set up to do.  The smaller deals are very difficult to make money but, says Eve, ‘boy, I still want to keep doing them because some of those deals just matter so much.’  Whether it is a tiny deal, or a larger one, as long as it is consistent with the change index, SmallChange will take a look.  The Index is essentially a tool that is used to measure the impact that a project can make on a community.

It looks at features such as the walk score where the project is located or is it close to transit or is there a business corridor nearby. If there is a sustainability play, are they using green building practices or is it in a principal city or is it close to a park or plaza.  If it is a residential project does it activate the street with a porch or low chair and table; are jobs created?  Is it an underserved community.

Eve is frustrated with the real estate crowdfunding industry because she sees that they really use buildings as a way to make money and do not think about buildings as a way to make places better. She believes the industry can do both and that because of crowdfunding and the influence that investors will have on the motivations of developers, in 10 years from now people will have started to build investment portfolios out of businesses and buildings about which they care and not solely for the money.

Nov 12, 2017

CONSPIRACY AGAINST THE LADY

Real estate is not just a financial services play but it is the largest asset class pretty much in the world, and just everything involving a transaction for real estate is subject to change.  Most particularly it is the intermediary person who has, in most industries, been removed.  The same thing is happening for real estate as well though real estate is probably the hardest one to change partially because the frequency, at least for residential real estate.

LISTEN TO THIS EPISODE IN THE SHOWNOTES

Every industry is a conspiracy against the lady.  In the case of real estate, your average consumer might buy a house every seven to ten years so transactions are not so frequent where consumers are up in arms about getting better service or better functionality.  Plus there are entrenched forces within real estate where you have this idea of concentrated benefit and diffuse harm. This apparent when you ponder why it is that real estate fees and commissions on residential real estate transactions are still stable at between 5 and 6 percent. That seems odd when there's so much competition and when there are so many different technology platforms that would drive that potentially lower.

But part of it is this idea that there is very concentrated advantage to real estate agents who benefit from that fee enormously and that that is their livelihood, and where there is somewhat diffuse harm in terms of consumers who would prefer not to pay such high fees. But if it is a once every 10 year transaction and then once every 10 year fee consumers do not actually care enough to drive change in any way themselves. It is harder to affect change in industries that have those concentrated benefits, diffuse harm and very episodic transactions as opposed to very high frequency transactions.

FINTECH

Fintech is the merger between finance and technology, though the skeptical view of fintech would be that it is much more Fin than it is Tech. In general, fintech is just technology enabled businesses that are trying to do something around finance.  We have to think about solutions where banks, for example have branches that we no longer need, and a lot of old fashioned in-person communication that is also anachronistic for mundane transactions. We look to the types of businesses that we can build, because of these things.  Essentially, fintech is creating a marketplace for all things around money and for which there are four different categories.

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

While today we might apply the epithet ‘fintech’ to a company, in 20 years you are not going to think of it this way, but rather you will think about it as your bank or as your insurance company or your retirement account.   Only it will look very different than those types of companies look today. 

Similarly, you might think of Point or PeerStreet as being technology enabled investment platforms.  At their core they are simply technology businesses; there is no branch, there's no retail establishment. It is just a website where you go and it is a marketplace where transactions happen.  You can think of PeerStreet as being like eBay for hard money loans, and of Point as the eBay for equity shares in residential real estate.

WHAT MAKES FOR A GOOD VC DEAL

As venture capitalists, when we look at opportunities what we think about is the team, it is very, very good, and is the opportunity enormous.   In the case of Point it is about rethinking this idea of how does residential real estate work and that it does not make sense to only have two methods for dwelling. The first method is where one rents and is where one owns zero percent of the residence. The second is called owning in which case one will eventually own 100 percent of the residence by using a bank as a 30 year crutch. But why is that?  Why can someone not own 92 percent and sell the other 8 percent to somebody else.  We invested in Point because we thought it presented a very interesting opportunity where technology had come a long way and could resolve this anachronism.

So figuring out how to finance the loans or the equity slugs that you do get to homeowners is a good question for kind of the broader use case of a fintech. 

The venture capitalist does not buy the assets that these fintech firms originate.  This is an important distinction because the assets that are originated look more like credit instruments that might yield 10 to 15 percent or some cases even more.  Getting a 20 percent annual return secured by a real asset might be pretty compelling, but ironically it is not very compelling for venture capital.  The venture capitalist is betting on managers like those at Point and PeerStreet to yield, every once in a while, a thousand times return on equity.

PEERSTREET

PeerStreet is about people that buy old properties fix them up and then sell them typically within a short term time horizon.  So for PeerStreet it could be described as being speculative but in supply constrained markets with low loan to value ratios a strong case can be made that it is not that speculative of an investment. 

The main characteristics that make PeerStreet compelling is that they have a very unique model.  A local private lender may make loans to real estate developers in his vicinity and over time comes to understand what kinds of loans and which borrowers pay back as promised. Once they are paid back, they can make loans again. The problem for the local lender is that they cannot scale their model, but they can scale much more quickly if they could go sell part of the loans that they are originating to a third party – and that is what PeerStreet does. 

Very important for PeerStreet, of course, is to avoid adverse selection so the company actually does its own underwriting on top of the underwriting that the local lender has done.  In fact, they scaled to over half a billion dollars of loans with no defaults in just their first couple of years.

A compelling aspect of their model is that, normally, intelligence is trapped in humans heads and PeerStreet is kind of the opposite in the sense that they have identified this and are using it to their advantage.  They recognize that the local lender understands their market intimately and has their own network of borrowers that they go to.  So by utilizing this network of lenders, they are able to force multiply the market.

This is very appealing because your average venture firm might give seven to ten million dollars as an initial investment where it can be very difficult to get the customers and the cool thing about PeerStreet is that they actually they do not have to spend any money getting the end customers because of the relationships they are leveraging with local lenders.

POINT

Apart from the product type, the main difference between Point and PeerStreet is the duration of the investment.  Point presents a much longer duration product.  Point is also an equity product that can lose money if the value of the home decreases, as can PeerStreet, but it is a secured form of equity, backed by a lien on the property.

ANDREESSEN HOROWITZ

Alex is one of nine general partners at venture capital firm Andreesen Horowitz and they are the ones that make the investment decisions, but in addition there are some 120 other people that work at the firm.  Unlike other types of VCs Andreesen Horowitz brings added value to portfolio companies beyond capital infusions.

For example, they provide recruiting support because it is very hard to hire engineers.  There is a policy and regulatory affairs team, and another team on communications and marketing.  Additionally, every single one of their fintech companies needs debt capital, and in some cases accredited investor capital, so these are areas of support that they have been beefing up also.

Nov 6, 2017

Transformation of Equity Financing

When the JOBS Act which of course created crowdfunding came on the horizon, I said to myself, one, this is super cool, but two, this is going to transform the American capital formation industry because it's just about bringing the Internet into capital formation. Something that we haven't been allowed to do for 85 years by publicly advertising private investment. I just said this is this is going to be transformative. Disruptive. Awesome.

Listen to this episode on the shownotes page

Crowd funding Dominated by Real Estate

Probably 90 percent of crowdfunding is still real estate. When the JOBS Act was enacted most people actually saw it as kind of a Silicon Valley phenomenon and that we were going to see lots of high tech companies; who's going to be the next Facebook kind of thing.  Indeed that is what the first sites were really about. And I actually wrote a blog post way back then and said, well what about real estate. Real estate is perfect for crowdfunding. For one thing unlike a social media startup, investors investing from a thousand miles away can see a picture of an apartment building or a house or whatever the deal may be.   

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In addition, in real estate equity crowdfunding companies are actually issuing stock and giving people something for their money that is making people investors rather than just donors – in contrast to many crowd funding sites geared to business startups. This is, in part, what makes real estate by far the dominant sector in crowd funding.

Transformative for Real Estate

I don't it's hard to speculate about what impact equity crowd funding is going to have on real estate because it's just the internet and whenever the internet comes to an industry whether the travel or the dating or taxicab or the hotel industry, It is totally disruptive. The internet directly connects buyers and sellers and gets rid of middlemen. So traditionally private real estate transactions are financed through lots of very inefficient and opaque private networks. Who you know, who does your father know, who does your friend know, who does your lawyer know. But this is just a normal thing for the Internet to do.

The internet comes in and says, none of that matters anymore because now you can connect directly with your customers and for real estate developments that means investors. What is happening now and what will continue to happen I'm sure, is that as the word gets out, as the public education process continues, within a few years when a real estate developer wants to raise money the first thing that will come to mind is let me go online. Let me get listed on a crowdfunding site. It just will become the normal way to raise capital. That's what's going to happen.

Impact on Private Equity Funds

The Internet of course first picks the lowest hanging fruit and then it picks a little higher hanging fruit. At the top of the tree there's always fruit that the Internet doesn't pick. In the real estate market the sweet spot now is maybe raising a few million dollars for a developer. That will go up and up, but at some point it won't go up anymore because the efficiencies that the Internet is bringing to bear on the market no longer matter. That is to say, if you're the New York developer who put up the new World Trade Center, if you're raising billions of dollars, that market is already a very efficient market in the sense that everyone has access to the same information and everyone knows who the players are. The Internet doesn't have much to add at that level. In this way private equity firms won't be driven out of business, but they will see their lowest hanging deals disappear and they will move upmarket. That that's just what happens when the internet comes to an industry.

Crowd Fund vs. Private Equity: Better for Sponsors

I'm sure you could find a deal if you looked hard enough where someone paid more in a crowdfunding deal than he or she would have paid to private equity. But by and large crowd funded equity is less expensive for the sponsor than is private equity. The real estate crowdfunding world sort of started with some developers going to a meeting in New York to meet with the private equity folks for the umpteenth time and coming back and saying, we're just not doing that anymore. We're not dealing with those guys. Many of my real estate developer clients have told me that they could get their deal funded by private equity but that they can get a better deal from the crowd.

Industry Challenges

I think investor education is certainly what I would say is number one. Crowdfunding, particularly the kind of crowdfunding in which ordinary investors can participate, is very new.  It will take time for information about the crowdfunding opportunities to penetrate.

Indeed, depending on the geographic area, some people have not heard about crowdfunding at all. It is still something that only at the far edges of public consciousness. People are becoming aware that they can invest outside their ordinary choices they have; mutual funds and pension plans. So that's the biggest impediment. And after that there are other impediments to the growth of the industry. I think all of which are pretty transparent if you start checking around real estate crowdfunding sites. The sites can be better. The consistency can be better. The ability to compare apples to apples can be better. The explanations can be better. I always say we're in crowdfunding we're where the car industry was in 1914 its just right at the beginning with almost all of the innovation yet to come.

These things tend not to go on a linear scale. Once it takes off it will grow extremely rapidly.

Standardized Contracts

The benefits to investors of having standardized contracts I think are clear. There are people who have a hard enough time understanding the differences between two real estate investments without on top of that needing to understand the differences between multiples 100-page legal documents that go with each real estate deal. There is no reason at all for deals to have different document sets.  Indeed, as I have said , what the Internet does is it squeezes middlemen. Well, in private real estate transactions among the many other middlemen there are these people called lawyers and securities lawyers. And there's a lot of money that gets spent on lawyers in private real estate transactions but does not have to get spent. Should not be spent. And the Internet just has this way of finding inefficiencies and kind of pointing the finger at you and saying, you're getting paid too much for this. So that's definitely going to happen with legal documentation.

Impact of the Next Downturn

 

There will certainly be a shake out. I'm concerned as to whether some platforms, good platforms, can survive a downturn in the way they depend on the cash flow from doing deals. There will be definitely a cut to people's cash flow and I hope that all the best platforms can survive. I'm a little bit concerned about it and I think the weaker players probably will not survive. And we're also going to see investor losses as well. And we're probably going to see lawsuits. We're going to get negative press. People are going to say you lost money in these crowdfunded deals and we'll be able to say but you lost money in the Dow also.

 

There will be a public relations downturn and the public will get a little skeptical, but this is just the normal business cycle. It's inevitable that the Internet is going to you know come to dominate the capital formation industry as it dominates other industries. It will be a temporary down and then the industry will pick itself back up.

 

Nov 5, 2017

PeerStreet - Investing in First Position Debt on Single Family Homes Nationwide

Listen to the Episode and Read the Shownotes here

Brew Johnson: [00:00:00] I was in law school from 98 to 2001 during the dotcom boom and did an undergraduate degree at USC here in L.A. and went to law school at UCLA across town and had planned during the dotcom boom obviously like everything was tech and at law school I was planning on getting into when I graduated, you know the whole goal was to do tech work in the tech industry. And so I graduated from law school I went to work for a top 25 international law firm that was the number two kind of largest tech focused firm in the world, a firm called Brobeck, Phleger & Harrison.  And when I was in law school I helped my brother found a tech company which was a user generated content travel company. And I planned on kind of doing tech work and obviously from the start from you know from 98, you know 2001, the dot com bubble that exploded kind of. And then in 2001 obviously.  So I got out of law school going into this great job with this firm. And when I was in law school was I was working on IPOs and in M&A and just all this exciting stuff and I got out and things had blown up and cratered. So the office that I was going into there was something like 10 or 11 incoming lawyers were coming in. And they fired most of them except me and one or two others and said basically, hey, the tech work had completely dried up.

Get Your Free Primer on Crowd Funded Real Estate

Brew Johnson: [00:01:21] So we have labor work or real estate.  Our labor or real estate departments are busy. So where do want to go. I said real estate and this it was one of those kinds of serendipitous kind of things, I think. So I started practicing real estate law. And I got recruited to go over to what is generally regarded as the top real estate firm on the west coast, a firm called Allen Matkins which you may have heard of.  And I started practicing what was by happenstance really, I mean to be totally frank. I kind of started practicing real estate law from 2001 to through 2005. So I kind of came out of the dot.com bubble environment into this real estate market that was starting to go crazy. And when you are working for a firm like Allen Matkins you just get exposure to all every sort of real estate related client from major banks to small banks to developers of all size I mean everybody from the small local developer to you know Toll Brothers and Centex and Lennar and just are just huge breath of experience and things were happening on the market just didn't intuitively make sense to me you know. I'd go out to our clients projects you know or I'd talk to somebody had qualified for a loan that felt like it was dead all the time.

Gower: [00:02:34] This was when exactly what, this was 2005 and six or so...

Brew Johnson: [00:02:38] To be honest earlier than that because the whole thing that was strange is that well my first firm I represented, the client was a master plan developer who was developing Ladero Ranch in southern California this huge master planned community in southern California. Every week they had this project and like prices were just going up as early as 2002 and very early on a weekly basis. And you know the story was like oh it's just the affordability. Interest rates are low. People can afford more. And it's kind of like OK well that makes sense when interest rates are going down. And the reason interest is going down is that the Federal Reserve is driving these prices down. After this dot.com blah. OK what happens if this unwinds. So really very early on in 2003 it just seemed like things like the whole the whole that was driven by this kind of thing was being driven by monetary policy always seems strange to me. And it does seem like, OK well this is not a sustainable kind of thing if that's the only thing that is driving this. You know obviously things revert to the mean and then there's probably like a point where rates are going to be going down or affordability isn't going to continue going up and then so it just it started pretty early and kind of like OK well that makes sense to a certain degree. But is this like a sustainable thing or like why that affordability is driving things. And then just as years went on it just like it went from that affordability thing and the interest rate thing to just like this excess liquidity.

Brew Johnson: [00:03:58] So it was like a lot of things built on it and you know a day like what was happening in the market just didn't make sense intuitively to me and I became obsessed with what was driving everything. So the first signs were in 2002 2003 something like OK the thing is this affordability argument is a complete, it's not forever and then as thing got later in the cycle it was just like I mean it was just almost without doubt like across the board of stuff going on there was insane. I mean you know we had clients were buying properties you know for 5x with, you know industrial properties for five x what they traded for year before because there were going to put up 10,000 condos in that city that it sold a thousand condos over the previous decade. And there were 150,000 condos going in the next city. You know there's one of these things and you hear people rationalizing things like oh they're not making anymore like Las Vegas is all land constrained and it's like. Well no it's not. If you've ever been to Vegas you know there's no constraint on land and like you all these kind of stories that seem like these justifying them you know just your saw this kind of that classic behavior of people you know like people I'm friends with who were buying properties to sit on and hold for six months or sell you know like that.

Gower: [00:05:10] Right exactly with that. No added value. Exactly.

Brew Johnson: [00:05:13] Yeah. Yeah. You know it's almost like a story of you know who it gets attributed to like whether it's Baruck or Joseph Kennedy or like pre-crash in the 1920s the shoeshine boy you know like giving him stock tips. Yes you know it was like a similar environment I mean I think my haircut is like a Supercuts and the hairdresser was giving me advice...

Gower: [00:05:37] Right.

Brew Johnson: [00:05:37] Buying condos in Vegas and that's a great way to get in early to make all this money. It was insane. So you know so I just became obsessed with it. I became obsessed with the securitization market, everything was driving it and it was just like such an obvious house of cards. I mean in 2004 I convinced my fiance to sell our condo that she'd own for two to two years in Brentwood and doubled in price right. So like I was very it was too early on the side, so I started shorting Fannie Mae and the banks because it was just to me it was like it was it was based on this crazy leverage. I mean you know people that have 50 homes that were financed by 100 percent financing by banks just you know holding so they appreciate value. Like if you have no if you're getting 100% financing from financing to buy a product you don't own property you're renting that property, so you have no skin in the game so anything if interest rates spike up a little bit that's going back to the bank so to say that idea of excessive leverage and risk taking in the system which was just so apparent to me pretty early on,

Gower: [00:06:35] Well listen you know what. I think this is probably amongst the most valuable experience anybody could have in this space. Right. When we talk about crowdfunding and the JOBS Act and the way the industry is developing just to pivot to the bigger picture. Briefly before you continue one of the issues is the JOBS Act was enacted in 2012. Right. So nothing that has happened yet in the crowd spacing real estate arena has seen a downturn in the cycle. It's only been up-tick so far. So having the insight that you have in what happens when the market has a downturn I think is absolutely critical. And as we get a little deeper into Peerstreet, there's actually something that I've seen you do that I'd love to talk to you about. But before we get, you know I have written it down so I won't forget it, but let's continue with how you got to Peerstreet and how you managed to bring these two worlds together.  Tech and real estate.

Brew Johnson: [00:07:37] Yes. You know and I can to I sort of go on for hours but I think it's important like that sort of perspective and so for me like on that side of the table like I identified some early in it being a 100 percent certainty that it was like a house of cards and just I mean my brother would always comment what was the worst cocktail party host because everyone was like talking about how much money were made on these condos in Vegas and I would just telling everyone that the world would end constantly what are you. It was one of those really frustrating things. The fallout effect of it was be so massively negative so many people. Right. It was like really this was this frustrating thing and to me it was just like the system the base of the kind of this mortgage finance system seemed broken to me.  And I mean I try cut this out but it's like it's really instructive of how we structured PeerStreet. Like today it was I want to talk about a little bit you know and the other part that was frustrating me is like I knew this was coming. And I'd go into my like my 401k account or my wife's 401K account and they like the safest option that you can choose,

Brew Johnson: [00:08:43] the favorite option was like a U.S. government bond fund like there's one of those classic back in like 2000 and my wife worked for a major pharmaceutical company limited choices of what you could invest in for the safe option was the Goldman Sachs something like the U.S. government bond fund and if you went into that thing it was about 1 percent or 2 percent treasuries and the rest would be like CDOs and all these like crazy leveraged vehicles like or not. So it's like right here right. This like the securitization finance machine driving this thing and just putting the average person at risk. So it was just incredibly frustrated with me. So by the end of 2005 and I I had this idea that OK the world is definitely going to end, I don't know if it's going to end next year or in three years, but it's a 100% certainty that it's going to happen, in the kind of financial market. And so I was planning on doing like a you know waiting for the things to fall out and then doing  some sort of like a real estate vulture fund or something. But my brother had this tech company that I helped him found when I was in law school and it was growing and he needed help.

Brew Johnson: [00:09:45] So I went to work for him as his general counsel and Director of Business Development.  And that was like in 2006 and you know helped to build  that business but you know as well as anybody that like the cracks in the system were happening in 2006 and  2007 and you know Lehman was kind of like the final straw but like it's not happening much earlier than that. And you know people were kind of deluded by the fact that it was happening. And I persuaded my brother into selling his company because I was like look at this is bad things are happening. But the key feature is I think like coming out of the real estate world like which you identified as like so just you know it's antiquated and old school for reasons because it's like this physical you know market where things are very unique and you know you need to  know there's a reason why it hasn't been transformed by technology and it's the kind of last major asset classes do it. But then they go into day to day operations of the tech company and seeing the power of it. At that point I thought wow when the banking sector a huge portion the banking sector goes away there's going to be a need to fill the void.

Brew Johnson: [00:10:48] And I saw with companies like Lending Club and Prosper were doing in consumer credit and I thought wow if we could do something like this in real estate it can be incredibly powerful. So I actually kind of started incubating this idea in 2008.  I actually worked up a business plan but it wasn't the right time for a lot of reasons. A lot of it had to do with the legal and regulatory environment right.  But I put the idea on hold. You ended up selling my brother's company to Tripadvisor which at the time was wholly owned by Expedia. Stayed on there for a while. But during the crisis you know did a lot of things,bought foreclosures, bought distressed notes from banks made a lot of hard money loans to other people who were buying foreclosure. And had this really interesting experience.  Now fast forward to 2013. A lot of things had changed in the market that made this business that had been very passionate about them going back four or five years, very very, a a lot more viable. Right. One is the JOBS Act and I think the passage of the JOBS Act itself was kind of like OK this is big, but when the SEC promulgated the original rules of how they would like enact it it was like OK now is a good time to do this.

Brew Johnson: [00:11:50] But in addition to that like LendingClub had hit critical mass in the consumer credit space things were going on in Europe in terms with crowdfunding and peer to peer lending and markets place lender. The market acceptance of it had kind of hit that. And so at that point it was like a bunch of different real estate stuff  I was working on. I had put everything on hold and then I reached out to my co-founder Brett Crosby to raise some money for the idea and then we started building the business. And so that's kind of the background of it and the reason I can of got long at it is that that long kind of background of the real estate legal this kind of securitization, this knowledge of how at least large big picture of how that system works and the kind of tech aspect of things and how to create like a stable tech platform. We kind of pieced it together in a way that we think is very unique and different than anybody else is out there doing any sort of like you know what is crowdfunding or marketplace lending in real estate and the end of the day is sort of a pause there for a second.

Gower: [00:12:51] Well I was just going to say yes tell me in what way is it unique. Why is it unique and you picked a particular asset class to pursue. So tell me about the asset class that you're looking at why you like it's a particular, Brew in the context of your experience having seen a major downturn.

Brew Johnson: [00:13:11] Yeah that's a great question. So just in general I mean I am a firm believer that I mean the transacting through an online platform and the idea of crowdfunding and allowing people to access investments but access it, you know, in smaller amounts more transparently, I think it's just clearly the way the future goes. You're looking at types of assets invested, and obviously in real estate investing which you know as well as anybody. There is a million flavors to real estate investing right from equity investing to preferred equity to mezz debt to you know all sorts of things. And so if you if you look at it from the outside. OK. Where is the most appropriate place to do a real estate investment on line. Right. And so if you you are looking in, the second piece is like okay if you're going to be exposing investors around the world creating like a platform there's things you want. You want to kind of grow a large online platform you need, it's imperative that you establish credibility right. And it's imperative that you do your best to establish some level of safety or security for investors right. And then you need something that can scale because like if you're not going to be scaling down large numbers a technology platform doesn't really work and it doesn't provide that much value to the to the users, the participants right.

Brew Johnson: [00:14:34] And so I guess one example to look at there's like you know in the back in like the dot com days, it would be the difference of like you know they like the field and it's like eBay or Amazon versus somebody that has a shop and puts up a Web site where they can sell their goods. Right. There is power in that in that scale because scale creates network effects. It's like OK I'm so kind of this idea that scale is important. Credibility and safety for safety for investors and credibility for that platform to help loosen up scale that feels important and what the class of the most appropriate to do this and to me you know. And then the other fact on my side of mine and Brett my co-founder considered is like we think the long term ramifications of a platform like de-leverage is like a marketplace where you know we're more of the marketplace lending, or in a market place for investing in real estate. We actually think of the long term ramifications of like are very very massive it could potentially transform that securitization market I was talking about.  So for us it was like OK. The most appropriate asset for most investors to invest in is real estate debt. And specifically first position lien debt. The reasons are obviously very simple; it's the safest part of the capital stack. Right. It cash flows so that throws off cash for people.

Brew Johnson: [00:15:56] And it's also just a lot more consistent in terms of like the idea of like you know if you're doing an equity investment in real estate that's an independent kind of deal that almost every single deal is unique and there's not that much consistency. So the idea of being able to create a sustainable platform that provides value for both investors, you know let's start with investors, you need that consistency you need that homogenization and really something that you know in our opinion where you know put them in a safer position than other options out there so we specifically from day one we're saying we're going to focus on first position lien debt, because it's safer than other types of kinds of real estate investments. We think it's more appropriate and also it's like in the event that there is a downturn and you're kind of trying to create a new industry or a new asset class that is investing online, in the event of a downturn that end investor is much more protected. So that's part of what dictated the idea of all right there's always risk in investing. But if you're the opening of a platform to kind of the masses and investors you want to position from a place that that is that puts them in this in the most consistent and of the options out there, the safer part of capital stack.

Gower: [00:17:05] Ok. So I think that you have actually have a very interesting metric. Your capital is used to take out local lenders. What I would call hard money lenders and you are welcome to correct me if you don't like that term.  Who invest in local people local developers who are doing single family home primarily single family home loans for fix and flip typically. You have a minimum loan to value threshold so that's fairly standard but you also, very interestingly, you also have a metric that looks at that particular location's decline relative to its peak over a 20 year period right to measure what your maximum leverage is going to be. Can you explain that to me because that's an interesting thing how you came up with it and why you think it's important.

Brew Johnson: [00:18:00] Sure. So obviously like the number one risk factor in a real estate loan and to acquire a loan is the loan to value.  Is the loan to value ratio. So the idea is like OK that's the starting point. But I think the idea of when we look at risk in in a loan in terms of that particular metric. The idea is okay well you know what are the typical risk factors of the loan, like what is the LTV. Who is the borrower, you know, those metrics. But the idea of that kind of looking at data to make informed decisions or investors to make informed decision I think is like a part where that hasn't been available for before. So you know for in our opinion if you're looking at kind of historical cycles of the real estate market, it's like you can have a great LTV but if you're in a market that is declining or you potentially have a huge amount of overhead or a huge amount of inventory your risk factors a lot larger because if things slow down, prices would drop and or there's a lack of liquidity.  So the idea of like trying to analyze what is the health of a sub-market where a property is located kind of currently and what we think kind of like the current health of that market, then also letting investors look at the term and like OK what's the worst case scenario in this market. You know is this the type of market that during the financial crisis drops 5 percent.

Brew Johnson: [00:19:19] Or is it the type of market that drops 50 percent. And so I think the idea there is just getting a lot of investors to to make a determination or be able to go serve that information where investors can say can look at it and make informed decisions. So for us it's kind of like when I look at investment I'm kind of like one these cynical guys following people I always start from like OK what's my worst case scenario on this particular investment. So that's really the idea there and like look at you know the classic thing that history doesn't repeat itself kind of thing but of like you know it rise thing. Yeah. We have this recency effect of what happened in 2008. Could there be another financial crisis. Absolutely. Could there not be another financial crisis for another 20 or 30 years yeah that's possible too. But I think the idea is like being able to form a decision and allowing people to look at information is OK here's this loan, the market is currently trending up and oh by the way crunching a lot of data and statistics it looks like it's forecast to continue going up but if for some reason that's wrong in the market turns here's what a potential downside scenario I think is important. Now so I think that's important like looking on a loan by loan basis and investing on a loan by loan basis.

Brew Johnson: [00:20:27] But I think the most important part of why Crowdfunding is such a, or crowdfunding or marketplace investing, or marketplace lending, or however whatever term going there they're all kind of like related to each other but to me the real innovation in that is the ability to allow investors instead of like investing in one loan at a time or one investment at a time and putting a large amount of money in a concentrated position. Have a look at that loan. Analyze the risk for them or whatever, you know whatever the risk is. But  spread the risk across a huge broad a broad pool of loans to be able to minimize risk through diversification. And I think the combination of looking at data smartly and looking at data correctly is also the ability to just diversify very very broadly. It's like just a fundamentally different way to invest in real estate. And real estate  a little bit but particularly in real estate debt there's never been a vehicle like that. And so the idea is like to be able to kind of create these, a), let's analyze data but be very transparent with it so investors can look at it and it's get their idea of what they think the risk is. But the last piece of it is allowing investors to get broad diversification. We think that combination is very powerful.

Gower: [00:21:38] Right so in your case the broad diversification is instead of putting for argument sake, say $100,000 into one loan with one guy on one house in one town, you could put ten thousand with ten on 10 different properties across a range of locations.

Brew Johnson: [00:21:57] That's right. That's right. And so you know and I think I guess I kind of skipped so I guess I skipped over a little bit the asset class; that a hard money lending.

Gower: [00:22:05] Yes, tell me about that because that's something unique to PeeStreet as far as I can tell at least so far.

Brew Johnson: [00:22:14] Yeah. There's other players playing in it. But the way we the way we've attacked it that you've identified is like partnering or you know or working with these off line hard money lenders is a very unique thing. So yeah I mean like for the focus of the asset class is short you know is short term bridge loan on single family property. To fix and flip and kind of short term bridge or short term buy or rent type loans is the focus. And so yeah you nailed it historically it's been called hard money lending. It's kind of had a negative connotation historically in certain areas because historically you know the kind of use cases like either a real estate investor or entrepreneur has a property or finds a deal that they want to do. They need to move quickly on the deal. So they need they need capital fast so they would historically go to a local hard money lender pay a very high interest rate to get a short term loan to go buy and take down a property and then potentially sell it or refinance it later you know to take out to take out a short term high interest rate loan.

Brew Johnson: [00:23:19] It's a really interesting kind of shadow part of the market in this niche part of the market it's always existed and been there, and it's actually been very important. But historically it's an incredibly localized business. And you know borrowers have borrowed there were very local, the lenders that operated there was very local borrowers typically only had one or two kind of places to go to kind of source that type of short term capital. And then investors most investors, it was just kind of lucrative asset classes almost like this country club thing whereas certain lenders would make these loans and have their own capital or have like a small network of friends and family that they raise capital from to lend wit. So it was this really highly fragmented localized market. But incredible risk adjusted returns. I mean if you look at like you know historically hard money lending you can range from anywhere from 10 to 20 25 percent annual interest rate on a secured loan that is collateralized by real estate. And so this really is just really interesting niche market.

Gower: [00:24:15] So Brew, let me ask you, how did how did this niche market perform during the downturn.

Brew Johnson: [00:24:22] Yeah great great question. Great question. So it really depends on who the lender was and who the originator was. And so this is a key key thing and my love of this asset class, like when I was, my best friend's dad growing up you know he owned a ton of property in our hometown single family rental properties he made up much of his hard money loans or trust deed investments and you know in California. And you know over 30 or over a 30 year period he never took a loss on a property because he lent you know in areas that he owned property understood of the value the value of these properties and where he'd be comfortable owning that property. Right. So and when I became a real estate attorney and was doing these deals are like people making these loans at 3 percent interest or 4 percent interest on a commercial property or something like that, I was like there's another thing where people are making 15 percent return and I know for a fact that these guys have never taken a loss on these properties. It's just an amazing risk adjusted returns; this major asset class right. And but during the crisis guys like my buddy's dad or the experienced lenders who lent in their area and knew it very well and put their own money at risk and knew that they performed OK. They did well. A classic example is one of the largest hard money lenders in the country is Anchor loans in LA and they have been lending for a long long time very experienced.

Brew Johnson: [00:25:42] Through the downturn their investors, you know I think their yields to their investors went down like 1 percent or something during the crisis. And I think they as a fund they may have cut their management fees, but their investors didn't take a loss during the crisis. Now other people lost everything right everything because they were making risky loans and they weren't structuring loans correctly and they were over there were over advancing and giving too much capital. So I think the idea here I think the key thing is like look at people who know what they're doing and have expertise and track records and you know understand their markets are lending it and their borrowers. I think will fare well in almost any and in a variety of different markets. And so in terms of kind of like a regular functioning market I think it's a good asset. And then there's this other kind of interesting thing that in downturns lenders that know what they're doing to lend in downturns actually become have an advantage of countercyclical because downturns' source of capital dry up. So I actually like advance rates can decrease and interest rates would go up but really who makes that loan is really really important in my opinion. So when you asked earlier that we structure things a little differently, is there's a lot of people out there in crowdfunding or marketplace lending that are going and wanting to do the deal or investment directly or make a loan directly to a borrower.

Brew Johnson: [00:27:06] You know in our opinion you know we don't want to be in the lending business and we don't want to do that because in this asset class it's such a localized business we rather rely on we would rather rely on those lenders that are track record and experience to go in the first layer to go make a loan to go underwite a loan, to go service a borrower. And so that's our idea here was like OK let's create this tech platform that that connects those local lenders to the capital markets and to investors. And by doing that and being this kind of intermediary between those, you create value for all parties. So the analogy here is really what we're trying to do is take all the positives from the securitization market that exist in regular lending you know broad diversification you know cash flow, all that stuff but apply it to this more lucrative kind of historically very fragmented market but then learn from all of the issues that created the financial crisis. You know leverage and allow investors to get invested in this asset class, access it, be able to diversify, in a way that they had never been able to do before by investing small amounts across a lot of loans as opposed to putting a lot of eggs in one basket. Right. And then and then make it a hassle free and very very transparent. So my so. So that's the idea. So we try to kind of the idea is like OK we've create a secondary market for these lenders out there. We can drive down capital for their business to go make loans for more borrowers.

Brew Johnson: [00:28:34] And then at the same time providing us this access to these investors we look at it as like a much better asset and so do you if if our opinion that's the proper way for a crowdfunding platform or a marketplace like us to invest is not to be the one out making the loans, it is to be the gatekeeper intermediary between those are the connective tissue between those groups the investor and those kind of the experts. And I actually think this is kind of similar model while we think it's more appropriate in debt because we think debt, the consistency you can apply technology a lot more consistently to debt, I think the same concept applies to equity investing in real estate and Crowdfunding. And so I think the idea there is like look at the experts of real estate are experts; they know their market. They do that. A new entrant that comes in to try to compete with existing experts doesn't make as much sense as opposed to being this this intermediary that aggregates up high quality supply curates it, and then homogenizes it for investors we think that's the proper way to attack it. So that's a fundamental difference of like how we're doing things versus most crowdfunding companies do that. Our goal is actually to be an intermediary in that because we think if we don't find value to both sides of the marketplace and reduces an adverse selection and risk for investors and things like that.

Gower: [00:29:54] So the due diligence that you conduct actually is two layered; one, you do due diligence on the lender.  Presumably that's your primary due diligence. You look at their background, their experience, their track record. And then you also screen out their deals and presumably also cherry pick might be the wrong word but you pick the ones that fit your own risk profile. Right. That conform with the your 20 year downturn risk adjusted investment strategy.

Brew Johnson: [00:30:27] Yeah that's right. That's right. That's right. Cherry picking is I mean you know cherry picking. Yeah. That's right. And that's the curation aspect of it I guess is not cherry picking as much as; the goal is to serve as many high-quality assets and the highest quality amount. Right. Right. So the idea is like yeah we have our we have our underwriting kind of overlay that we lay on top of.

Gower: [00:30:49] On top of their overlay. Right so they have their own underwriting standards and then you apply another layer on top of that and whatever screens through from theirs that meets yours as well goes into your pool.

Brew Johnson: [00:31:05] Yeah that's right. And so look at a loan that like you would look at on a loan by loan basis. So our goal with this is like look at that local lender that lender the one who is making that. You're premise is exactly right. We first underwrite them, and that's the first step that is very very key and get comfortable with that sponsor effectively. Right. And a track record in the licensing and their legal and all of that. So once they're onboard them then they bring us these loans and so the idea is right. Yes. You know can you just say you've got the value of that low that local ideally local expert with track record and then we have this overlay. Now our overlay tends to be a little more conservative than if you know our underwriting guidelines like our maximum LTV is generally a little below what the overall market out there is for these loans. And at the end of the day like some local lender, like we have a max loan to value of 75 percent currently. A lot of markets people lend more in certain cases and as we grow and develop more data in terms of what we think of like our high performing borrower loans and market we  will adjust that will adjust that LTV and set it up in certain cases right if it's like if it meets a fact pattern or data set that seems to be that to allow that.

Brew Johnson: [00:32:25] And then if investors had wanted more risk they can take that. At the end of the day the person who is mostly right, if one of our local lenders wants to make a loan at a 90 percent or 95 or even 100 percent LTV to a to their best borrower because they know the street they know the borrower, they are comfortable with it and things are going great. Well I think that's fine if that lender wants to take that sort of risk as they know their market really well. But for the average investor who's investing his assets from some or that's probably not the appropriate type of risk right. What was interesting about the platform itself is like we can kind of have the best of all worlds.  Those local lenders can still take the risk level and we and so investors invest at a healthy deal level that we're comfortable for. They idea is like you know try to surface those what we think our higher quality assets and higher amount.

Brew Johnson: [00:33:18] This is a combination that we think is powerful. I think over time the more data you collect by analyzing what people are doing and which lenders are having great track record over you know you can then adjust the underwriting criteria to do that. But it should be data driven and it is one thing that most people don't quite understand how important the originator is, or that sponsor is in deals. I mean if you go back to the financial crisis you know if you look at like all loans originated by Wells Fargo IndyMac Washington Mutual that may have been securitized and had a very similar rating on top of them or like look very similar from a third parties view. But after the crisis the default rates on those loans were significantly different. Right. Like what. Wells Fargo outperformed those guys by a pretty significant degree. So there is this important stuff like who was actually that first kind of touch on the loan and the idea is that investors probably want not only more diversity across loans but also diversity across originator, or across the lenders who originate those because you know that potentially reduces risk.

Gower: [00:34:21] So where do you see the future for PeerStreet and for this industry all together. Right. That the real estate and what you might call crowd funding will syndicated finance and the way that regulations allowed.  We are right at the beginning of the of this new industry where do you think is headed, Brew?

Brew Johnson: [00:34:41] I think it's a form of bifurcate out you know debt from equity as a starting point and sort of like let's focus on what's, let's talk about PeerStreet because I live and breathe that every day. But like right here we think like technology. I mean we our whole thesis and I truly believe that that technology is going to completely transform real estate debt and the mortgage finance system and I know that if you ask what our long term vision for the businesses we think we think PeerStreet can disrupt the entire mortgage securitization market the finance market is really that's what kind of what we look at is like OK if we're if you can connect investors more directly to loans more efficiently and they get better yields and have a better product by having more transparency and the ability to do. You know it's a fundamentally better way for investors to invest in any sort of real estate debt

Gower: [00:35:38] You're talking about market rate loans as well as hard money loans aren't you.  That's a very big picture. That means that I want to go and buy a house and instead of going to the bank for my 4 percent loan I might come to somebody like PeerStreet who is able to offer competitive products. But instead of lending to me through deposits it's actually financed through your network of investors. Is that what you're talking about?

Brew Johnson: [00:36:07] Yeah. That's that. That's absolutely correct. I mean and the reason why I think that's the future and this is I mean big picture of things that I think some people like when I talk about this they look at me like I'm crazy or an alien. But if you think about they if you think about the big picture. I mean most people are saying that almost everybody has exposure to mortgages and real estate debt a traditional type mortgage debt. Right in the in the way the current system works is like a bank or something we'll make a loan. And if a bank is making a loan they're using depositors capital and they're applying leverage to it and they're making a loan for it and they make it. They make they make revenue and then they pay nothing to the depositor for it. Then that same bank sells that loan to Fannie Mae or Freddie Mac and then Freddie Mac brings in you know, spends a lot of money and creates bonds and may sell it off to financial institutions and then they create these mortgage backed securities these bonds and then that that bond, that mortgage backed security makes its way down to things like the Pimco Total Return Fund which is almost,last time I checked which is probably nine or 12 months ago was 47 percent mortgage related assets.

Brew Johnson: [00:37:15] Right. So every pension fund and bond fund is filled with mortgages right. But by the time the interest payment from a borrower goes from that borrower through to that end investor over 50 percent of the of the interest payments are stripped off to these intermediaries. Right. And so here you have this system where the average person is subsidizing the bank on the front end and then subsidizing all these like intermediaries on Wall Street and these other kind of financial firms and managers while it makes its way down to their retirement account. It's kind of perverse if you think about it from that. So like for me like going back to 2007 I would much rather have my money distributed across mortgages that I directly or almost directly owned versus having my money in a bank because banks were highly leveraged and could go out of business. So in the future I could see like you know I think in the future instead of having money actually sitting in deposit people can have money and distribute it across these loans actually earning the interest rate off of that versus that interest rate being able to go distribute it out of the intermediaries. So that's kind of the long term vision of a of a business like this.

Brew Johnson: [00:38:23] And you know we probably don't see that there's any reason why we think that can happen. Now whether somebody comes to PeerStreet directly or comes to some lender I don't know if that really matters directly I think. I think that what matters more is that if you have investment demand from investors on one side of the marketplace you can fund loans either through and through other other lenders or directly. But you can fund way more efficiently because you're not leverage that you're not putting the deposit money at risk. And so there's less there's less regulation for it. But then the other piece is interesting is that you could hypothetically price risk on a loan by loan basis much more accurately. I think that's why I think that's why by Crowdfunding and marketplace lending, however you want to describe it, has such a potential profound effect and just one little anecdote here, not to ramble, I mean definitely if you and I go into a bank to get a loan for the regular mortgage system and you go put 50 percent down and I put 20 percent down; if we go to the regular channel our interest rates are going to look very very similar. Now my guess is with your background and your history and everything you're probably a phenomenal credit.

Brew Johnson: [00:39:30] Right. And if you put a 50 percent down you should be getting a much lower interest rate than I am by putting 20 percent down. But it that doesn't work that way because of the averages which they are based on. Now the irony is there is investment demand it on the through the you know from investors for that really super like that your type of level of credit and it's at a lower rate than you know four percent of the market. So you could actually get the system I believe where like, you're not only are you giving better yields to investors better ways to borrowers. You can create a system where loans are funded really really quickly without having to go through the long onerous process.  But more importantly priced accurately, so you go in if you want to get a loan, here's the interest rate you should pay if you put 10 20 30 40 50 percent down to buy a property and that interest rate should accurately reflect the risk the risk for your particular loan. So that's where we think the future goes.  I think every type of will go through a platform like this because it's just more transparent, it's a it's a it's more transparent more data driven and it's better for both investors and borrowers.

Gower: [00:40:34] Well it'll be interesting to see how the industry evolves. Let me ask you a quick question actually that I've been thinking of as you've been talking. When you buy a loan and provide a secondary market to these lenders in local markets do you buy the loan with your own funds or investors funds and then backfill with crowdfunded money or do you only fund if you're able to fund it on the platform.

Brew Johnson: [00:41:01] We buy the loan and then we sell it off...

Gower: [00:41:06] And then you backfill. OK.

Brew Johnson: [00:41:08] I mean I think the goal the future would be like to to not. I mean that's just that's more a function of kind of operate. I mean in the current environment I think over time plenty more of that goes away and you just match things directly out. Currently we buy it. So there we have that we have a period where we have effectively a balance sheet and own it.

Gower: [00:41:25] Yeah. So the reason that the reason I asked that was because it sounds like when you start to scale up and do low credit risk market rate loans that you could almost create a fund. I don't know if you can do this under the JOBS Act but where you create a fund.  Maybe it's a Reg A type of scenario. Actually it might be Reg A+ where you create a fund that itself, it sits there waiting for borrowers to come along and as long as it meets underwriting you can fund with that.

Brew Johnson: [00:41:54] Yeah yeah. You know that's that's funny actually. So we've had conversations internally for that because it's an interesting thing it's like short term duration there's potential for liquidity from the people. Investors have asked like who are interested in that sort of thing. So there's some potential to do that or that sort of that sort of thing as well.

Gower: [00:42:15] But on the on the same. Right. But on the same side though you also need a secondary market for your loans right because if you putting out money to market rate loans you know on a 30 year basis you know that's that's a long time to be sitting on debt even if it only has a five or six year predicted life. Nevertheless you know it's a long time on on on low interest debt.

Brew Johnson: [00:42:39] Yes you are absolutely right.  I guess that's what that's that's one of the reasons that's kind of the last piece of like the ability to move into those longer dated assets like the 30s like the traditional mortgages right 30 right. There's the liquidity issue is massive there, right, like being locked up for that potentially locked up of that time. So that's a you know that's clearly not a place to start but it's a place to work towards in the future.

Gower: [00:43:01] Yeah well that's what we're talking about.

Brew Johnson: [00:43:02] Exactly. Yeah. So I think so to me like that you know the liquidity aspect of it's kind of like a future piece to solve. And so there's either right, the  kind of idea on that is either you know I think in the future the reality is there's like some sort of like a platform like ours look from investors side looks more like you can invest in a fractional piece of a loan but trade in and out of it almost like the New York Stock Exchange. You know something like that I think that creating some sort of a liquidity vehicle for investors to be able to like, I think that's I think that's where the future things happen. Potentially not. But I think the other thing is like you know there could be capital markets take out like an institution.

Gower: [00:43:40] Well exactly. Exactly. It's you know securitization if your pool's big enough you can go that kind of route.

Brew Johnson: [00:43:47] Yeah. And so I think the reality is I mean like practically like the reality is is that the securitization market or capital markets take out and then in the future some sort of liquidity thing gets involved. But I I think one thing actually I should probably highlight the idea of the crowdfunding. I think a lot of people think OK this is a bunch of like mom and pops like you know small investors are investing in this but the reality is we have major institutions that invest alongside in individual investors. You know we have institutional take out from I mean mortgage REITs hedge funds. So the idea to this is that the long term goal is clearly give like any investor more direct access and allow them to do that. But you know I think that piece is interesting is that this is the type of asset that institution as well love. And I actually like most sophisticated institutions in the world are investing right alongside individuals and that's think an interesting thing that looks like you know I think we have the same idea that why have money in bank accounts because the reality is like you know it's a long term time before you get there.

Brew Johnson: [00:44:55] And a lot of investors actually rather have an institution invest their money or at least like it right now. So you know we have. And one of the names, you know one of the reasons we named it PeerStreet was the idea is like you know individuals can be peer with Goldman Sachs like the most sophisticated  investor and access the same investments of the most sophisticated institutions in the world right. And the idea is like, that everybody should have access to the same type of investment. So they're leveling playing field between Main Street and Wall Street that's really been kind of like an ethos for us and like we say having institutions are important because institutions will help scale. Scale's an important thing for all investors because it means more loans means more data means more diversification. And so the idea is kind of like a lot of those investors of us side by side. We think this is important.

Gower: [00:45:44] Brew.  Thank you so very much indeed for your time today. You are an absolute wealth of information.

Brew Johnson: [00:45:51] Well again I'm sorry if I you know I think you probably tell that I like I am very passionate about this. I think this is definitely the future of investing and I think that the future of real estate and I think and I think why it's so powerful that I think it provides a better investments for investors but also provides better and more efficient capital the to borrowers plus real estate sponsors. I clearly think it's the future.

Oct 17, 2017

Crowd Fund Capital Advisors Group 

Crowdfund Capital Advisors was born with two entrepreneurs, Sherwood Neiss and Jason Best, who, after the market crashed, felt that businesses were really having a tough time raising capital and, having gone through trying to find capital themselves for their own different entities, realized that there had to be a better way to capitalize businesses.  Once the JOBS Act was passed, and while it was wending its way through SEC processes, the principals visited and advised entities in over 41 countries on how to develop meaningful legislation and ecosystems that support the financial growth of their own entrepreneurs.

LISTEN TO THIS EPISODE ON THE SHOWNOTES PAGE

CrowdFunding

Crowdfunding is actually a way to do something that that has been done forever:  It is nothing more than thinking about passing the church hat except that it comes in many forms. It can be through the form of a donation like passing the church hat, it can come in the form of a rewards based prize, or, as in the case of real estate, is can be that you receive a share of something in return for the money that you give.  Until the JOBS Act, unaccredited investors, those that did not have high net worth, were not able to access the kinds of deals that typically high net worth individuals were able to.   It opened up a pathway for both equity and debt investing, that was not available to the common person.

But what crowdfunding really needs is education because so many people out there think that it is as simple as putting your deal up online and the money will start pouring in, but it is far more complicated and involved than that.  Growth of the industry has been steady, which is good because steady healthy growth is a recipe for success.  Speeding bullets are a recipe for fraud.

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The Funding Portals

To be able to raise Reg CF (Regulation Crowd Funding) money, you must do it through an SEC registered funding portal.  The SEC wants to make sure that there is complete transparency and that everything is disclosed to the investing public.   It does not take that much time to get to market, depending on which crowdfunding methodology you use, but timing is not the key issue, marketing is, and you have to have probably 30 or 40 percent of your proposed raise earmarked before hitting the market.  If you do not know precisely where that part of your capital is going to come from before launching, your campaign is likely going to flop.  Even then, you will be raising a lot of money, in smaller amounts from more people than you are used to.   To be able to do that and to have people you do not know or who are once removed from who you do know requires a lot more effort before you ever get started.

Establishing a Relationship With Investors is Key

Lisa’s role is to help companies understand these factors and she has, unfortunately, seen very successful real estate brokers and agents, investors and borrowers, go out onto sites, plonk down their hard-earned money, spend fifteen or twenty thousand dollars, who have done real estate deals all day long and screw it all up because they do not understand some basic principles.  Going to the same old people that they have previously gone to may or may not work because they may not be interested in sharing the deal with a variety of unaccredited and unknown investors.   Think of it this way:  If you have a close relationship with somebody that you have in the past raised money from for a real estate deal and then suddenly you try and put the next deal up on line you are going to be distancing yourself from them in some way. Crowdfunding a deal means you are approaching a different market that requires a different approach.

Not only do prior investors need to be acclimatized to the new methodology, but the entire process needs to start way earlier before you ever worry about the portal.  This means developing a sophisticated social media presence, promoting your project by through podcasts or live Facebook video, through networking.   In short, it involves ensuring that you are out in front of the right people long before you ever need the money in advance, creating a relationship with an audience of people who don't know you and who you don't know.  And from who you are about to ask for money.

From the investor perspective, you must do your homework on a deal before investing.  You have to thoroughly read the prospectuses, thoroughly read the offering, and have all of your questions answered before signing the check.  Investing is a risk, and you can lose all of your money.

Confluence of Three Industries

Crowd funding real estate platforms have to be experts in three industries:  They have to function within a strictly regulated framework; they have to be expert in tech and online marketing (not trivial), and, last but not least, they have to be real estate experts.   That said, crowdfunding is a modern solution to an old technique that increasingly our world has forgotten which is sharing your knowledge and investing in our community and partnering with people who you know and with their friends. 

Regulation CF – Crowd Fund

To issue an offering under Regulation CF, a developer has to work through a portal registered with the SEC, and can decided whether or not they will accept the developer’s deal [Subscribe to the podcast at www.nreforum.org  so that you do not miss my guest Eve Picker, Founder and CEO.  Eve owns the SmallChange portal, which is of one of the only registered portals doing Reg CF for real estate deals].  Portals charge various levels of fees, all regulated.  A lot of times people think that a portal will bring them the investors which they may not.  So far, Lisa says, the data has proven that investors typically will invest in a deal or two in a space or a project or that they know really well, and then they will not invest again. Consequently, assuming that the portal will bring you investors, while true, is not the beginning and end of the process of raising capital.  You still have to do your own marketing.

The Clarinet

Lisa wears another hat.  Over the last few years she has been very focused on trying to create jobs and finds that the music industry needs more of them too.  Consequently, she has been developing musicians into consultants to sell clarinets – the sales model is very flat with Amazon.  Her website is https://www.lisasclarinetshop.com/ and she is working with a few different manufacturers to sell direct manufacture to consumer really high-quality instruments.   Check it out and I hope you enjoy the sounds of Lisa playing in today’s episode.

Crowd Fund Capital Advisors

Lisa’s Clarinet Shop

Oct 17, 2017

LISTEN TO THIS EPISODE FROM THE SHOWNOTES PAGE

The First Mini IPO and Regulation A+ Origins

It was from a background of being a real estate sponsor, being an operator and having to raise money that the idea of Fundrise was born.  Prior to the 2007/2008 downturn, Miller was raising capital from private equity and insurance fund partners, and in 2008 one of his big financial partners, with some $250 billion in assets, went bankrupt.   Coming out of the 2008 recession feeling like there had to be a better way, Miller founded Fundrise with the idea that utilizing JOBS Act Regulations he could raise capital online and not be dependent on the institutional players.

Miller’s work, however, and insights to why this methodology could be effective predates the JOBS Act by two years.  Together with his partners, he conceived of the idea of raising equity capital online as early as September 2010 and first approached the SEC in 2011 to propose that they permit it. 

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Before Regulation A was reformed to become Regulation A+, Miller worked with a former general counsel the SEC to figure out a way of raising money for a real estate deal at $100 a share; a process which paved the way to informing the SEC that the idea generally it worked.  Initially, it was very difficult to navigate through the SEC because, while these things are now taken for granted, they had not previously been contemplated.  Questions that had to be answered included, how does somebody buy a security online, what forms do they fill out, how is SEC staff expected to oversee the applications, what kind of language has to be used?  Working with the SEC to take, what was effectively the first online deal through the system, Miller and his team created the initial protocols for what was eventually to become Regulation A+.

It was a painfully slow process and essentially the deal was like a mini-IPO .  They raised $320,000 at $100 a share a year and it took us almost two years to put all the components together.  In the beginning it was very intensive and slow going but in time they were able to spin it off and scale it, and eventually it became Fundrise – the first company in the industry to be a real estate Crowdfunding platform.

GET YOUR FREE REAL ESTATE CROWD FUND PRIMER (PDF)

Miller’s team concluded just one deal in two years working with the SEC – and this was after they had already bought the real estate.  But the deal they worked on was just five six blocks from the SEC's headquarters.  The helped, not only the process in some way, but by making it easy for SEC staff to actually see the deal first hand, they became intimately familiar with the concept as a tangible case study.  Consequently, the issues were real and immediately apparent to all and this helped to illustrate the concept and flesh out the solutions.

While the first deal took nearly two years to complete, now Fundrise is trying to close a real estate deal a week.  Scaling became possible because Congress and the SEC and the President [Obama] recognized this as an opportunity to innovate. And they did.  That said, the JOBS Act was oriented primarily to tech companies and the benefits that have accrued to real estate have been, in a way, accidental yet becoming increasingly influential.

Why CrowdFunding Real Estate Works

Looking back at e-Commerce in 1999 everybody thought it was going to change the world and then, when it blew up in the early 2000’s everybody came to think it was overblown and not likely to do anything, or have any kind of major impact on the economy or society.  The same is likely true of the crowdfunding space; in the beginning it is having this tremendous impact on the way deals are being financed and, those getting involved are evangelizing future transformational changes.  The next downturn will cause people to turn off the idea, and then it will re-emerge to dominate how capital is formed in real estate.

It is similar to the way that people thought about e-commerce in 2001 when the bubble burst.  The market predicted that Amazon could not have that big an impact and their shares dropped 94 percent to around $7 a share – trading today at over $1,000 a share.  What makes the impact of crowdfunding so difficult to contemplate, is that lots of things, especially in the modern era where you have technology in particular, are non-linear.  That is the nature of a lot of technology.  People tend to underestimate growth rates and the growth in crowdfunding will likely surprise everybody.  Looking out 20 years, it is not inconceivable that all fund raising, all investing, will be, in a way, a form of crowdfunding.

Deal Aggregation

Fundrise has taken to aggregating deals and offering different return profiles and different risk profiles to investors through debt platforms with different characteristics, rather than offering individual equity deals, one by one.  In Miller’s eyes, equity investments do not make sense unless you are in a pool vehicle.   Investing in a single deal, say an office building, and crowdfunding it is a disaster waiting to happen.  In every deal Miller has been involved in – and this is commonplace across the real estate industry – there is always the need for more capital than originally budgeted.  In each case, Miller has made zero percent loans personally.  Once you pool these kinds of deals, there are more sources of capital, more diversification, and better cash flow streams.  In short, in a pool there are more ways that you know you can borrow against it if need be.

The Liquidity Premium

But buying into a REIT is not a prudent move for most investors interested in diversifying into real estate.  A share of a public REIT is really just a piece of paper that is a secondary trade.   The derivative that is a public REIT is so separate, so different, from the real estate itself it that it does not act like the same asset.   In fact, buying a public REIT, the investor is paying t has at least a 20 to 30 percent premium.  Consider this:  In a public context, buying into a public REIT, you are getting daily liquidity, a wholly liquid asset.  That liquidity is not free.  The building underpinning the share in the REIT is not liquid.  It is not possible to pay the same price for a building that is illiquid and a piece of paper that is liquid.  What do investors pay to make an illiquid asset, liquid?  Whatever that is is the liquidity premium.  The transaction costs on a piece of paper is almost zero, but the cost to sell a building is much higher than the cost to sell a piece of paper.  This begs the question, if you are going to buy something and hold it for in retirement or for 5, 7 years i.e. if you are a buy and hold investor, why buy a REIT and pay a liquidity premium for something you have no need for liquidity on?

Eliminating the Liquidity Premium on Fundrise

If you invest a dollar on the Fundrise platform, that dollar goes directly into buying a property.  Because Fundrise is closing on real estate transactions on a continuous basis, the process is happening very close to real time.  Investors demand certain return profiles, and so Fundrise creates buckets of deals that match the profiles investors are looking for.   Ninety nine percent of the population do not know whether, in any particular deal, they would be better off doing mezzanine as an investment in, say, a particular apartment deal, or JV equity, or a whole loan doing 100 percent of stack. What is the right way to do it in this deal in this geography with this real estate operating partner?  Fundrise makes these calls navigating based on investor goals.

Quicker to Raise Capital

Prior to the JOBS Act, if you wanted to raise capital, you had to go have coffee and lunch and meetings to raise the money, and to go on a road show for your institutional investors. Or you could go to the country club.  A lot of time spent for a normal developer would be consumed just raising capital and it could take on average 15 months to raise a fund. 

At Fundrise they do it in days.

 

Fundrise is Not Institutional

Although Fundrise is beginning to act as institutional investors or private equity funds, they are more efficient because they are acting online with tens of thousands of investors rather than over lunch and golf.  And there is also a cultural difference. Generally the financial industry maintains margins. There is not a culture of competing to lower fees among financial industry players.  Instead, while fees have remained constant for decades, more or less, an issuer will be sold on other benefits. 

That is not the culture of tech where there is a relentless drive for change.  They are not motivated to because their institutional clients don't necessarily find it attractive.

The Fundrise Model

The company takes a 0.85 percent as a management fee, instead of 1.5% to 2% as is typical with a private equity fund.  They also take an origination fee of 1% to 2% on the close, which is amortized over the normal life of the deal, say five years.  So Fundrise’s total fees total around 1.25% a year, which is a flat fee. And they take no carried interest.

Carried interest, Miller says, is an incentive for developers to invest recklessly.  The ‘natural’ rate of return on real estate is around 12%, but carried interest structures typically require far higher returns for everyone to be incentivized through their carried interests.  In these structures, developers are like a car with only an accelerator because they have such an asymmetric reward system. You have to recognize that even the best of developers will behave in ways that they really should not if it were not for the incentives. And that is why this system blows up.

Fundrise as a Technology Solution

Fundrise basically functions as a marketplace where investors and developers come together to transact.  The platform maintains a minimum level of quality where they do not pick winners or losers.  That said, unlike the straight venture capital approach which is solely looking for patterns to disrupt, Fundrise has to blend these ideas, as a tech company, with expertise in real estate.  In Miller’s words, Fundrise is both a tech company and a real estate company, it has ‘to have a spliced DNA.’

The Next Real Estate Downturn.

Most platforms will blow up unfortunately and Miller worries about how to protect his platform and their investors every day.  During the next recession there will be a wave of opinion that the real estate crowdfunding idea categorically did not work.  And then there will be a few models, a few companies, that will emerge from it proving that it did work. And by that point the industry will probably be 10 years old, with a billion of equity and three billion in real estate or more and will, basically, be institutional.

And that's when things will really get interesting.

Oct 17, 2017

THE JOBS ACT

The JOBS Act – Jump Start Our Business Startups –  was passed in April 2012 but it was not until March of 2015 that Title IV Regulation A+ was announced.   The intention of the Act was to make it easier for small companies to raise capital.  The first effective component of the Act was Title II which went effective in September of 2013, extending Regulation D to allow companies to market themselves to raise money from accredited investors via the internet.  The biggest change under Regulation D was that it allowed for public solicitation, whereas before only solicitation from investors with a pre-existing relationship with the sponsor was permitted.

LISTEN TO THIS EPISODE FROM THE SHOWNOTES PAGE

There are some nuances in Reg D that restrict the number of accredited investors depending on the specifics of the structure and approach that a company is taking.  A borrower can market an offering broadly on the Internet but can only accept investments from accredited investors. The thing that 506 (C) requires though is that the issuer, the company raising money, must take reasonable steps to verify that the investors are in fact accredited. You cannot take their word for it. In 506 B, the pre-JOBS Act version, borrowers were limited to soliciting from people they knew but there was no accreditation verification requirement. If they say they're accredited that's enough. An investor would have to sign off on it, but that was enough.

REGULATION A+

Reg A+ took the old Reg A and expanded upon it dramatically. That little plus sign kind of understates how much it changed.   With Reg A+ private, companies can raise money privately and raise up to $50 million a year and in some cases, more specifically in real estate cases, more by doing multiple offerings simultaneously for different geographies.  

There are two types of Reg A+ offering:  Tier 1 and Tier 2. A major issue is that investments can be accepted from investors worldwide at any wealth level. They do not have to be accredited anymore. And when they state their income and net worth, and whether they are accredited or not, the company selling the stock is allowed to take their word for it.  They don't have to prove what the investor states.

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Investors anywhere in the world can be accepted at any wealth level into a Regulation A+ and the SEC considers the shares sold through the offering to be liquid for the purchasers of them. If the company doesn't lock the shares then the shares can be traded someplace depending on whether the company lists, where it lists, or whether it provides some other form of liquidity.  Options for listing include one of the OTC markets like the QB or the OTCQ or the OTCQX. These come with reporting requirements that are considerably less onerous than listing on the Nasdaq.  The issuer can also retain the option of not listing at all or even locking the shares and then providing a redemption system.  This has been done by some real estate companies raising money using Reg A+.

COSTS ASSOCIATED WITH A REG A+ OFFERING

An attorney providing the legal services required will charge $50,000 and up depending on the complexity of the offering. That is a front-loaded cost.  In addition to this, there are marketing preparation expenses, and if it is a Tier 2 offering, the issuer will need to have an audit that goes back as long as the company has existed or two years. So those are the downsides: upfront cost and it is not a certainty that you will be able to raise the money which is basically true in any kind of capital raise. There are no guarantees.

REAL ESTATE A MAJOR USER OF REG A+

Real estate has become a very large segment of Title 2 capital raises.  This is probably because investors understand the nature of real estate.  Many investors would like to own more real estate but do not have the time or enough capital set aside to do so.  Many of the real estate offerings already issued are paying a reasonable dividend rate or a preferred return which is also very appealing in today's low interest environment.  Another reason real estate has taken off in Reg A+ offerings is that in regular business offerings under the Act, it is hard to get investors to pay attention unless they absolutely love a company. In the case of real estate, the industry has a critical mass where regular investors feel comfortable with the asset class and so more inclined to invest.

Reg A+ is not for a sole developer who has a deal in town that needs money for it; it is for established, experienced teams that have a track record and that can demonstrate that not only to the market but also to investors, platforms, marketplaces, and broker dealers.

MARKETPLACE UTILIZATION OF REG A+

The marketplace platform, Fundrise, [subscribe to the Podcast to hear Ben Miller next week, Founder and CEO of Fundrise as my guest speaker]  is using a Reg A+ as a completely central part of that platform.  They have three parallel Reg A+ offerings going on simultaneously because if you can divide territorially like that, and Fundrise has divided the US into three geographic regions, you can raise money simultaneously for each one, raising up to $150 million per 12 month period.

OPTIONS FOR DEVELOPERS RAISING CAPITAL

  1. A company like Fundrise aggregates smaller developers deals, adding layers of screening, to create a platform for capital generation. Developers list on the platform and use its’ resources to raise money.
  2. A developer prefers to retain closer control over who sees and decides to go it alone to generate the marketplace interest in their offering. Here they will not use a third party platform for the issue, it is conducted entirely internally.

THE CROWD AS INVESTOR; THE CROWD AS WATCHDOG

Typically, term structures in a Reg A+ offering will resemble those traditionally offered to friends and family, or to private equity, but economic terms may change as will certain key decision-making rights.  In a Reg A+ offering, for example, there is no requirements that issuers have skin in the game.  In pre-JOBS Act times this was also true, but investors typically expected it of the developer.  In the current environment with relatively unsophisticated investors entering the market – no matter how the SEC defines ‘sophisticated’ – sponsors are listing deals where they have no risk equity of their own.  Other terms highly favorable to the sponsor are commonplace so it is very important to be watchful of the fine print.

One of the big concerns about the JOBS Act from before the get-go was that there would be rampant fraud. Countering this concern is the idea that the online offering model is so transparent and so public that the likelihood of this is mitigated.  When you have thousands of people examining an offering and examining the social media profiles of the principals on the transaction, word will spread quickly if something is skewwhiff.   It is like having surveillance cameras in a neighborhood.  It puts thieves off because they would rather go somewhere else where they will not be recorded in a similar way.  That said, while the transparent access we have through online funding platforms is really good, the crowd will act as a crowd, and people tend to go with the herd, believing that if everyone else is doing it, it must be OK.  And sometimes that can lead off a cliff.

INVEST LIKE AN INSTITUTION – BUT THESE ARE NOT INSTITUTIONAL DEALS

Institutional investors take a very detailed look at a sponsor and their capabilities and add multiple layers of not only due diligence but also management oversight on top of that, on an on an ongoing, real time basis for any sponsor.  In Reg A these layer has been removed.  Now investors are investing directly in the developer itself and so although small investors now have opportunities to invest where before they could not, they also do not have the same skillset that an institutional investor would have.   

While it is true that the SEC goes through these offerings with a fine tooth comb to make sure that they are real, that the companies are real and that they are legitimate, it does not validate the merit of an investment in any way.  If there's a broker dealer on an offering, or an online marketplace is making the offering, especially a platform which has a good reputation, then maybe this adds some credibility to the offering.

Bottom line:  Do not invest anything that you cannot afford to lose.

Regulation CF – Crowd Fund

Reg CF is also known as Title III and is the most recent of these significant JOBS Act announcements.  It went effective in June 2016 and is geared to raising capital of sub-$1 million from non-accredited investors.  Reg CF issues are made through SEC approved portals that collect fees under various highly regulated formulae.  The issuer must undergo background checks via the portal, and submit GAAP level annual audits; a more stringent standard than otherwise might be usual.

[Coming Soon:  Listen to the National Real Estate Forum trifecta podcasts – Reg CF Portal Small Change CEO, Eve Picker, a sponsor on her site Jonathan Tate, and an exclusive interview on the Forum, the first ever CF investor Bill Bedell.  Coming up soon.  Don’t miss it; subscribe now on any one of these platforms]

Manhattan Street Capital

Manhattan Street Capital is essentially two things in one. The company focuses primarily on Reg A+ offerings but will do select Reg D offerings where they feel they can add value.  They are also a platform which enables companies to more easily raise money through using advanced technology.  The company accepts crypto-currencies as investment methods.  This expands the ease with which international investors can participate in a Reg A+ offering.   The company is essentially a concierge service where they introduce clients to all the different service providers needed, in order to get an offering out to market. 

Oct 13, 2017

LISTEN TO THIS EPISODE ON THE SHOWNOTES PAGE

Crowdfunding is sort of a misnomer.  It describes a format by which investors can pool money with other investors and that capital can then be put to work in a group method to take down larger assets than the individuals alone could manage.  The concept is better described as a private, technology enabled marketplace and almost like a wealth management platform

RealtyShares specifically is geared towards a high net worth investors and institutions.  The company has changed the medium that capital uses to access deal flow from the old family-and-friends sourcing methodology – and that medium is the Web.

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Investors, who historically may have had no access to real estate or limited access, now have access to a much broader set of deals located across different markets, different product types, different operators.   These marketplaces are accessible for both investors to deploy capital across a broad diversified set of deals as well, as developers to raise capital at record speed through a network of investors they otherwise would not have had access to.

It used to be that either you knew somebody that was doing a deal, or maybe you might have gone to a local mortgage guy to find deals to invest in.  Now we have basically taken this process and put it on the web.  Before, an investor would have been compelled to put $100,000 to work in a single asset, single market, single operator with a lot of concentrated risk.  And this presumes that the investor actually had the personal network to actually know an operator.

GET YOUR FREE CROWD FUND REAL ESTATE PRIMER

Now, with the Web, the investor can take that same 100,000, and with RealtyShares’ minimums being as little as $5,000, put it across a much broader diversified pool of assets.

One thing that is a little unfortunate in real estate is that there is traditionally very little transparency.  An investor investing in a country club deal is being charged certain fees to the project that they are investing in.  They do not know if they are getting a good deal, a bad deal, what's market what's not market.  Online this changes because investors can now see multiple deals alongside each other and compare relative fees.  Indeed, RealtyShares has standardized the fees sponsors can charge, and have transparently disclosed those fees and structures to investors.

On the RealtyShares platform, developers go through an online digital application process to request financing – for both debt and equity, which sets RealtyShares apart in the market.   Once a developer is prequalified as being eligible for financing they undergo a 20-point underwriting system.  This involves data collection on the deal, a financial model, an appraisal if applicable, an environmental report and due diligence on the sponsor.   Once the sponsor’s track record has been verified and market and deal numbers crunched, RealtyShares determines if, from a risk adjusted return perspective, it fits the marketplace and the appetite of the marketplace. 

RealtyShares only select about 10 percent of deals that come to the marketplace.  They seek best in class operators.  Sometimes this might be a first-time operator who has done transactions a principal investor or to a larger shop and now who are now breaking away. Typically, underwriting standards require seven years’ minimum, although many have twenty years’ experience. 

Deal preferences are for value add in core plus deals with the potential to generate yield quickly if not immediately, and in high growth primary or secondary markets.  Tertiary markets are not liked as RealtyShares looks to certain population minimums and employment growth numbers to mitigage potential loss scenarios.  So far, 80% of transactions have been in the multi-family sector and 20% have been across different commercial assets including hotel, retail, suburban, office, industrial, and self-storage.

Investors today are yield oriented.  This is driven primarily because they are not getting yield anywhere else, not from the stock market, not getting it from the bond market, and certainly not getting it from bank deposits.  On the RealtyShares platform, cash on cash returns are typically six to seven percent or higher, and on an IRR basis it can be kind of mid-teens.

To satisfy investor preference for yield, most RealtyShare deals are existing assets with in place cash flow, or fully entitled construction deals where prefs can be paid current, at least in part, and time to market is not going to be delayed by planning issues.

Deals are stress tested to determine what would happen if there was a drop in NOI, or increase in vacancy and a resulting drop in NOI, and benchmarked against the ability to meet debt service coverage.  While there are no guarantees, these measures serve  to mitigate the risk of technical default in the event that there is a market correction.   The platform also ameliorates risk by offering one of the most diverse online marketplaces for real estate Investing, providing debt and equity options, and deals across both commercial and residential multifamily classes.

POST CLOSE ROLE

RealtyShares is a full cycle investment platform.  Investors can monitor the performance of their deal portfolio via a dashboard where they can see how rehab is going, get earnings updates, updates on the asset, and robust quarterly updates directly from the developer.  Tax and legal documents also are all available through the dashboard.

The platform actively tracks how deals are performing relative to budget and pro forma.  The data this kind of analytics produces is valuable because it provides real time feedback on individual markets and asset classes which help with underwriting future deals.

In the event a debt deal goes bad, RealtyShares retains foreclosure or a deed in lieu rights.  For equity deals, investors can select from preferred and common equity, there are triggering events like defaults or a failure to pay that will allow RealtyShares to take over the underlying entity.  For common equity there is typically a management replacement right built in.  

Being a tech company, not a real estate private equity company, RealtyShares does use third party vendors to do workouts when needed.  Using third party vendors for these kinds of functions allows the platform to focus on their core strength which is really sourcing deals, underwriting deals and providing a very efficient marketplace to deploy capital in those deals.   

BIGGEST HURDLES

The real estate crowd funding industry needs to better educate investors and developers like around what this is and how it actually creates value for both. This is a very nascent market and the concept of online capital formation and investing for real estate is novel to most people.


LONG TERM VIEW

Ultimtaely, Athwal is aiming to build a wealth management platform; an online wealth management platform or digital wealth management platform for the private real estate market.  Part of that thesis is in giving investors options to invest in different types of vehicles.  This might be through direct access to deals and the ability to pick the exact asset, the exact zip code, the exact sponsor, an investor wants to work with, but also through creating a programmatic access to deal flow through development of an index fund.  In this case, instead of having to invest in every individual deal investors can get exposure to a diverse set of deals set by the platform.  Strategies might include income or growth, debt versus equity.  Ultimately the company’s vision and goal is to provide diversified vehicles for investors to get exposure to different types of investment options and the fund structure is just one kind of part of that evolution.

REAL ESTATE AS ALTERNATIVE TO STOCKS AND BONDS

One of the vision elements of RealtyShares is to build a global stock market for real estate:  To put real estate as an asset class on even footing with stocks and bonds.  Athwal is committed to bringing more transparency and trust in, and standardization and liquidity to, real estate.   A key component in this will be creating a market for third party validation of deals and platforms that does not exist today in private real estate.   There is still a lot to do to bring the level of analysis seen in other publicly traded securities like stocks and bonds and third-party validation is just one of those elements.

 

 

www.realtyshares.com

Oct 2, 2017

Professor Syverson looks at what has been going on in retail over the past decade or two.  He discovers that, while a lot of the mind share in the industry is focused on the effect of e-retail, more important than e-retail is the rise of the warehouse club and super center format size. While e-retail has, of course, had a great impact on retail, on several dimensions the warehouse club and super center has even more so moved the needle on the way that retail looks, and how stores are configured, since the year 2000.   

See these notes and more in the Shownotes to this episode

Economists are reluctant to make predictions, not exactly having a stellar reputation for predicting the future. But having some fun with the data, Syverson looked at the penetration of e-retailing and in various product categories and projected them out into the future.  Some that you wouldn't be surprised about are essentially dominated or close to dominated by e-retailing.  But some, drugs, health, and beauty, and food and beverages are two that are not.  These are both massively large sectors in terms of their share of retail sales – somewhere in the neighborhood of $400 billion dollars of sales for drugs, health, and $700 billion for food and beverages in the U.S.  And in both of these sectors there is still a huge chunk of retail sales – there is very little relative penetration of e-commerce in either of those two sectors.

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Some factors like regulatory restrictions on prescription drugs distribution is going to set limitations.  However, for the typical CVS or Walgreens in terms of revenue share, things that aren't prescription pharma is still a significant proportion for those stores.  So while there remains a continuation of the development of bricks and mortar building activity going on, to some the bulk of the warehouse club and Supercenter build out has happened already – and consequently you might expect that to slow down and for e-commerce to pick up some.   

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Given enough time, there is likely to be the full penetration of e-commerce, with some upper bound, for example in prescription drugs that might never become fully e-commerce, and there might be other reasons in other product classes where it is never going to get to one hundred percent.  The predictions in the paper are, therefore, quite bold in saying that various categories could possibly even get to ninety, ninety-five, or one hundred percent.

WHEN EVEN BIG BOXES VANISH, WILL WE THE CROWD BE FINANCING THE LOCAL NICHE STORE?

In the long run, e-commerce will likely replace the base currently supplied by a lot of the big boxes, and what will be left will be a throwback to the small niche type retail operations that used to be the typical thing several decades ago.  To survive in a retail world where most retail is e-commerce stores are going to have to be specialized in something obviously that e-commerce cannot deliver. It will either be some particular product category that has attributes that do not work well with e-commerce, perhaps something where tactility is hugely important and where the customer actually needs to hold the thing in their hand or look at it physically before they are willing to purchase.  Or maybe it is simply this need for personal service from someone you know, where not only do you want a salesperson there to walk you through how the product works, but also because you simply want to support their business. Maybe you invested $1,000 in the business directly; maybe you invested $10,000 in building the store is situated in.

And the future of the high street?  Retail will be dominated by small, niche shops that provide a social and highly localized service or product.  This requires that demand will be sufficient to support the local niche store once again as it did in the past.  But how will this be financed; how will these kinds of stores, or the developers that build the buildings in which the reside, finance their existence?  Well, that is precisely where crowd funded real estate will facilitate this change.  Real estate is fundamentally a local phenomenon.  The reason we have the large box stores and chains is because institutional underwriting likes the copy and paste efficiencies of scale.  Not so the crowd.  The crowd as a gathering of neighbors wants to support itself, locally and financially, and it is the crowd that will fund the next generation of retail – the small, niche, local product, owned by people who live locally and who support their community by sitting on local associations and councils.  As institutional capital has institutionalized our lives in every aspect, it will be we the people, we the crowd that will fund the next generation of retail.  And it will look a lot like it did a generation or two ago when you knew the shopkeeper and patronized the store because her kids went to the same school as do yours.

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