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

SEE THE SHOWNOTES FOR THIS EPISODE

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

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

Attraction of the JOBS Act

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

The Regs

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

The Sophisticated Investor

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

Potential Changes to the Act

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

Real Estate Compliance

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

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

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

Platform Stability

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

Lemon Squeezer

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

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

Future Changes

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

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

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

Introducing Max

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

Checkout the episode in the shownotes page here

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

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

Financing

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

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

Two Models of CFRE

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

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

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

CFRE Site Input to Operating Agreements

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

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

Marketing

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

Terms

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

Transparency

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

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

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

The Fremont Deal

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

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

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

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

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

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

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

Mitigating Downturn Impact Risk

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

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

Recommending CFRE

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

Easy for Some

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