January 2018 Investor Letter   Shortly after the new year, we sent our clients our Quarterly AlphaFlow Investor Letter, sharing our thoughts on our industry and how we view the investment landscape today. You can find that letter below: Please click HERE to download a PDF of this January 2018 Quarterly Investor Letter.

Sailing into the Brume

“To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them — ideally, all three.” – Howard Marks With a new year upon on, I wanted to share some of my thoughts on our industry today, where I think things are headed in 2018, and what AlphaFlow is doing to get ahead of these market shifts. TLDR: We are still seeing a great deal of outstanding risk-adjusted return in the market, but the noise has increased and so both diversification and independent underwriting are more important than ever. In the second half of 2017, we commonly heard about the larger role institutional investors are playing in real estate bridge lending but there has been less discussion of what it means for retail investors. Institutional investors bring two unique attributes: (1) the need to put enormous amounts of capital to work, and (2) an ability to accept lower gross yields in exchange for volume, as they can often boost returns via leverage. Lenders and marketplaces are naturally incentivized to focus on volume, so we’re seeing changes in behavior:
  1. Rates are dropping industry-wide but to a greater degree with online platforms than we see with traditional offline lenders. In some cases, borrowers are capturing these savings as lenders use rate to win more business while maintaining spread (i.e. they still earn a 1-2% spread for servicing, even if they lower the rate). Elsewhere, lenders are increasing their spreads as they push the boundaries of what rate investors are willing to accept (we’re seeing many notes where borrowers are paying 11-12% and investors are being offered the note at 7-8%). In both cases, investors are experiencing diminishing returns.
  2. Loan amounts are being increased. Historically, lenders have taken the LOWER of purchase price or appraisal / BPO in setting a loan-to-value. We’ve seen this switched to taking the higher of these two metrics in order to maintain a particular LTV benchmark while actually lending more capital.
  3. LTV thresholds are being blown out. Lenders who have seen low defaults in particular borrower cohorts are making big bets that these DQ rates will continue, even with higher leverage, so they’re lending close to 100% of purchase price in some cases.
To loosely borrow from the derivatives world, we’re starting to experience our own version of basis risk, in which yields are not moving in line with the risk behind loans. The larger worry for all investors though is if we are straying into basis uncertainty, in which we’re not even sure if the data and processes we use to underwrite loans are any longer tied to loan prices (yields) at all (e.g. we’re seeing loans we rate as highly risky being offered at 7% and others we think are fairly low risk at 11%). In a consolidated market like stocks, basis uncertainty can mean it’s time to step away. In a fragmented market like ours though, it creates an opportunity for generating alpha (particularly as housing markets correct), as the market may be rife with mispriced debt (particularly with offline lenders). Looking ahead in 2018, three things jump out to me:
  1. Shift to secondary and tertiary markets. The doubling of the standard deduction should help boost homeownership demand in the Midwest and South, where few mortgages (or property tax bills) are large enough to warrant itemized deductions. For those on the coasts though, where a much higher percentage of mortgages fall into this expensive category, we’re going to see cooling home prices. We moved past the “lowhanging fruit” in many primary markets like LA and Chicago 18 months ago, which today means flips there usually involve more construction and lower margins for error. Add in the new tax bill, and investors need to look more to smaller markets like Pittsburg, Cleveland, and Kansas City for attractive loans.
  2. “When do I get my money back?” From questions about rising rates to a potential correction in the stock market, the market is filled in uncertainty that’s only being exacerbated by today’s geopolitical environment. The result: investors are looking to decrease the duration on their portfolios in order to give them the opportunity to appropriately rebalance their investments as circumstances shift. To address this need for clients, in Q1 we’ll likely develop a shorter-duration product with a guaranteed maturity.
  3. So much noise! From new behemoth institutional investors transforming the space to lenders contorting their standards to meet their needs, 2018 is going to produce a lot of noise in the market. We’re already rejecting over 90% of loans we review today, and while we think that number will decrease as we expand our relationships with traditional offline lenders, the investment environment is only getting cloudier.
We’re addressing these shifts in a number of ways, but I’ll highlight three initiatives here:
  1. Doubling Down on Analytics: In Q2 2017, we launched our internally built analytics platform, AlphaFlow Advanced Analytics, powered by an amazing partner in TheNumber. We recently expanded our work here and will be pushing out v2 in January to boost our ability to produce our own valuations (and thus LTVs) and better track markets as a whole.
  2. Improved Portfolio Management: We’re now building better portfolio management tools, which combine monthly reporting and property monitoring via our analytics platform to enable us to spot dangerous situations like market shifts before loans hit maturity.
  3. Clustering: Over the next year, we’re going to shift most of our investing to 12-15 target markets. Clustering not only allows us to drill in at the neighborhood-level to produce good returns, but also helps us mitigate downside. If you’re in this industry long enough, you need to be comfortable that at some point you’re going to own houses. Investors with the ability to manage assets (i.e. finish projects and fill homes with renters) will not only protect their downside, but also produce huge returns by positioning themselves to buy non-performing loans from lenders/investors who lack such capabilities.
There is more noise than ever in the market, but I believe the cycle has a long way to go in a number of cities around the country. Diversification is necessary but not sufficient in this fragmented market filled with bespoke underwriting practices and a lack of standardized metrics. Ultimately, we still see attractive risk-adjusted returns, but they require more work than ever to earn. Thank you for entrusting us with such an important part of your life. Happy New Year! Best regards, Ray Sturm Additional Note: I’ve heard from a number of you that you’d like us to write about the market more often, so we’ll plan to do so at least quarterly moving forward. We don’t claim to have a monopoly on market intelligence though. I’d love to hear what you’re seeing and what you think about the market in general, specific lenders, what you’d like us to do, or anything else you’re thinking about as you build and adjust your portfolio. Please click HERE to download a PDF of this January 2018 Quarterly Investor Letter.

About the author:

Ray Sturm, CEORay Sturm is a leading entrepreneur in financial technology, and is currently the CEO of AlphaFlow. Prior to launching AlphaFlow, he founded RealtyShares, one of the P2P industry’s top platforms for real estate investing. His early career in finance included investment banking at Bear Stearns, restructuring at Lazard Frères and private equity at CCMP Capital.

Ray has a BBA-Finance from the University of Notre Dame and a JD/MBA from the University of Chicago.

  Legal Information and Disclosures This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. AlphaFlow has no duty or obligation to update the information contained herein. Further, AlphaFlow makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.  This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. AlphaFlow Advisor, LLC (“AlphaFlow”) believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumption on which such information is based.  This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of AlphaFlow. 

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Please click HERE to download a PDF of this September 2016 Quarterly Investor Letter.

“We don’t have to be smarter than the rest. We have to be more disciplined than the rest.” – Warren Buffett

2016 has been a tumultuous year for investors. Between volatility in the stock market and a dearth of fixed income alternatives, many are questioning where to invest. We’re even seeing many of our customers pull their capital off of platforms like Lending Club. To fill that void, many investors have gotten creative – perhaps too creative – in looking for one-off opportunities to produce yield.

In the meantime, it’s continued to be a strong time for AlphaFlow and our origination partners. However, general market conditions have led to an influx of new capital, which brings both challenges and opportunities for us as investors. Unfortunately, deciphering which is which isn’t always obvious, making discipline paramount. Below please find our thoughts on the real estate market and our industry.

Best,
Ray Sturm
CEO, AlphaFlow

Commentary
AlphaFlow Portfolio
In a world of limited upside with debt investing (your return is generally capped by the interest rate), protecting your downside is critical. Prudent investing suggests a highly diversified portfolio is the most effective shield. In February 2016, we launched AlphaFlow Fund 1, the first of its kind in the real estate crowdfunding industry. The idea was simple: You make 1 investment, and we build you a diversified real estate portfolio.

Since then, we’ve launched two more funds (Fund 3 is still open for investment until 9/24) and have invested in over 150 loans across over 20 states. Both Fund 1 and Fund 2 are on track to exceed their 9% target returns and are both substantially below the 75% target LTV ceiling we set. Within these two funds, we have one deal in default and with a 70% LTV on that specific property, we feel optimistic about making at least a full principal recovery ahead of the original maturity date.

Investor re-investment has been high, as many of our clients have suggested they’ll continue to choose their own equity deals but we’ll now serve as the debt arm of their portfolio. With 75-100 properties per fund and a single K-1 at the end of the year, things are working well.

Crowdfunding Industry
“Growth is never by mere chance; it is the result of forces working together.” – James Cash Penney

I keep hearing real estate crowdfunding insiders speak loudly about consolidation coming to the space. We’ve been told only a few players would survive and that a 2-3 winners would emerge and ultimately absorb the loan volume currently originated by the long tail of smaller platforms. As we get ready to go into the 4th quarter, the world simply isn’t playing out that way. Instead, we’re seeing an increase in the number of platforms being launched by real estate veterans. Along with these new entrants, we’re hearing about a number of larger platforms significantly behind on their board-approved 2016 volume goals. That may mean a change in leadership at some platforms, but I also think it means a misunderstanding of how the real estate industry works.

Our thesis continues to be that real estate is inherently fragmented because it is and should be a local business. Today, inputting a zip code into a database doesn’t tell the story of why a property on one street should be valued quite differently from a structurally similar building only two blocks away. The result is that the market defeats any winner-take-all scenario in loan originations, as the efficiencies of scale still lose to the superior underwriting that comes with local expertise. As an example, below please see an overview of the U.S. mortgage industry, in which the biggest player (Wells Fargo) owns about 12% of the market and the top 10 players combined represent about 40% of the market.

2015 Mortgage Market

Our focus is on finding strong originators who share our values around transparency and disciplined underwriting. We are in discussions with a number of new platforms about investing in the loans they originate, but to date, the majority of our investing has been done across five platforms (in alphabetical order):

Fund That Flip
LendingHome
Patch of Land
PeerStreet
Sharestates

Market-wide, we’ve seen interest rates decline as new players emerged and increased the competition for attractive borrowers. That does not seem to have decreased investor demand, as platforms like PeerStreet had to actually send out an email to users apologizing for how quickly they were filling deals. That’s a testament to PeerStreet’s work over the last year in establishing a platform with good tech, responsive customer service, and of course, strong underwriting.

As mentioned in our previous quarterly letter, Patch of Land went through a small restructuring in the spring. Consequently, we did not heavily invest on their platform in Fund 1. In April they brought on Paul Deitch as CEO to help scale the company. Since then, Paul has built a strong management team and impressed us in our in-person meetings. As a result, Fund 2 invested in a number of deals on the platform and we look forward to working more with the Patch team in the future.

Real Estate Market
Housing is arguably the most important sector in the U.S. economy, accounting for 15-18% of GDP. Given its enormous position, it’s not surprising that growth in the housing market has often worked to pull the country out of recessions. However, when housing is the catalyst behind an economic near-collapse like we experienced in 2008, its potential role in any recovery is less clear.

Internally, we caution against absolute acceptance of the term “the real estate market” when pundits and journalists attempt to speak about where we are in the cycle. Yes, home prices in Fort Myers, FL have some correlation to those in Portland, OR as both are affected by myriad factors including interest rates. Real estate is extremely local though, so being well below the peak nationally may not mean that parts of Santa Monica are not overheated. Similarly, feeling like we’re at the peak doesn’t mean there aren’t great opportunities in places like Austin, TX or Ashville, NC. Prudent investment means nuanced and local analysis. With that large caveat, below are some macro factors we’re paying attention to as we evaluate each and every deal on a local level.

Yes, people are actually looking to buy and not just rent forever.
“Owning a home is a keystone to wealth – both financial affluence and emotional security.” – Suze Orman

A common topic today is how millennials aren’t buying homes and are instead choosing to be permanent renters. Whether it is that generation or others, buyer interest in purchasing homes has increased substantially in the last few years.

One factor driving this: buying is now more affordable than renting in 58% of U.S. markets. Obtaining credit from banks is still difficult for many middle class borrowers though, leading to an increase in alternative lending opportunities.

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Building Bigger Houses
“Generally, the greater the stigma or revulsion, the better the bargain.” – Seth Klarman

New home construction is certainly on an upswing, with a lack of workers actually serving as the bottleneck to even greater growth. However, it’s incredible to see how much bigger new homes have gotten over time. There are a number of tailwinds supporting the rise in fix-and-flips. One is certainly illustrated in the graph below: buyers of average-sized homes have fewer opportunities to purchase new construction, spurring the rehabilitation of current housing stock.

Conversely, we’ve been wary to participate in loans in homes above a particular valuation threshold (currently $800k for us), as the data around these properties is much less reliable above this hurdle. Given the additional market competition this type of property faces from new home construction, we subject these investment opportunities to greater scrutiny. There is a temptation by many investors to actually have a lower underwriting bar for these, as they may look prettier and be in neighborhoods where you’d want to live yourself, but that doesn’t necessarily make them great investment opportunities for us. As is often the case in real estate, the ugliest homes can lead to the most beautiful investments.

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Please click HERE to download a PDF of this September 2016 Quarterly Investor Letter.

Note: AlphaFlow is available today for all accredited investors.

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About the author:

Ray Sturm, CEORay Sturm is a leading entrepreneur in financial technology, and is currently the CEO of AlphaFlow. Prior to launching AlphaFlow, he founded RealtyShares, one of the P2P industry’s top platforms for real estate investing. His early career in finance included investment banking at Bear Stearns, restructuring at Lazard Frères and private equity at CCMP Capital.

Ray has a BBA-Finance from the University of Notre Dame and a JD/MBA from the University of Chicago.

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This AlphaFlow Quarterly Investor Letter is a summary highlighting key points regarding AlphaFlow Fund 1, LP (“Fund 1”) and AlphaFlow Diversification Fund 2, LP (“Fund 2”) to its investors.
This document does not constitute an offer to sell or the solicitation of an offer to buy any security, product, service or fund. This document is for informational purposes only and is not intended to be, and must not be, taken as the basis for an investment decision. The information contained herein may not be used, reproduced or distributed to others, in whole or in part for any purpose without the prior written consent of AlphaFlow, Inc. (“AlphaFlow”). Neither AlphaFlow nor any of its affiliates is under any obligation to inform you if any of this information becomes inaccurate. No representations is made as to the accuracy and completeness of information obtained from third parties. This document is qualified in its entirety by the Offering Memorandum of AlphaFlow Diversification Fund 3, LP (“Fund 3”), which should be carefully read prior to any investment in Fund 3, a successor fund to Fund 1 and Fund 2.
This document has been prepared for prospective investors who are legally eligible and are suitable to invest in the type of investment described herein. Generally, prospective investors would include investors who are “accredited investors” under the U.S. Securities Act of 1933, as amended (the “Securities Act”) and verified pursuant to rule 506(c) of Regulation D promulgated under the Securities Act. An investment in Fund 2 is suitable only for sophisticated investors and requires the financial ability and willingness to accept the high risks inherent in such an investment. It is the responsibility of any prospective investor to satisfy itself as to full compliance with applicable laws and regulations of any relevant jurisdiction. For a description of certain risk factors associated with an investment in Fund 3, please refer to the “Risk Factors and Conflicts of Interest” section of the Fund 2 Offering Memorandum.
Interests in Fund 3 have not been and will not be registered under the securities laws of any U.S. State or Non-U.S. Jurisdiction, and have not been recommended or approved by any U.S. federal or state or any non-U.S. securities commission or regulatory authority. Furthermore, the foregoing authorities have not passed upon the accuracy or determined the adequacy of the information contained herein.
Past performance is not indicative of future results. Any AlphaFlow Fund 1or Fund 2 investments listed herein are being provided for informational purposes only. Investments in real estate loans may result in the loss of principal. There can be no assurance that Fund 3 will be able to achieve the same portfolio composition and underlying loan terms as Fund 1 or Fund 2.
These materials contain projections and other forward-looking statements. Any statements that are not historical facts are forward-looking statements that involve risks and are inherently uncertain. Sentences or phrases that use such words as “believe,” “anticipate,” “plan,” “may,” “hope,” “can,” “will,” “expect,” “should,” “goal,” “objective,” “projected” and similar expressions also identify forward-looking statements, but their absence does not mean that a statement is not forward-looking. Projections and other forward-looking statements, including statements regarding AlphaFlow’s assessment of the market, are by their nature uncertain insofar as actual realized returns or the projected results can change quickly based on, among other things, unexpected market movements, changes in interest rates, legislative or regulatory developments, errors in strategy execution, acts of God and other developments. There can be no assurance that projections and other forward-looking information will not change based on subsequent developments and without further notice, and no assurance can be given as to outcome. You should not place undue reliance on forward-looking statements, including forecasts and projections, and statements regarding the assessment of the market, which speak only as of the date referenced herein.
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