|Type of investment||Lender to Property Owner||Property Owner (shareholder)|
|Return||Interest (Fixed)||Share of net profits (Varies)|
|Return Potential||Capped, limited to the loan interest rate||Uncapped, can be in the double-digits|
|Secured by||Payback of loan is either (1) secured by the property or (2) unsecured promisory note||Unsecured-You own real estate value after debt|
|Seniority Default||1st to receive payout, but you may have to pay some of the foreclosure costs if loangoes into default||2nd to receive payout|
|Distributions||Yes, monthly or quarterly interest payouts||Varies, sometimes quarterly distributions are paid|
|Fees||Typically 2% + possible loan origination fee||Typically 1%–2%, no upfront or service fees|
|Holding period||Varies: 6–24 months||Varies: 1–10 years|
|Tax benefits||No||Yes, investors can tyypically take the depreciation deduction without owning the property directly|
|Deal Sponsors / Developers||Investors|
|High Costs||Minimums are way too high
|Tough to get access to capital||No access (“country club” deals)
|Banking restrictions (Dodd-Frank||Only local exposure
|Too small for institutional investors||Massive fees for REITs
|Banks are too slow||Lower returns
Or click the image below:By: AdaPia d’Errico The private lending industry has benefited from several years of growth in bridge financing with fix and flip, purchase, refi, and, more recently, single-family rental financing. While this growth has brought significant institutional capital off the sidelines, another group of early-adopter investors had already been making an alternative play in private money lending and investing through online real estate crowdfunding platforms. A traditionally private industry, as the name implies, lenders and capital investment companies could not rely on general solicitation and advertising due to private placement rules dictated by the SEC through Regulation D, Rule 506(b). Then, real estate crowdfunding came along and flipped the industry on its head. Crowdfunders leveraged Rule 506(c) and took a decidedly different approach to acquiring investors. They created a user experience akin to e-commerce purchases and applied visual merchandising to present deals. Then, they simplified the process of obtaining investment information (and documentation) making it entirely digital, mobile, and available 24/7. Having launched a real estate crowdfunding platform in 2014, I realize that what I consider standard regarding targeting an audience and acquiring clients is not the way it is done in private lending. For example, online community development, social media, brand activation, and digital marketing—these are the elements that form the backbone of reaching people who interact online, whether they are digital natives or baby boomers. We are all part of the “connected generation,” and we all use the Internet to inform hundreds of daily decisions. Beyond the user/client acquisition phase, there are far deeper criteria for engaging with people who may be interested in investing in real estate online. One must understand online vs. offline behavior, expectations, and requirements of a potential client. Decoding the potential investor’s mindset, which may be fraught with well-founded and well-researched concerns, solving for UX (user experience) and CX (customer experience) pain points, and earning trust with a website and strategic content are elements used by the most successful online real estate investment companies. The number of people investing online and including real estate as part of their investment mix is growing. In the recently published 2017 ‘The Americas Alternative Finance Industry Report,’ research shows that Real Estate Crowdfunding (RECF) increased by 70% to $821.0 million in 2016 from the $483.8 million in 2015. Over the three-year period, RECF saw an average annual growth rate of 160%, and it accounted for 2.3% of the total market in 2016. The naysayers have been proven wrong. Why are investors interested in online real estate opportunities? For most private investors, real estate crowdfunding platforms offered the first opportunities for many people to invest directly in real estate as an asset class without writing a six-figure check. That meant few people truly had access to real estate investments, particularly if they did not want to make it a full-time job. Platforms like Patch of Land and RealtyShares, which was co-founded by AlphaFlow’s CEO, Ray Sturm, changed all that by letting people invest as little as $5,000 in great projects from all over the country. AlphaFlow itself purchases loans from private money lenders and online origination platforms to build personalized portfolios for private investors. Below are some insights from our experience and our growing clientele. What are the some of the most common investor concerns? Many private investors are venturing into real estate investing for the first time. Their biggest concerns typically revolve around understanding investment risk and possibly feeling overwhelmed by the complexity of investing in certain real estate structures. When deals get too complicated, with multiple types of equity and complex rules and tax situations to map out how they get paid, new investors tend to pull back and wait for a simpler deal. It is one of the reasons first-lien debt on residential real estate has worked so well. The deals with clear value propositions, transparent risks and easily understandable timelines and return calculations tend to fund most quickly. What makes investors uncomfortable? Investors will also have a healthy dose of skepticism about investing in real estate if they have never done it before. There is also negative nostalgia around real estate due to the housing crisis and both the real effects felt by so many people and the effects that media has added to the national psyche, most recently with the films, ‘The Big Short’ and ‘99 Homes’. Also, there is discomfort around investing with a new, unknown company. Building trust with a potential client is the number one prerogative of an investment manager, or any company raising capital. What are the online investors’ preferred investment duration and rate? New investors—and that may mean investors new to real estate investing or new to an investment platform—typically look for investments with a 12-18-month duration. Once they make a few of those investments and see their payments arriving on time, they have a positive experience and begin to think longer term. They may be happy with their returns but not necessarily interested in repeatedly finding new deals in which to invest because of the burden of time required to do thorough due diligence on each project, and on multiple sites. This nascent space commands a considerable risk premium from private investors, and in the first few years, many deals (debt or equity) paying less than 9% would languish. However, the last few years has taught many investors that projected returns are not necessarily going to match actual returns every time, particularly with risky equity deals. The result is a shift by investors to include first lien debt in their portfolios, in addition to better understanding the risk-return profile, especially as it relates to LTVs, judicial vs. non-judicial states, and local market factors. Are investors’ risk/reward expectations reasonable? A philosophy shared by experienced investors is that you can be a successful investor and incur defaults or losses as long as you have a diversified portfolio to minimize the impact of any single problem investment. Diversification includes a mix of different types of investments within each asset class of your portfolio and a solid mix of asset classes. In online real estate investing this includes diversification across platforms, borrowers, and geographies. What are the demographics and experience levels of online real estate investors? In the early days when crowdfunding platforms first emerged, a high percentage of customers were experienced real estate investors. They viewed the platforms as another avenue to access opportunities, particularly in attractive MSAs far from where they lived or typically did business. Because they knew how to evaluate opportunities and projects, they could make investment decisions using the information provided by the platforms, and to further diversify their investments geographically, without the need to make a trip to the property location. In addition to this group, we have identified two other groups who are regular investors. The first group is made up of highly educated professionals like doctors, lawyers, and engineers who meet the significant income required by SEC regulations but lack time to make these investments on their own. This group is attracted to a passive income and an easy way to access investments, without a significant commitment of time or expert knowledge. The second group is made up of successful small business owners who, like many real estate business owners, may have started out with their own small, local business and grown that over the years, and with it, their net worth has increased substantially. This group understands and is attracted to the tangible nature of real estate. Do investors need to speak to someone at the platform? Are they happy to invest online with no interaction? Many investors are happy to work with platforms electronically, but they often want to kick off the relationship with a conversation. Investors, both those who are unfamiliar with real estate investing and those who have been doing it for years, have many questions and want to speak to ‘real’ people. They are prudent, sometimes skeptical and very smart. They are vetting the professionalism, experience, and expertise of the company, whether they speak to a founder, a VP or a client services employee. While a seamless experience, engaging online presentation, and thorough project information are vital elements to success, investors are seeking to vet the people behind the platform to build a level of comfort and trust before investing their money – no matter how attractive an investment may be on the surface. How important is investor communication and what does an investor expect? Clear and honest communication is critical to building long-term relationships with investors. It is especially important when communicating the progress of a project, repayment of loan interest and principal, including delays in payments, extensions, and foreclosure proceedings. One of the reasons online investing is being adopted is that platforms have made it easy and accessible for investors to ‘see’ and evaluate a deal without needing to go on-site to see it in person, or meet the borrower or sponsor. The investor trusts the platform and the deal that is being presented for investment. However, the platform is also responsible for maintaining consistent and transparent communication about the returns ‘promised’ to the investor by way of regular updates, especially when returns do not match stated or expected payments. If an investor does not receive those updates, or cannot easily obtain progress reports, accurate payment calculations, or is unable to reach someone at the company, their worst fears kick in. Any miscommunication, misinformation or lack of communication creates a situation in which investors cannot wait to get their money back and invest it elsewhere. Given the cost of acquiring customers in the space, that is an expensive mistake. What percentage of investors are completely new to real estate investing – online or traditional? Today, we estimate that about 70% of customers have never invested in real estate before working with AlphaFlow or one of the real estate platforms. Also, as we have seen from the research mentioned above, the figures for dollars invested and participants in crowdfunding is growing, but the industry still has not penetrated beyond a relatively small number of early adopters. There is still a large opportunity for reaching the individual investor at scale. Growth in online platforms has opened private lending and investing to a broader audience. Most investors doing real estate investing online today would not have found their way to a private lender or private capital company. Understanding the nature of online behavior, and investor requirements and expectations is a key factor in converting interest into investment. However, we cannot discount the importance of active relationship management both in earning an investor’s trust, as well as building long-term relationships based on fundamental business practices and communication. This article originally appeared in the July-August 2017 edition of Private Lender Magazine.
About the author:
AdaPia is the COO at AlphaFlow. Previously, she was Chief Marketing Officer at Patch of Land, one of the first debt-focused real estate crowdfunding platforms. She co-founded two previous businesses and has served such companies as Disney and Mattel in brand development and online audience engagement initiatives. AdaPia is an active real estate investor and is currently doing a complete renovation of her home.Our friend and industry colleague Joe Stampone recently put together a great eBook on his top 7 real estate crowdfunding platforms. While we were excited and honored to be included, we wanted to share Joe’s post and eBook because it’s a great 3rd party view on the industry. I’d encourage you to not only take a look at the eBook, but also follow Joe’s blog if you’re interested in learning more about real estate from a true industry insider. We’re excited to work with Joe more in the future! Blog Post: A few months ago I provided an overview of the various opportunities for real estate crowdfunding investors, however I didn’t dig into the specific platforms. In my latest eBook, I break down what I view as the top 7 real estate crowdfunding sites for investors. While there are 100’s of sites out there, the 7 I chose are established players, well-funded, operated by experienced real estate professionals, and sites I’d trust with my own money. This is by no means exhaustive, but a good starting point for any potential real estate investor. Direct investing in cash flowing real estate should be part of any investors’ portfolio. However, a millennial who is an unaccredited investor with a few thousand dollars to invest has a much different investment objective than a high-net-worth individual who recently retired and has $1mm to invest. Why I wrote this guide: 1. There are a lot of poorly run platforms funding risky deals and it’s impossible for the amateur real estate investor to identify the good ones. 2. There are several investment models and it’s challenging to determine which is right for you based on your investment objectives. 3. The space is evolving rapidly and there are new investment models that investors should be aware of. In the guide, I break down each platform outlining what I like, my concerns, fees to investors, their underwriting process, and even fun facts. There are 5 core investment models to choose from: . . . You can read the rest of Joe’s post and download his ebook HERE. Joe Stampone is the VP of Investments for Atlas Real Estate Partners. He also authors a popular blog, A Student of the Real Estate Game, a community of real estate professionals driven by a passion to be on the cutting edge and grow their careers through collaborative learning.
At any given moment there are likely multiple factors influencing the price of a particular investment asset. The fundamental driver of investment returns over the long term is growth in the asset’s ability to generate free cash flow (per unit of ownership, but this is for another day). The generation of free cash flow enables a reinvestment in the asset with the objective of producing incremental free cash flow over the subsequent period. To simplify, picture a business consisting of a large portfolio of rental homes. Using the free cash flow generated one year, the owner purchases a few more homes. The following year, more cash is generated, and the process is repeated. While this obvious cycle of business investment had been a key source of asset value growth since the dawn of capitalism, it has been shown to be extremely difficult for an investor to generate returns in excess of this Return on Invested Capital (“ROIC”) of the underlying asset.
Although ROIC has many permutations, for the purpose of this post it will represent the basic unlevered free cash flow generated by a business (after taxes, but before any growth-oriented capital expenditures), divided by the total capital funding of the business:
It is an imperfect metric that often needs to be customized for a specific investment opportunity, but the idea is to identify how much “re-investible” cash a business is generating relative to the amount of capital the business has invested in its own cash-generating assets.
If a company generates cash that it can use to invest in its current line of business, it can simplistically be expected that this incremental cash investment will generate the same ROIC as the existing business. Shown below in Figure 1 is the hypothetical rental-home business compounding its growth through continued reinvestment in its asset base, self-funded through its own Return on Invested Capital. As the cash flow stream grows over time, it is intrinsically more valuable to the owner. This growth in cash flow, over the long run, is what typically generates investment returns.
There are several key hurdles to the investor in generating returns equal to or greater than the compounded ROIC of the underlying asset. Primarily: taxes. An enormous chunk of investor value is soaked up by Uncle Sam. Given that any crystallization of an investment gain will result in significant leakage, the investor is, by default, at a disadvantage in generating returns comparable to the after-tax ROIC realized by the business or asset. In Figure 1 above, the realized after-tax returns for the investor are highlighted in grey. Although the business is generating annual returns of 10%, the investor only realized 8.6%. This difference may seem insignificant, but over long periods of time this difference in compounded annual return can have truly astonishing implications for investor value.
Two key assumptions in the table above are (1) the multiples of cash flow used to value both the initial investment and (2) the sale of the investment. Valuation multiples come in many forms (price-to-earnings, EBITDA, revenue, cashflow…), but in most circumstances they are utilized as a shortcut for the investor to ascribe a value to an investment that renders it comparable with other investment opportunities. The two typical drivers of valuation multiples tend to be either (1) the predictability of the denominator relative to price paid for the denominator value, or (2) the growth (real or expected) of the denominator, also relative to price. An example may include a long dated, high quality bond or other fixed income asset, or real estate, which often includes a reliable income stream. Cash flows from these assets, due to their predictability or contractual nature, are often ascribed high multiples in the marketplace. Separately, a start-up enterprise that earns comparatively little cash flow today may command a high multiple relative to current earnings power due to the expectations of future cash flow growth. Opposite characteristics of these examples, such as unpredictability in cash flows or expected earnings declines, can also be drivers of lower valuation multiples in the marketplace.
Multiples (i.e. valuation) are important as they provide the only real mechanism for an investor to outperform the underlying ROIC of the asset – buy low, sell high. In Figure 2 below, an example is shown of an investor buying and selling the same cash flow stream as previously depicted, but with the benefit of lower purchase and higher sale multiples.
Just like the rental home company recycles its own investable cash in an attempt to generate additional future cash flows, the investor recycles his cash in the securities representing ownership of the underlying assets. The natural fluctuations in the marketplace of ascribed valuation multiples give the investor the opportunity to capitalize on any deviation from what he or she ascribes as fair value. In this example, only the successful recycling of capital at purchase multiples lower than those of the sale multiples can enable the investor to both make up for tax leakage on gains and outperform the Return on Invested Capital of the underlying assets.
Of course, the strategy of consistently churning investments at high multiples and repurchasing them at low multiples comes with many risks: One key risk is in regards to timing of the reinvestment. In Figure 2, the investor is assumed to remain uninvested during Year 5, and for the period makes no return on his money. In the case of an investor sitting in cash, not only is he or she not generating investment returns, he is actually diminishing his own purchasing power through the erosion of inflation. The time lag between appealing investments can last far longer than shown in this example, and if extended for too long can decimate investor returns relative to ROIC. Given its natural unpredictability, the market simply cannot be expected to consistently provide timely reinvestment opportunities.
The negative impacts of taxes are also amplified in a scenario where an investor chooses to churn his or her money. The more frequently gains are realized, the higher are the required future returns to offset the tax leakage and maintain trajectory of investor returns. Each profitable sale ups the ante for future required performance.
But all is not lost for the investor as there are other ways to converge realized returns to that of underlying asset ROIC. One method is simply time. The longer the investor waits to monetize the investment and realize his or her gain (assuming the same purchase and sale multiple), the closer the realized IRR is to that of the underlying company ROIC. Said differently, if Figure 1 above is extended to include a full individual lifetime investment horizon of 40 years, the after tax IRR for the investor would converge to 9.4% versus 8.6% after 10 years. Again, these seemingly minimal discrepancies in return can have tremendous absolute dollar impacts for an investor over many years.
Purchase and sale multiples have a similar diminished impact over long periods of time. Even if one pays a relatively higher multiple to acquire a high ROIC asset, and sells the asset at a lower multiple after an extended time horizon, the compounding effect of the high ROIC asset goes a long way to negate the impact of the valuation multiple mismatch. Although you cannot close the gap on realized IRR and underlying asset ROIC through these methods, on high quality assets the investor can still realize exceptional returns over time.
Although other systems exist to structure investments such that they outperform the underlying business performance (i.e. leverage, cash flow reallocation), it is easy to see the hurdles an investor generally faces in outperforming the underlying asset class. Time is the friend of an investor if they simply want to approximate the ROIC of the underlying asset, and if outperformance is the objective, the age-old adage will always apply: Buy low, sell high.
About the Author:
Jacob D. Chase is currently an investment professional at one of the world’s leading distressed debt hedge funds and is a Managing Partner of The Denver Fund, a privately held residential real estate investment vehicle. Prior to his current roles he worked as a restructuring advisor at Lazard Frères.
Jacob is a lifelong student of investing, and has a BA in Finance from the Daniels College of Business at the University of Denver.