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From Law Firm to CFRE
Charles started his real estate career as an attorney working at a firm called Simpson Thacher in midtown Manhattan mostly for big private equity clients like Blackstone, KKR, Carlyle and others. All the real estate giants. He worked on huge, multibillion dollar transactions and found that his actual exposure to real estate investing was pretty limited and opaque and during the day and oftentimes late to the night he’d be working on these big real estate deals, but when it came to investing his own money, he always found that a difficult thing to do. Maybe he would find a friend doing a small deal or looking at buying part of a brownstone or some such thing, and it just seemed like such a weird mismatch to him. So when the JOBS Act passed in 2012 Charles was immediately interested. He started reading through it and especially as the first companies like Fundrise got into the space, was interested to see where it could go. It seemed like this was the path really for solving the mismatch.
Fast forward after a few months of studying up and trying to figure out what his path of entry into that space might be, he enlisted a friend of his, Marious Sjulsen, who was in real estate private equity on the buy side and had been doing it for almost a decade. Marious was of like mind and similarly thought that this really was going to be the future. And so they set out trying to start a company.
Despite having taken the safe route and going to law school and becoming a lawyer, Charles has always had a little entrepreneurial spirit in his heart; a willingness to bet on himself and see what happens. He also had a real conviction that CFRE was going to be a major disruptive industry that would change the way that individuals invest in real estate. If you look at kind of the big picture of the real estate industry you have professional investors and endowment funds investing 10 to 20 percent of their total assets into real estate and then you look at your average individual high net worth investor much less your non-high network investor. And they're averaging under 3 percent of their net worth into real estate outside of their home. There's just such a big systemic imbalance here. Charles thought that if he could be just a part of correcting that imbalance there's really a tremendous opportunity there.
How CFRE came about is complicated but the end result and why this will change things is really pretty simple. At the end of the day especially for investors it's about access. Access to direct real estate investments just hasn't really existed historically outside of personal connections or the country club or that that kind of thing. And if you look at the way that people have invested in real estate it's been through REITs primarily. You have the publicly traded REITs which have their own risks of market volatility and then you have the non-trading REITs which really have been decried by investors in the know in the SEC for almost as long as they've been in existence because they're just opaque and they have really high fees and that's a lot of what real estate crowdfunding will be is the replacement for; that world of non-traded REITs. It can offer access into clear, transparent investments in real estate. It can normalize having real estate be part of everyone's investment portfolio just like it is for professional investors.
The process starts with the information that's presented about the deal that the investor is going into. For one of the deals on the EquityMultiple platform, for example, you can sign in and you're going to see long web page filled with an overview of the deal, pictures, a description, the business plan, the financials, information about comparable properties, about the markets, about the condition of the property. In short, information to let you as the investor know exactly what you're putting your money into and make an informed decision.
Vs. Non-Traded REITs
You can contrast that with the typical non-trading REIT where the sales process has largely been people sitting in a warehouse cold calling and trying to sell a product over the phone where you don't know exactly what you're investing in you're just investing in REIT number 472 maybe it has a particular strategy but you have no idea what the properties are. Furthermore, information about the fees which tend to always be extremely high as high as 10 to 15 percent annually is buried in tiny fine print and really it's about pushing a product on people and trying to trick your way in versus presenting something laying out all the facts and letting people make their own decisions.
Plus, when you invest in one of these non-traded REITs, you don't know what the assets are in the portfolio. The investor may know some of the prior investments but won’t know any of the ones that the future dollars, including your investment, are going to be spent on. Sometimes it's even difficult to get real good data on the existing portfolio. That's just really the exact opposite of what EquityMultiple is trying to do and what most of the good crowdfunding businesses are trying to do.
To start any company you need money. Like many firms Charles and his partner went out and started pitching their idea but instead of pitching it to venture capital the normal place you'd go to raise money they capitalized the business with their own money and also went out and targeted real estate companies because ultimately what they saw from their prior institutional backgrounds was that the real value and the hard thing to find in real estate is good transactions from good reputable operators. They spoke to several real estate firms and ultimately ended up finding a good partner in a firm called Mission Capital. They are a real estate capital markets firm. They have several different business lines they have offices throughout the country. They've done over $70 billion of transactions over the last 15 years. What they provided at the outset and still today is a good pipeline of deals that they can then diligence and look to offer out to investors.
That how EquityMultiple tried to get out on the right foot and differentiate themselves from the start. Charles says that “the big challenge that you think you're going to have at the beginning are not the ones that you end up having.” He believes that it is important to do and see what works and see how the industry evolves to know what your investors, your customers actually want.
Initial investment capital was used to scope out the legal and regulatory framework and in figuring out how they could take something that was really a pretty bespoke, these interests in ownership of a building, and to make that something that is scalable and where you can efficiently bring in smaller investors into these bigger projects. They spent a significant amount of time and money and effort building out the technology platform itself which they did in-house with their CTO and getting that up and running. Making something that at the end of the day is easy and intuitive and makes everything more accessible is an important piece too. From day one from when they were funded to getting our first deal off and running was about nine months.
EquityMultiple’s investment strategy has evolved as the market continues to develop and the principals of the platform try to stay responsive to what investors are actually looking for. Geographically speaking they are pretty agnostic. They work both the east and west coast and everywhere in between. They do limit themselves almost always to primary or secondary markets and have done the largest number of transactions in Los Angeles. They have done a lot in Texas, in big population centers where there's more natural stability through rockier economic times. In terms of asset class, they are strictly commercial real estate. Their biggest investment category by volume is multifamily. They have also done office, industrial, mixed use and then a couple more esoteric things like mobile home parks which Charles thinks are a fantastic little sub niche investment.
What they have found is that they are placing more of a premium on shorter duration investments and investments that have a bigger percentage of their total return being paid out along the way in the form of dividend distributions rather than having most of it be kind of back ended. And that's a little bit of a change from the partner's backgrounds where they would really look at the longer-term value add hold for five years and it's okay if there's no cash flow upfront.
Some of that is what they have seen investors want and some of it is given where the market is they don't want to bank on that asset level appreciation as much; they really want to make sure that the business plan is something that can work right now. That it doesn't rely on a 5 percent year over year growth or anything like that. Their returns on equity investments and preferred equity investments are targeted at somewhere between a 13 and a 20 percent total annualized return and somewhere in the high single digits to low double digits being paid out currently along the way.
EquityMultiple is transitioning to find things that they either can fund with an interest or reserve up front so that they can support that cash flow during the value add component or that have cash flow in place right away and then that cash flow can just strengthen over time through the whole period. They have found that investors place such a strong premium on that that they realized they had to also. They are also doing a lot more preferred equity structures. Preferred Equity is essentially a hybrid of equity and debt. You get more upside and the returns tend to be higher than for debt investments, but you also have some good debt like protection. You're going to get paid before other investors or sponsor operator in the project gets paid. EquityMultiple found that those are popular with investors because they produce current cash flow even if it does need to be prefunded upfront. At a time when there is be market volatility they will also offer some good protection.
To illustrate this, a deal on the platform right outside of Mempis had a 7 percent current pay to investors starting in the first quarter after the investment closed. Then investors had payment priority ahead of all the other investors in the deal. This is just for equity multiple investors. Once the deal is refinanced or sold they get their principal back, and they'll also get another 7 percent return annualized on top of that for a total 14 percent annualized return. Maybe if the deal does fantastically the equity holders will make more, but the goal really is to really increase the chance of getting to that nice strong low teens or mid-teens returns.
Facts, figures, and details
Primer on Crowd Fund Real Estate
Cap on Upside, Downside Protection
The [common] equity investors are behind the preferred equity investors in line for the cash flow and they're also behind in line for repayment. If the deal does really well, then they have more upside. If the deal itself produces a 20 percent return they're going to do really well, perhaps yielding a 20 something return. But if the deal produces a 10 percent return then equity multiple investors will still make a 14 percent return and the equity investors will make very little if anything.
In short, EquityMultiple investors i.e. the preferred equity investors, are capped at a 7% pref plus 7% if the deal goes well, whereas the [common] equity investors who sit on top of that in the capital stack have more upside but also a higher risk of non-recovery of principle. The sponsor and their investors generally take the common equity slug in the deal.
This structure comes out of the institutional world where it's very common there to see these kinds of different tranches of investors. EquityMultiple thought that this was not just a good fit for the institutional side but also a good fit for individual investors because it checks a lot of the boxes that they believe investors are looking for to deliver a nice return. They are still getting a good portion of that return on a current basis, but there is also some real protection in the event that the investment doesn't perform as well as the sponsors is projecting.
To education investors EquityMultiple is putting a lot of emphasis on two things. In addition to having a lot of resources available explaining everything from the basics to the most complex subjects, they also provide customer service and Investor Relations. One thing they try to do extremely well is that they’re very responsive to questions whether it's by phone or email. They talk to a lot of investors in a very old school sort of way. They have a huge range of people from a doctor who's never invested in real estate before to someone who is in the real estate industry sitting in the middle of an office in Manhattan or L.A. or Houston or something. They try to cater to that range in how they explain things and the level of detail that they provide.
While in some ways the background structure of their deals might be a little more complicated on an investment when it’s done as preferred equity there is something that's also very understandable about fixed rate returns; that the investor gets paid after lenders and before the equity investors and EquityMultiple finds that they are dealing with smart people and they have found that it is something they have been able to communicate effectively.
Finding new investors and getting the word out has always been a challenge. It is part of the reason why they love doing podcasts like because in doing so they reach new audiences. There's still a huge swath of the world of the country that doesn't know that this kind of investing exists. They are definitely starting to see some real snowballing momentum on that side of the business. As they look to the future they see a situation where their challenge becomes the other side of the business i.e. in sourcing and underwriting enough good quality deals to meet investor demand. That's the problem where EquityMultiple feels like they have positioned themselves well for. They are ready to grow to that stage of the business.
Charles sees that the CFRE industry is at the absolute beginning still. We're in the very first few innings and have no really hit the point of mass adoption yet on either side of the business, whether it's real estate companies looking to bring on new investors or investors looking to get into real estate. That's still lurking in the future which is great. The world of non-traded REITs is going to start being displaced in a major way by CFRE. The introduction of disclosure rules decimated non-traded REIT volumes and really opened the door for the real estate crowdfunding industry to come in and start filling the void because the demand is there and investors are interested in real estate. They want to allocate a portion of their money into real estate.
Charles sees a real spike in demand likely from investors over the next few years and suspects with that we're going to see further consolidation in the industry. We'll probably see some of the bigger players in the real estate or the asset management world looking to come into the space either directly or possibly through an acquisition of one of the existing businesses. We've already seen sort of more specialization right. Fundrise has now gone into the REIT space. They're really raising money for their own non-trading REIT albeit in a new way. There are platforms like Peerstreet that are very honed in on single family kind of fix and flip lending and really concentrating on growing that space. We’ll probably continue to see that and continue to see the good platforms grow stronger and deeper and, in Charles’s view, there's really room for several different variants of this business model that offer different value props to investors so as you look out as an investor your options are only going to continue to improve.
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