Webcast: Real Estate Investment Contracts

How to Read Between the Lines

Dan Drew, CEO First Real Fund

My father is in commercial real estate, and when I first got my driver's permit, I was driving around with him, taking pictures of commercial real estate assets, specifically apartments. That was my first sort of intro to the world of commercial real estate. Out of college, I started working for a lender that was primarily focused on Fannie Mae, and Freddie Mac debt. I did that for the bulk of the start of my career, and I learned some very important lessons, but, I was obviously exposed to the intricacies of commercial real estate. With Fannie, and Freddie, you're obviously really focused on multifamily.

One of the things that Fannie Mae did that I thought was really smart is they have a risk loss sharing agreement with all of their lenders, their designated underwriter, and servicing lenders, which gives them a certain amount of rights, and responsibilities, when it comes to who they make loans to, and at what terms. In exchange for having that responsibility, there is a risk loss sharing agreement.

BRAND NEW BOOK

How Real Estate Came to Dominate the Crowdfunding Industry

Institutional Experience

Fannie Mae, to its credit, has created a structure, where these lenders out there that are interacting with borrowers, and dictating terms, and doing the hard work of actually getting money out the door, gave an incentive to these lenders to make sure that it was good money out the door. It was an early lesson that I learned. Essentially, we were underwriting loans with an equity perspective. That's how I got started.

I did that in Chicago before I moved to Boston. In Boston, I continued that. I ultimately moved from Boston to New York. One of the key reasons I moved from Boston to New York was I'm a Midwest kid, so being in New York was a really easy sort of transition, where the diversity is really, really broad. I also had a nice crew of both personal, and professional friends here. I went to work for a company called The Carlton Group, and I got to expand from just doing multifamily debt to doing preferred equity, and mezzanine debt, and all asset classes, not only in the United States, but throughout the world. Having an opportunity to learn about other asset classes, and other positions in the capital stack was kind of the focus.

Real Estate Volume Trading

Now, if you're familiar with Carlton, I was there for four years. To Howard Michael’s credit [CEO at Carlton who has, sadly, since passed away], it's not an easy shop to live on a day-to-day basis. It is, however, an exceptional place to learn a lot. It's a tradeoff that I was certainly willing to make, and I think other people have made. Howard took his professional performance very, very seriously, and expected the same from his team. It was an interesting time, and I was there from 2006 to 2010, which was a time of radical transition for virtually any commercial real estate executive, so, it was interesting.

One of the great things about having a boss like Howard at Carlton is he understands the mandatory evolution that's required. We went from raising capital on fairly straightforward deals to attempting, and successfully, in certain instances, trading distressed paper. Carlton set me up with some expertise in the note-trading space, and I got drafted to Cantor Fitzgerald, which is a large fixed-income trading shop. They trade a lot of different things at Cantor Fitzgerald, but I was brought in, and integrated a loan-trading platform into their fixed income.

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Deal Structure

I sat next to some muni traders. I sat next to some CMBS traders, high-yield traders. A lot of the clients that were buying the types of fixed-income products from other salespeople within Cantor Fitzgerald were, of course, curious about some of the buy opportunities in commercial real estate, and we had our own universe of buyers, as well. We advised the FDIC on some of those transactions, and Colony [where Gower worked at the time] was such a compelling bidder, for a lot of different reasons. The FDIC put together a really interesting structure, and, at the time, and you've already pointed this out, there's a lot of different reasons to sell, we would call it a piece of paper, or a mortgage instrument to a buyer. There's a relationship there that maybe didn't exist prior. There is yield there that is probably above what currently existed. Interest rates were significantly lower, then, than what some of these loans, when they were originated. Even paying par for a loan still meant a premium yield.

It was a great, great opportunity that forced all of us to learn not just what the value of real estate, and collateral was, but how these positions are structured, and how certain terms, and conditions - whether it's a mortgage, or a preferred equity position - might impact the long-term value, and how it relates to the underlying collateral. It was a very interesting, and compelling time to be in the industry.

Genesis of First Real Fund

It was an exciting time. It was those of us that adapted to the transition in the market and were able to provide a service that was relevant to what was currently happening was a really important lesson. I think it was one of the key lessons for me, in my career, and my willingness to sort of take the step into commercial real estate crowdfunding, because I think this, what's going on in the private placement space on these crowdfunding platforms, is still nascent, but it does have similar characteristics to what has happened from 2008,'09, and '10, and then, as the market stabilized in 2015.

That's how we got here. I was at Cantor Fitzgerald; I made the move to GE Capital, because I thought it would be a nice, long-term, stable place to have a 20-year career, and GE Capital sold everything, so, I was in and out at GE. Despite my move towards something that was maybe a little bit more longer-term, and stable, it ultimately turned to be remarkably short-term. It was a reminder to not be afraid to constantly adapt, and stability isn't necessarily strength, in anyone's career, at any point in time. I had to make the decision, after GE Capital, I had to decide: do I go back, and get a more traditional role, like I had, or do I go get a job that I think I'm going to want to have five years from now?

Webcast: Real Estate Investment Contracts

How to Read Between the Lines

Relationships

It was very evident to me, especially people in financial services, how important, and how massive the fintech space not only is, already, but is likely going to become over the next five, and 10 years. With a little bit of time to think about it, it ultimately was a no-brainer. I think you've made a mirror step in establishing the National Real Estate Forum and understanding the potential in this space.

It was an aggregate of the long-term potential. It also happened to be a really great fit for my skill set. I had done a lot of underwriting, for a really long time. At Cantor Fitzgerald, I had to make a lot of phone calls, and I had to establish a lot of relationships. Those two skill sets are actually particularly well-suited to crowdfunding. There's a constant demand for underwriting and reviewing an awful lot of deals. The ability to quickly, and efficiently select the ones that make the most sense, and have a reasonable structure is a skill set that not everybody has. It takes time, and it takes generally seasoned executives to pull that off.

Real Estate Crowdfunding

Then, you've also got to not only interact with the sponsors, and borrowers, but there's a lot of investors out there - more than a traditional real estate deal - that are very curious. Some of them very, very sophisticated, that have been doing this for a lot longer than I have. Some of them not so sophisticated that need very complex ideas distilled into relatively short, and efficient answers. It's kind of like the traditional teacher, until you really know something, you can't teach somebody. This is an opportunity to help other people learn about what we're trying to do, and it's an opportunity for me to learn from people that have been doing this for even longer than I have.

I decided that I wanted to get into real estate crowdfunding. I went and looked at the top real estate crowdfunding sites, like a lot of people do, and I went, and tried to get a job, and I ultimately did. Now, unfortunately, it ultimately didn't work out. I had a series of clients, and was given an opportunity. I have a co-founder that had a really remarkable vision that coincided with mine, as well. I had the opportunity to start my own platform, and there were a few key things that we needed to resolve.

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Establishing the Brand

One of those is how do we differentiate ourselves in this market? It was a somewhat crowded market, but not terribly crowded, with really qualified, and competent players, but we wanted to distinguish ourselves. It's what you mentioned before: we need to make co-investments. I have a single source of capital that not only understands commercial real estate, and is an active investor throughout the world, not only in the United States, but in Australia, as well. They are willing to, in certain instances, prefund these deals. They're willing to provide capital for co-investments, and they understand real estate.

Having a good co-founder, to people out there considering starting their own business, having a good co-founder that not only understands your vision, but can help you execute it is an irreplaceable asset, when it comes to navigating the world of startups.

It's been a little bit over a year since we started the company. I've been active in private placements, now, for almost two and a half-three years. The biggest challenge is relevant to pretty much any startup, I think, and that is establishing the brand. It is, from a macro perspective, something that is done by just the basic blocking, and tackling, every day. We're going to have our first capital-raise payoff next month. The process of getting that deal funded, keeping regular updates going out, and then, ultimately, making the repayment, that's how you establish the brand. As inquiries come in, providing timely, and accurate responses, that establishes the brand. Doing podcasts like this, making sure that articles go out, all that stuff is the day-to-day responsibilities of First Real Fund, and that's how we established the brand.

Managing the Platform

Fortunately, our biggest problem is a relatively straightforward solution, and that is keep at it, and do the little things right. I think that's our biggest challenge. One of the great questions, I think, about crowdfunding platforms, in general, is are you a tech firm, or are you a real estate firm? The answer is we're both. From an integration standpoint, and resource standpoint, we are more a real estate platform than we are a tech platform, but all the platforms do a really good job of integrating technology into this.

There are some key avenues out there. Google is a remarkably powerful tool. When you look at the value of Google, it's an impressive thing. Then, when you are managing an online platform, and you see Google Analytics, and their ability to provide specific data feedback on what's happening on your site, you have a whole new respect, and appreciation for the things that Google can accomplish.

Webcast: Real Estate Investment Contracts

How to Read Between the Lines

Building the Brand

We, like a lot of our competitors, and a lot of people in this space, and, given that we're an online platform, it's obvious that online advertising is a prudent place for us to be spending advertising dollars. Twitter is one place. We've found that Twitter isn't necessarily the best place to attract the most relevant attention, but Facebook is obviously interesting; LinkedIn is obviously interesting. Google Ads are a part of our monthly ad spend. What we have found is that you give one of these platforms a budget, and if you don't limit it, it can take off like a rocket, and you can spend unlimited amount of money in a very short period of time. The challenge is, of course, understanding how those are converting into actual investors. It's a little part of our growing investors, but that, at least, gets attention for the platform.

I think, without revealing too much information, things that move, any type of video, gets more eyeballs. I think that LinkedIn is probably the most efficient social platform to be on, and it's impossible to ignore Google's remarketing capabilities.

Sourcing Deals

Given the 20 years I have in the industry, I have plenty of relationships that ... I have plenty of people asking for First Real Fund to help them raise money, so, if you put ... We also have on our site, "If you're interested in having First Real Fund raise money, submit a deal." We, like a lot of platforms, get to see a lot of deals that way. What do we like is kind of one of the key questions, and this goes back to our initial conversation about handling distress in the market. We like sponsors that have experience, or some sort of demonstrated competitive advantage. There's two things we like to see. One is local expertise, and at least a certain level of track record when it comes to per-unit, or per-square-foot history.

We also love sponsors that are in growth mode, and they've outgrown their current source of capital. That, frequently, is friends, and family, or a small private equity firm, where they're giving up a huge amount of the upside. We would prefer to have either a preferred, or mezzanine position, and limit the upside for us, and for our investors, in exchange for subordinate equity from the sponsor. We love to be in the 60 to 80, even 85-percent loan-to-value, and loan-to-cost, and we're willing to cap our yield, in order for that preferred position.

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Benefit of the Lien

When you do a stress test, you can have a material change in value, and still have the investment position be sufficiently protected to not only have zero loss on principal, but also still achieve the return. We're comfortable doing mezz debt, or preferred equity. In fact, a lot of our preferred equity looks, and feels like mezz, but it's typically behind senior debt to prohibit a subordinate debt position. In other words, it'll have a fixed rate of return, and it'll have certain triggers, so that there's the equivalent of a maturity date. It'll be directly behind the senior debt, and it'll be superior to the equity from the rest of the sponsor, which is kind of like a mezz loan.

It's got a maturity date; it's got a fixed yield right behind the senior debt, and there's a lot of support, and equity, but it has the benefit of a lien. There's a little bit of a yield differential there. It can be as tight as one or two interest rate points. It can be as wide as four to even six, depending on sort of how high in the capital stack you're going.

Mitigating Risk

What we have done in the past, and I would say what we ... A great deal for us would be 50/50. If it's a $10 million deal, and I think that's a nice middle market sort of a round number, because we're only raising $1 to $2 million dollars per transaction, a 10, or 15, or $20 million deal, we're still a material portion of the capital stack, our raise.

We'd love to see 50/50. If it's a $10 million deal, there's a senior lender that comes in for really cheap, up to 60-percent loan-to-cost. We come in for the six-to-eight tranche, and then, the sponsor comes in for the eight to 10 million, the last piece. That's a homerun deal for us; that's 50/50. The maximum that we would go would be probably 80/20, where we would provide 80 percent of the equity, and the sponsor provides 20.

Our investments are kind of the pref-equity mezz debt, which has similar characteristics. Then, JV equity is a significant part of any of the aggregate commercial real estate universe. It's definitely a product that we like to participate in.  We like to have a transaction, where we're the sole other capital provider. The reality is, is that, in order to have access to some of the biggest, and best deals, we'll make a $2 million contribution, but if it's a $50 million deal, we're just not the only equity partner. We're simply one other limited partner amongst many others.

Webcast: Real Estate Investment Contracts

How to Read Between the Lines

Negotiating Power

It's less desirable, because you're not the primary contact. You're one of many people in a larger pool, but sometimes, for larger deals, that's what ... We'd be crazy to ignore investors' potential appetite for a really high-caliber deal that's larger, and has a sponsor that has a tremendous amount of experience. Otherwise, investors wouldn't normally have access to that type of deal. We do do that; I mean, we do both.

Being a majority investor feels better, is one thing, right off the bat. You're really establishing a clear relationship, and it's less complicated to understand every relevant party's interests, if you just have fewer people involved. That's one reason.

It’s also a huge advantage, as majority investor, to be able to negotiate terms. When you're negotiating either a loan doc, or the operating agreement, you're the only party that's involved. If you're one of 50 joint venture equity partners, you're signing the docs, as is, more than likely, 90 percent, 99 percent of the time.

Investor Protection

Knowing what to negotiate in the contracts is the level of expertise that you don't get as an analyst; you don't even really get any type ... As just a real estate person, you really have to have entity-level experience, or executive experience, and you have to have access to lawyers.

There's a few key things to look for in the offering documents to negotiate. You always want the control provisions to be favorable for you, and you want to treat your co-investor, your sponsor, with fairness, and you also want them to treat you fair. If they make mistakes, if something happens that's beyond their control, the ability for you to execute your workout plan, and this is relevant ...

Living through 2008 to 2012 was really relevant for me, and certainly, for you, because we learned to address, and how important some of these terms are. The market has evolved since then, and some of the terms have become more clear, and some a little bit less clear.

The best way to summarize it is you want to be able to take control of any property without too much hassle. Sometimes, frankly, being in a preferred position is easier than being in a mezz position, because foreclosure is a terribly long process, and, sometimes, simply the threat of foreclosure is your greatest asset, when it comes to that.

If you're in a preferred position, and there's a series of provisions that allow the sponsor, or require the sponsor to hand control over to you, as the sole co-investor, that's a really powerful position to be in. That's top of mind, when it comes to what we look for in the offering documents.

Related to this episode

BRAND NEW BOOK

How Real Estate Came to Dominate the Crowdfunding Industry

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