When to Use Self-Directed IRAs for Real Estate Investing

For the past year, I’ve been working with a leading online real estate investing platform, iFunding. It’s exciting to see how technology and legal innovations are changing the way real estate is financed through online marketplaces and crowdfunding. Here, I’m extending my thoughts delivered in iFunding’s blog to cover the individual real estate investor’s perspective, which is the focus of my own LLC, Heartland Real Estate.

Retirementsavings tree

Growing Your Retirement Account with Real Estate

Today, we look at self-directed IRAs, which allow investors to place tax-sheltered retirement funds into specific property investments, as well as other alternative assets like gold, private loans and LLCs. The promise of significantly higher after-tax returns makes SDIRAs well worth considering for someone with an IRA next egg already built up.

Based on several months of research, my takeaways are:

  1. With real estate investing, SDIRAs offer the strongest tax-offset benefits if you are making loans to property owners/builders, or acquiring ownership (equity) in an income-generating property purchased mainly with cash. If these are your types of properties, you can increase your after-tax profits by 1/3 or more versus investing with non-IRA money.   Read an overview interview I conducted for iFunding with the author of “The SDIRA Handbook.”
  2. If you invest in other types of situations – house fix-and-flips, or acquisitions/rentals financed by mainly debt with some equity – then you’ll be subject to special taxes in your (often significantly) higher, marginal income bracket. An SDIRA doesn’t seem worthwhile if these represent the majority of your investments.
  3. Spend time to pick a reliable custodian – this vendor is responsible for executing the financial transactions that you request for use of your money. Some are highly responsive speed-wise and provide advice, while others can be flighty right at the time you need to close a deal quickly. Read the interview for iFunding I held with one custodian, IRA Trust Services, about finding the right company to work with. Also, on Bigger Pockets, you can search for a
  4. Understand the fees related to different account providers before choosing to work with one. Some custodians are more favorable to investors with a couple of assets and few transactions, while others are more favorable to active property owners that are receiving rent payments and paying lots of expenses. Many custodians publish fee schedules on their website.
  5. There is some setup and ongoing administrative effort involved with an SDIRA account. Most investors who apply for such accounts already have experience with real estate investing and are comfortable that their focus aligns with the best uses of SDIRAs. It’s fine to make several investments before creating your SDIRA, and crowdfunding sites make it easy to invest small amounts over periods of 6 months to a year or more.

I welcome dialogue with those who have questions or experience with self-directed IRAs. For further reading, I recommend the SDIRA Handbook or these discussions on Bigger Pockets.

The impact of commercial real estate taxation across the 50 states

While blogging about the impact of inter-state (non-residence) taxes on real estate investments, I came across useful research on real estate taxation parameters in every state. The research demonstrates how important it is to understand the tax regime in a state you invest in, in order to predict profits.

The taxation guide is available at no cost to anyone who requests it, at Alan Blairreiadvise.com/50-state-guide by emailing admin@reiadvise.com. I spoke with its creator, Alan Blair, Managing  Partner at REI Equity Partners, which is a Connecticut-based real estate investment and advisory company focused on stable, long-term cash-flowing investments for its clients.

Highlights below include:

  1. Alan, you’ve put together a pamphlet that summarizes tax implications of operating properties in all 50 states and Washington, DC.  The research you’ve put into this is quite an accomplishment. I count 17 columns worth of taxation and customs considerations by state. What was your goal?
    Necessity was the mother of invention in putting this together. We began servicing investment clients from the US and abroad that had a nation-wide scope for acquisition criteria.  The tax information grew beyond a legal-sized piece of paper, so I went to all of the states’ websites – secretary of state, taxation, business departments – and began capturing all these parameters. It took weeks to drafts and months to complete.
    Now, this desktop reference guide helps us accurately estimate total property acquisition and disposition costs. We had a real surprise, in fact it took our breath away, when we first understood taxes and additional costs in New York, for example.

  1. How important are taxes and fees in calculating returns?
    Very important! When you compare the least favorable state for taxation of non-resident property owner income against the most favorable, it’s a difference of keeping just 87% of your profits after state taxes, versus keeping 100%, the entirety, of your profits. Some of the other taxes and fees that most investors and developers don’t think a lot about, such as mortgage tax, transfer tax, leasehold tax, can also slice significantly into returns.
    On cash flow properties, you’re interested in the spread between the cap rate and mortgage rates. As that spread begins to narrow, it’s absolutely important to sharpen your pencil and understand how much you’ll keep in the end.

  1. What is different about New York?
    Our model ranks New York as 27th out of 50 states in terms of how favorable, or in this case burdensome, the tax regime is. New York state charges 1.4% and New York City charges an additional 2.625% transfer tax upon the sale of the property. The seller bears that expense, which is above and beyond state and city income tax. New York state also levies an annual franchise tax on the asset. And, there are annual withdholdings. I haven’t even addressed capital gains taxes here.
    Let’s go further. In most states, closings can be conducted remotely.. All documents are prepared by the attorneys in advance, executed and overnighted to the title company. Once everything is in place the order is given by the lender and buyer to wire the funds to the title company who then distributes the funds to the seller. To compare, in New York, it’s customary for a closing to occur in person. The parties and lawyers appear, a representative from the title company joins, then you sign documents. To close electronically in New York, I believe you’d need to start with attorney authorizations to sign on your behalf.
  1. What other parameters do you track?
    Mortgage tax, leasehold tax, the owner’s policy premium are some of the customs levied in various states, but the amounts and expectation of whether the buyer or seller pays differs. The seller isn’t going to volunteer this information if you’re negotiating to buy a property, so you need to be aware yourself.
  1. Can an individual investor make use of this research? What about developers?
    For both groups, especially individuals, our guide is a starting point to ask the right questions. It’s an alarm bell in a sense. Then parties can use us as an advisor, or turn to their CPA or tax lawyer, to determine all the details for a particular deal.
    In terms of asking the right questions, let’s take the case of title insurance. In some states the cost is fixed and the process is fairly standard. In other situations, you would want to understand how diligently your attorney is looking after your interests by helping negotiate the title insurance cost while ensuring that your interests are adequately protected. When I recommend an investment property, the last thing I want is for all of us to be surprised about unanticipated closing costs.

  1. You’ve developed a ranking formula for the states and list the top 10 states in terms of favorable tax regime for real estate. Which states are in the top 10 and why?
    There are 5 states where you get to keep 100% of the real estate profits as a non-resident entity. There are no filings, no surprises, nothing really is required. These became our top 5; they are Florida, Nevada, South Dakota, Washington state, and Wyoming. The next five have minimal franchise/opportunity taxes are Delaware, Illinois, North Dakota, Ohio, and Texas. Compare North Dakota, which levies a 4% franchise tax against West Virginia, at the bottom of the 50 states, with a 13% tax. And franchise taxes are levied on assets and or income annually!
    Of course, taxation isn’t by any means the only criterion for selecting investment locations. It also depends on the opportunities available in the state and the deal’s terms. Texas has a lot of opportunity currently with not as many investors bidding up prices, though that window is narrowing. Illinois works for us in terms of opportunity, yet with a 1.5% franchise tax.
  1. How closely do you estimate taxes? What does your model look like?
    Property tax rates can vary based on the amount of profit, just like a marginal tax rate on income. The numbers I report in the state tax rankings are based on assumption that a property yielded $117,000 gross profit, but the underlying model adjusts for the different tax tiers.
    Institutional real estate investment firms generally use ARGUS for assessing risks and returns. It’s considered an industry standard. On the other hand, our our proprietary model focuses solely on fully-rented, existing cash-flow, retail and office commercial properties. I personally think our model is better, more insightful, for this purpose.
  1. What does your own real estate investment company focus on?
    We operate two companies. One is Real Estate Investment Advisors (REI Advisors), which represents larger investors in their search to acquire new properties. Then there’s REI Equity Management, which is the general partner in properties we own on behalf of investors. We operate both companies under the brand “REI Equity Partners”. We specialize in high-quality properties that can provide long term passive income for our investors. Often our individual investors are planning for their retirement one day. In particular, we emphasize properties such as multi-tenant retail with strong leases and tenants, and medical office space. All our investments are based on extensive financial modeling of the income potential and risk reduction considerations.

  1. Let’s consider crowdfunding for a moment, the trending model that allows a wider range of investors to get involved with real estate properties with lower minimum investment amounts than is traditional. How can they get a handle on the risks and rewards modeling for real estate?
    It can be challenging. They should start by understanding the various property classes. For example, they may have an instinctive feel for house flips, being a home owner. However development carries additional risks in terms of unexpected surprises with the land and existing property, the cost of materials, length of time to build and sell, and especially on the high-end, exposure to economic downturns.
    Compare that to high-quality commercial leases, such as multi-tenant retail. Rental properties like this are very predictable over the long term because you can read what the lease says and you can evaluate the economic strength of the tenant and the nature of the business. This type of real estate investment would be a good substitute for other types of “fixed income” investments such as bonds. Real Estate has the added benefit of not re-pricing daily with interest rate changes and valuations are not inversely related to inflation because with inflation you get rent increases, albeit with a time lag.
  1. How do you reduce risks with your commercial RE investments?
    Well-written triple net leases are key, but not every region of the country commonly see these, so you have to be selective about location. We invest in properties that are already tenanted: you know exactly who the tenant businesses are, you can read the leases, and study the traffic around the location. All the tenants in our properties are national or super-regional companies. In our last investment, the anchor tenant is Starbuck’s, and premium coffee has proven fairly resistant to changes in the economy. Starbuck’s in turn encourages traffic to, and interest in, the other spaces on the property. Other properties we have invested in are shadow-anchored by a local medical center or university or a super regional Wal-mart.

Real Estate Investing and Out-of-State Taxation

In a recent web discussion forum, the question came up about required tax filings when an RE investor participates in a property LLC operating in another state.  Let’s say the investor lives in New Jersey, the property LLC is registered in Delaware, and the property itself (which could be a development, a flip, or rental/commercial) is in South Carolina.  Who pays the state taxes on the profit, and where?

While I am neither a CPA nor lawyer, and the following isn’t official advice, I believe it will be a helpful starting point for investors.  The question is particularly important if you’re investing in crowdfunding deals. Because investment amounts and absolute returns can be relatively modest compared to non-syndicated properties, any costs an investor faces when filing taxes could eat noticeably into the profits. So, how might the taxation work? In short, “it depends” but there are a number of factors you should be aware of…

First, this link notes that construction (I read this as property management as well) in another state is regarding as conducting business in that state, so ‘someone’ is paying the out-of-state/non-resident taxes should they exist.


Steven Winchester, a Partner and CPA at Citrin Cooperman, a national accounting, tax and consulting firm, indicates:

“The filing requirements for nonresident investors is contingent on the manner in which the underlying entity (the property developer’s or crowdfunder’s LLC) files its tax returns. Many pass-through entities file composite returns. The composite returns for the most part file and pay the tax that the nonresidents would have to pay. It is usually a bit higher rate. The benefit for the composite filing is that individual partner would not have to file a return in the non-resident state.”

“However, real estate generally is highly leveraged and generates losses due to depreciation, interest and other operating expenses which when held in a pass-through entity—pass out to the investors pro-rata. In this scenario a composite return would neither be practical, advised nor is it the common practice.  The investors would, if their tax picture dictates, utilize those passive real estate losses against other income generated from other passive real estate activities.”

Winchester continues: “An additional state tax filing is not difficult.” It could take a firm one to a couple of hours of effort to prepare, proof and electronically file a basic return in another state. However, if the crowdfund or other real estate investment is only going to yield you a few thousand $ or less in profits, and you’re covering accounting costs, then the extra charge for out-of-state investing is worth factoring into your return calculations.

“However, the administrative cost to individuals could be prohibitive if the fund/partnership invests in many states and puts the onus on its partners to take responsibility for deciding whether they want to file in all the states notwithstanding the obligation to do so.” [This shouldn’t be an issue with single purpose LLCs set up by crowfund sites for each project]

That’s the general principal, but as with all interesting tax questions, the true answer may be “it depends.” Steve says “there are many nuances and scenarios.” Another CPA has advised a leading RE crowdfund venture, Patch of Land, that “It will partly depend on what activity the LLC is actually conducting.  It will also depend on if the investor has any other activity in the state.  It will also probably depend on exactly which state the taxpayer resides.”

Patch of Land‘s AdaPia D’Errico and the firm’s advisor kindly shared this “it depends” feedback: “Consider in California entity that formed an LLC to make short-term, real estate, rehab loans.  Many of the owners/investors in the LLC reside outside of California.  Because more than 90% of the assets/activity are securities/loans, this qualifies the LLC as an ‘investment partnership’ in California.  As such, the interest income allocated to non-California residents is only taxable in their home state (unless they already have a filing requirement in California).  If they already have to file in California they will have to include income from this partnership on their California return…but then will get a credit on their home state return for taxes paid to California on this income.

Net-net: It would be ideal for crowdfund sites to advise as best possible on how each deal is set up, particularly whether the property’s LLC plans to file composite returns on behalf of  non-residents. Even though the investor will still have personal factors that could impact the outcome, the crowdfund’s advice would make the research a little “less taxing…”

iFunding CEO William Skelley Interview – Real Estate Crowdfunding

William Skelley, founder of iFunding, has given considerable thought to crowdfunding real estate, and how this market will grow relative to other innovations.  It’s a pleasWilliam Skelleyure to share his thoughts on these investment opportunities and how best to structure a crowdfund business that’s attractive to real estate investors and developers.

Prior to founding iFunding, William was a principal at Rose Park Advisors, a hedge fund founded by Harvard Business School professor Dr. Clayton Christensen. He has also worked at General Electric, Olympus, Bain Capital and as an advisor to several start-ups. He co-leads iFunding with Sohin Shah. Former New York Governor David Patterson serves as Director of Community. Their web site is www.ifunding.co . In this interview:

Company Background

  1. What was your prior background in real estate and how did that inform your decision on how to go about setting up iFunding?
    While the JOBS act is an accelerant to real estate crowdfunding, it had little do with starting iFunding.  Prior to downturn in real estate several years ago, I owned a boutique investment bank.  When Lehman and others went under, real estate came to a halt. I was thinking of my next steps and came upon a program at Harvard Business School. There, I met Clayton Christensen, who is known for his work on disruptive innovation, and was leading a prominent hedge fund that focused on investing in innovative companies on a global basis. I joined the group, and one investment we made was in CircleUp.  It’s now the largest crowdfunding angel investing platform in the US, with a recent $7m cash investment from Google and Union Square Ventures. From these experiences, I realized the same potential for innovation is applicable to real estate.
  2. Describe iFunding’s differentiating characteristics, in a nutshell.
    We focus on institutional quality deals with commensurate returns, scalable investment amounts and asset types, and we operate on a global basis.

For Investors

  1. The returns targeted by many of your investments, at least for home refurbishments, are well beyond that aimed for by other sites. On house refurbs, iFunding has offered a preferred return plus an equity upside component that – should the project go well – offer significant double digit yields. This compares to private money loan investments on other sites, in the high single digits to very low double digits. How do you accomplish these returns?
    It’s simply unfair to the investors to offer them something akin to private money lending terms for home refurbishment lending. It’s not truly innovative. We feel that our investors deserve returns like they could receive from a Starwood, for example, if they had access, but with lower minimums.
    For the real estate operators, we make the returns competitive in part by allowing a higher loan-to-value than some other sites will, based on greater due diligence.
  2. Do you do debt deals as well as equity deals?
    We offer our investors preferred equity deals. We have a partnership with a large family office that provides all the lending we need for our projects.
  3. Crowdfunding is billed as a way to democratize the investing process, allowing many more investors to get into quality deals. Are you seeing this expansion of involvement?
    We’re seeing a range of investor backgrounds. The most active tend to be seasoned real estate investors. We have one investor who has participated in almost every deal; she used to be an institutional investor.
    Others have never invested in real estate before, and we’re seeing them increasingly at educational events.  We have a rule now that one person cannot invest more than 50% of the deal, in order to provide more access to smaller investors.
  4. Do you think the newer investors have the experience to understand what they’re getting into from a risk/reward perspective?
    We provide as much information as we can about each opportunity on our website. A lot of what we do is educational. We provide a top 10 FAQ for each deal to get investors thinking.  In a continuous effort to educate the community on our company and industry, I’m speaking soon at the New York Law School, and in April as part of a Harvard Business School club panel in Manhattan. There is also a very popular crowdfund expo in San Francisco that will cover real estate this year, where we will have a presence.
  5. How should investors think about getting into real estate deals outside their geographic region? Regional diversification is a way to reduce risk, but how well can investors do their own due diligence if they’re not familiar with the location?
    You want to perform a lot of due diligence on the operating partner and ensure that they are completely familiar with the region and asset type.
    In addition, we can use technology to improve investors’ ability to make decisions. We ensure that there are high quality photos from around the property, similar to what AirBnB might provide in the domain of vacation rentals.  And, we encourage our operating partners to capture video of the property and post it on our site.
  6. As investors become familiar with real estate via crowdfunding, some also are revisiting REITs and REIT funds. How do they compare with crowdfunding of specific properties?
    Every investor will have different interests and there’s room for both in a portfolio.  A major downside of REITs is that you’re susceptible to the vicissitudes of the stock market.  REIT values can overreact to news over something as loosely-related as emerging markets. Compare that to a retail property investment, like a storefront leased by McDonald’s for 30 years with corporate guarantee, where the income stream and investment value is very reliable.
    REITS are, however, very liquid to purchase and sell shares. To make crowdfunding more liquid, we have future plans to establish a secondary trading platform for our investors’ holdings.
  7. What are other unique aspects of your mode – you mentioned ‘global‘ at the outsetl?
    We recently opened an office in Singapore. That office is expanding our presence into 11 countries. This will enable Asian investors to more easily participate in US properties, as well as give US investors access abroad.We also believe in community outreach and development.
    A sector that is very close to my heart is affordable housing. iFunding is working on this now with our Director of Community, the former Governor of New York, David Paterson. Many years ago, my grandmother worked in affordable housing in Cambridge, MA, which helped foster my deep interest in this cause.

Working with Developers

  1. How receptive are real estate operators to working in your model?
    They are very receptive and find us easy to work with. We receive 10 to 15 operating partner solicitations per day. For every fifteen, we will perform in-depth research on 1. In the end, we go forward with 1% to 2% of the deals brought to us.
  2.  iFunding serves as a general partner on the deals you facilitate. What are the advantages of being GP?
    We serve as a joint venture partner on every single project and have oversight of the funds.  If we raise $200K for a single family home, for example, we don’t just send it to a sponsor. We agree to a budget with the developer and capital is distributed based on hitting milestones. We feel this control is very important. In real estate, should a deal ever go bad, it’s extremely difficult to recoup the money through legal action. So we take extra measures to ensure it doesn’t get to that stage.
  3. What would you say to critiques that iFunding may be adding a layer of management to projects that it doesn’t have a lot of expertise in?
    Just because one is not an expert in industrial parks in North Dakota, doesn’t mean that you can give up responsibility to do everything feasible to due diligence investments and protect them. Beyond review of operating partner’s experience and proposal, our research team ensures the reasonableness of the budget and timeframe. We want to make sure our partners are hitting their goals every month. I think some crowdfund sites will become more involved in oversight going forward, to reflect the model we already have.
  4. Real estate operators have questions about whether they can be sure that each investor is fully accredited. What is iFunding doing about accreditation proof?
    There are handful of firms that, for a modest fee per person per year, will verify accreditation. I’m shocked that crowdfund sites are asking for 1099s or letters from lawyers and investors on their sites. Our goal is to create less work for our investors, not more.

Regulatory Considerations

  1. What are the major regulations that apply to crowdfunded real estate?
    You should be aware of 506.  Rule 506(c) of regulation D allows a private company to solicit accredited investors using social media, Internet and traditional advertising.  There’s no limit on how much an accredited investors can commit to deals under this structure.
    Title III of the JOBS Act added a section to the Securities Act, which allows for true crowdfunding transactions with non-accredited investors. This is in the public comment period.
    There’s also Reg. A and the pending Reg A+.  Reg.A allows for $5m in offerings by a platform over any 12 months, without having to file a registration but it’s considered a low threshold with a lot of effort. The proposed Reg A+ would allow a company to offer up to $50 million bit with greater investment protections.
    Finally, there’s an S-1, which is what Lending Club used. It’s like an IPO.
  2. How did you decide on the legal structure for iFunding?
    I spoke to many top law firms, but couldn’t find any two that agreed on the best method to structure the company. Some said you had to be a broker-dealer. Others felt you needed no-action letters. The research took six months. Eventually, we became a broker-dealer, operating under regulation 506-d.  Through our legal structure, iFunding is permitted to support nearly unlimited offering amounts; a billion overall is permissible.
    Some of our competitors make use of the crowdfunding act, which allows them to solicit any and all investors by posting real estate deals and target returns to the general public on their web site. We feel it’s more prudent to keep the specific deals and terms within our secure web site, accessible only after investors have provided profiles and confirmed they are accredited. In the future, when Title III of the JOBS Act is completed, we may reassess the process.
  3. What does being a broker-dealer enable you to do?
    Being a broker-dealer (BD) allows you to charge a commission for introductory services. If a deal is raising $10 million, it requires more effort than a $500,000 deal on our part.  Or, if we only do a partial raise, we’d want the financial arrangement to reflect that.
    More strategically, my sense is that VC firms much prefer to invest in broker-dealers. It comes down to both the robust regulatory framework already there for brokers, and the economic scale that can be achieved.  I think the real estate investors also will be more comfortable with a broker-dealer.
  4. For the specific properties you offer for investment, describe the legal and operating structure?
    We use a master-sub LLC framework for adding investment opportunities.  The sub is efficient to set up, and allows us to distinctly protect the assets and guarantees for each investment.

Looking Forward

  1. What kind of changes might we see in RE crowdfunding, and for your company, in 2014?
    On a macro level, I think you’ll see more crowdfund platforms become broker-dealers, as the most viable means of scaling the business.In terms of iFunding, we are making the user experience more friendly and robust, especially the education component. Education is key to growing the community. You’ll see an update to our look coming soon, based on feedback from the investors on the site.
  2. This market reminds me of many startup segments I’ve been in, such as e-commerce and social media. Only a few companies are likely to grow to dominance.  How should RE investors look at iFunding in order to gain confidence that you will be one of the major players in several years?
    There’s a checklist of components to consider. The crowdfund team should have real estate experience. The way they structure the investments should be scalable, but more importantly protect everyone’s interests.  Confidentiality is extremely important. For example, we never turn over the names of investors in a deal to the operating partner. I’ve seen other crowdfund models that have tried more of a social network approach, but that hasn’t been the most effective in terms of sound deal-making.

Bitcoin as a currency for real estate investing?

Real estate crowdfund investing site, RealtyShares, has announced that it is accepting Bitcoin as a currency for investments.  Is this a big advance or more bleeding edge news-bite?

** Addition as of 2/25/14: The NY Times reports that an important administrator of bitcoin currency, Mt. Gox, has announced the digital theft of a significant amount of users’ currency. This illustrates the risks with bitcoin and some say poses a threat to its long-term viability. …My original review from 2/5/14 follows below:

Bitcoin is a purely digital/virtual currency. Rather than issued by a government or backed by a real asset like gold, bitcoin money is created (or “mined”) when someone uses extensive computing power to produce an encrypted data point. Once bitcoin is issued, it can be purchased in an online exchange that swaps traditional currency for bitcoin, or bartered for goods and services using computer-based bitcoin “wallet” software.

RealtyShares is one of the crowdfund sites that has opened real estate investing to a larger audience by facilitating investing online and offering low minimum investments in the range of $10K or less.

RealtyShares says online that they had investors interested in bitcoin, particularly to reduce the transaction fees of 5%+ that can occur when transmitting money, especially when currency conversion is involved.

So, is this a game changer? On the positive side, a number of web sites now take bitcoin, such as overstock.com.  And, can you argue with the Winklevoss twins (of Facebook/”The Social Network” fame) who have invested VC money into this area?

However, the bleeding aspects of bitcoin make it risky to say the least.  The currency value is very volatile and subject to speculation. During December 2013, the value dropped from over $1,000 USD to under $600, then climbed back to over $900.  It’s hard to see who in the real estate ‘chain’ would take ownership of the bitcoin for any period if it adds significant currency risk to the unknowns already in crowdfunding returns and swings in real estate. Instead you’d need a market to hedge the currency exchange. And,  government authorities have warned that your ‘wallet’ may be subject to hacking and theft.

My takeaway is that bitcoin makes for an interesting new-bite and praiseworthy creative project for the technical team that produced it.  However, the majority of crowdfund RE investors are looking other types of enhancements: greater clarity on the deal risks, terms and financial regulations that apply; a wider spectrum of deals on each site; more interaction with the RE operators on the other end of the deals; and of course strong returns.  Bitcoin may work best for the few sites that take $100s as the minimum investment, rather than those that are average $10K-100K per investor per deal.

RealCrowd CEO Adam Hooper Interview – Real Estate Crowdfunding

Adam Hooper photo

I had the pleasure of interviewing Adam Hooper, the CEO of RealCrowd, one of the prominent real estate crowdfunding sites. Adam has spent the last ten years working with a spectrum of real estate professionals including operators, lenders, investors, developers and institutional clients. Prior to RealCrowd, he founded two national platforms for brokerage, consulting and joint venture equity investments.

As investors and developers look for education about crowdfunding, I’m pleased to be able to share in-depth thoughts from an executive at the forefront. In this interview:

About RealCrowd and crowdfunding

  1. When and how did RealCrowd start?
    We initially came up with the idea around late 2011 when we were continually working on transactions that were beyond where most real estate operators could efficiently and effectively syndicate, yet were too small for institutions to get involved. At the same time, we had friends and family reaching out to us regularly with smaller amounts – $15k-$50k – that they wanted to invest directly in commercial real estate. Unfortunately, there really weren’t any options for them. So we had the “ah-ha” moment of realizing both sides of this equation existed, we just had to build the platform for them to exist together.
  2. What exactly has changed with the JOBS act to permit sites like yours to exist?
    The biggest change is of course lifting the ban on general solicitations. Real estate has been syndicated for decades if not centuries, but the basic mechanics haven’t changed over that same time. Investor networks have been historically limited to growth by the fact that one could only solicit investors they had a pre-existing business relationship with. That is no longer the case, and issuers can offer their investment opportunities to anybody and everybody – a major shift in how operators can access capital and how investors can access opportunities.
  3. Can you share any information about the amount of activity on your site, such as # of deals?  It looks like your offerings are consistently being over-subscribed, so that must feel good.
    We have done 6 deals so far, totaling over $62M of total asset value. And yes, it feels great that we’ve come that far in only a few months of being live with the platform!

RealCrowd’s benefits and differentiators

  1. What differentiates you from other real estate crowd-funding sites?
    We take a very different approach in that we are not forming individual investment entities for each deal. That is, we don’t create a “Crowd Shares III, LLC” type of entity in order to control investors’ money being placed in “123 Main Street, LLC” for the property.  We feel that is a terribly inefficient approach (having to replicate all of the diligence, accounting, reporting etc. that is already being completed at the asset level) that adds unnecessary complexity and uncertainty to the investments – if that platform implodes, unwinding those deals will be a nightmare. Another is our product focus. We came from an institutional background (with a combined 20 yrs and nearly $3B of transactional experience) and want to bring deals of that caliber to Main Street investors that traditionally would never have the opportunity to participate in those assets.
  2. Some crowdfund sites invest in their own deals and/or serve as general partner. One might justify that this provides more skin in the game and better control. What are your thoughts on this approach?
    Why should investors have to pay another layer of fees, overhead and risk additional complexity to roll dice on the hope that Crowdfunding Co. will be in business for the life of their investment? We reduce that risk and provide the opportunity for direct investment in real estate, not investing in a fund manager.

For investors: requirements, risks & rewards

  1. A low minimum investment level should encourage new investors to include real estate in their portfolio. Your minimums range from $5-10K, correct?
    Minimums on the platform are set by the real estate operator, remember these are their offerings on the website, not ours. Offerings have ranged from $10k to $50k minimum investments.
  2. What is the typical range of investment amounts you might see on, say, apartments with several hundred thousand in equity up for investment?
    Average investments have been in the $35k-$40k range, but keep in mind that’s a spread from the $10k investors up to six figure(+) investors.
  3. Do you offer debt and equity deals?
    Right now our focus has been on equity deals as that’s our background and expertise. We also feel the debt markets are so aggressive right now at historically low rates, that to provide an attractive return to investors you have to go way outside on the risk spectrum (hard money loans, major rehabs, house flips etc). This will likely change in the future and we do have our eye on debt opportunities as the markets shift.
  4. For equity deals, if the deal goes insolvent and the assets need to be liquidated then would you have a significant number of physically-separate individuals, and their lawyers, who have to agree on next steps?
    While I am unable to give legal advise, typically in real estate deals there is a managing member of an LLC, or a general partner of a limited partnership, that would control the unwinding of the assets. Every deal may be structured differently depending on the circumstances however.
  5. What could you advise someone like me, familiar with east coast 4-family units, about investing, say, in apartments on the west coast? Is diversification a good thing for me, or taking me out of my zone of expertise? Is it better to be in travelling distance to the property, “just in case”?
    I think the biggest benefit of platforms like ours that are emerging is to provide the ability to diversify. Yes, one can diversify somewhat locally, but to build a truly diversified portfolio, one can now take advantage of this new reach to look at other asset types (office, retail, industrial, multifamily etc) and geographies. The benefit of investing with best in class operators is that they are the ones doing the “on the ground” work at the assets – passive investors don’t need to be just down the road to handle the day to day maintenance or hassles that can come along with property ownership.
  6. Do you get a sense that the majority of investors are experienced enough to understand the opportunities and risks? For example, I think I see more multi-year commercial deals involving equity with 16-20% IRR being funded more quickly than, say, house refurbishments with a 1-year maturity and a secured loan. And one web commentator noted that investors won’t really know how real estate works until one of their deals encounters challenges. …On the other hand, I’m told that crowdfund investors ask as sophisticated questions as traditional, direct RE investors.  What are your thoughts on participants’ understanding?
    Education is a big part of our mission. E-books, regular blog posts and eventually seminars are all in our roadmap. Real estate is a fundamentally simple asset class to learn – tenants pay rent, expenses are paid from that cash flow, the remainder is distributed to investors. Granted, that’s a VERY simplified view, but you get the point. I do think the crowd is smart however, and would agree that questions we see coming through on specific deals are sophisticated.
  7. I like one of the benefits you promise: “[Online,] investors will be able to track the many benefits of owning real estate, including net cash-flow distributions (distributed quarterly), adjustments in net operating income through changes in the property tenancy and potential growth of their investment through property appreciation.” Is this information now available on your Portfolio dashboard?
    Our platform provides for direct communications from the real estate operator to the investors, including a real-time update feature. As soon as the real estate operator has an update, posts a quarterly update, makes a distribution etc. the investors will be notified immediately and the information is available within their dashboard. This is one of the areas where you will see the biggest roll out in terms of user experience shortly!

For real estate developers and promoters

  1. I’m colleagues with smaller developers, typically refurbing houses, 4-families, or small apartment buildings, interested in getting better terms than from a typical hard money lender, through crowdfunding. It appears that your site focuses on larger developers, however. Do you have a sense of whether the effort and costs of getting involved with crowdfunding are worth it to the smaller RE developer?
    Absolutely. This is the most revolutionary change in the real estate capital markets in generations.
  2. How do you perform due diligence? I understand you focus foremost on the developers. Your site says that “typical sponsors will have been involved as a principal in a minimum of $50 million of real estate, bought and/or sold at least 10 transactions.”
    Our level of diligence is heavily focused at the operator level. We feel this is ultra critical and we strive to have a platform with best in class operators. We also feel that it is impossible for anybody to be an expert in all asset classes in every market across the country. Therefore we cannot believe that some of the platforms in the space are recommending what is a good deal or a bad deal. That isn’t our position as a platform to make. Now, we do know how to find and attract operating partners that are experts in specific product categories in specific markets across the country. The best operators tend to do the best deals over time.
  3. I read that “RealCrowd will charge a nominal fee to the operating partner for its services to arrange for the investments to be made.” Is there anything else that we should be aware of in terms of fees?
    We do charge an up front flat access fee to the operators to utilize our set of tools / a fee to them with each deal. At this time, we do not charge any asset management fees nor do we participate in the upside of the deals. We also take a firm approach that platforms should not be taking any economics from the investors.

Crowdfunding regulations

  1. Investors need to be accredited to participate, correct? And that requires them, or jointly with a spouse, to have income of several hundred thousand or liquid assets of $1m.  What steps do you have to take at the outset, and over time, to demonstrate one’s accredited status.
    Everybody that participates in a 506(c) offering must be accredited. To start, we have our users fill out a self accreditation worksheet as part of their signup process. We then speak with them to determine they are in fact a real person! When time comes to invest in an opportunity, we will take the necessary steps to verify that they are in fact accredited. We take this very seriously and have even seen investors that we are unable to verify based on the documentation provided showing up on other platforms with testimonials about how easy it was to invest! Those are some of the things that cause concern for us a bit about the space.
  2. Some web commentators have voiced concern that you, or other sites, act like a ‘broker’, or promoter of investments and that this role is restricted of crowdfund sites by the JOBS act. Are these the correct words to use or is there a misunderstanding here?
    There is a misunderstanding. There is an exemption to registration as a broker/dealer in the JOBS Act that we fall under. Our approach is again different than other platforms in that we are not an issuer selling our own securities, but we provide a SaaS platform of tools for operators to run their own offerings in an online environment.  We are best described as a ‘platform’ right now.  Technically we are approaching it as a true marketplace as well, which by definition includes multiple sellers (operators) and multiple buyers. Other companies are only offering investments in their own securities which doesn’t seem like a true marketplace to us.

The future

  1. What are future strategic plans for RealCrowd?
    Eventually we will look into adding debt opportunities and may eventually look international as well.
  2. What are improvements  being made to your process and site?
    We just hired an amazing Director of User Experience (he was a Lead Designer at Salesforce.com and we managed to court him to eventually join our team!) and will be rolling out major improvements shortly. Our goal is to continually innovate and provide both operators and investors with the best experience possible. We are also always looking for feedback in how we can better the experience as well.
  3. It seems to me that the future of crowdfunding will be about balancing careful due diligence and presentation of offerings against growth rates. The first crowdfunder to have deals go bad could tarnish the entire field. How do you feel about that risk, and what is RealCrowd doing to be as transparent and prudent as possible?
    We agree completely. Real estate investing, as with all investing, carries with it an inherent risk. Deals will go bad, the market will sour, people can and will eventually lose money. This gets to the earlier point that I brought up – we are not in the business of recommending investments for individuals. We want to make sure that we have the best real estate operators in the industry on our platform, companies that have been through multiple market cycles and take a very proactive role in operating the real estate. Those are the companies people want to invest with, and they are the ones that have the local market intelligence and experience to be a steward of their investors’ capital. Our platform is about access to invest directly with real estate experts.

Disclaimer: This blogger, Scott Lichtman, has made a real estate investment through the RealCrowd site. I am not otherwise involved with the company.

Real estate crowdfund differentiators: benefits/risks to investors

“No one comes here anymore; it’s too crowded.” – Yogi Berra

RE Crowdfunding is becoming more accepted

After 6 months of researching crowdfunding sites of many kinds, I’m coming to the conclusion that real estate crowdfunding is very likely to deepen its roots and spread its branches. The main benefit of providing a broader set of investors access to this asset category, with relatively low minimum investments ranging from $100 to $10,000, is compelling.  The precautions taken by the RE crowdfund web sites suggests to me that – while there could well be hitches along the way, as with any new and sophisticated service, especially if the economy turns downward – the steps the sites are taking to protect investors and developers are sufficient for the regulators to keep this market as a viable investment path. You’d expect though, that of the dozen RE crowdfund (I’ll abbreviate them as “CFs” in this post) sites available now, a few will emerge as market leaders.

Differences among crowdfund sites – and impact to the investors

Some differences among the sites are fairly obvious, such as the states they do business in, the property types emphasized, whether they offer equity and/or debt deals, and how the user interface displays property details for evaluation. Other differences are less obvious, however, it’s these that are likely to make a difference in managing your risks.  Some questions to investigate with each site include:

  1. Does the crowdfund company participate in the deal? Crowdfund sites may be thought of as ‘neutral’ platforms, however their role can vary from “broker” that receives a fee to promote the deal, to “general partner”/investor. The CFs with greater involvement claim this to be an advantage for investors, ensuring more “skin in the game” from an organization they have contact with, should something go wrong.
  2. How are forecasted returns calculated? Inspect carefully whether the loan-to-value on the debt portion of any small property financing is based on current property value, or after repair value (ARV). This might be in the fine print.
  3. If offering debt deals (investor makes loans), how are guarantees structured? The majority of debt-issuing crowdfund companies hold the guarantees – first lien on property, any personal guarantees – themselves. So, should the website/crowdfunder become unavailable, it will be difficult to take action to ensure repayment is made.
  4. How is due diligence performed? Most CFs assess the strength of each individual property and deal (though always reminding participants that due diligence is ultimately up to the investor). At least one site says they concentrate on due dilligence at the developer level, upfront, then rely on that developer to propose robust deals with appropriate prudence.
  5. What fees are charged, and to whom? Most CFs charge fees to the developers as opposed to explicitly to the investors. Look closely at any deal’s operating agreement to understand how the developer and/or general partner is compensated. Some receive a promote fee before equity returns are split up. Others contain a transaction fee that takes effect when the first repayment to investors is made. Much of the time the fees are one time, but on a multi-year, complex commercial deal, you’ll also see management fees.
  6. Are the terms the same for the crowdfund investors as they are for any private/direct investors? I am hearing several sites say “yes, they are the same, for now…” (in the operating agreement), but it’s preferable to understand what advantages any private investors may be given.
  7. How are accredited investors checked? Some sites rely on checkboxes for the investor to assert their situation. Increasingly, they are seeking documentation to be sent to prove income and/or assets. At least one site asked for such proof to be renewed every 3 months should you want to invest on one of their deals.  While this may be legally prudent, I find it cumbersome especially if it involves an affidavit from one’s lawyers about assets. On the other hand, developers are duly concerned about what happens if their deal investors weren’t all accredited.
  8. How much real estate experience does the team have and with what types of properties? Further, how sophisticated is their board and support team, including their legal counsel?  Should you speak to executives at these firms, you may pick up nuances about how well versed each is in terms of what can happen to a syndicated real estate deal, and how the contracts are structured vs. traditional “off-line” deals.

Your returns may vary…

Finally, shop regularly across sites to check returns. Crowdfunders are evolving in terms of what is considered “fair” and “attractive” returns to investors vs. rates to the RE developers. For example, on simple house flips, I’ve seen target returns ranging from 8% annual interest for 3-9 months, to 13% returns with premature repayment penalties, to 10% preferred equity plus a 50/50 split of further profits.

What is crowdfunding for real estate?

““I am a firm believer in the people. If given the truth, they can be depended upon to meet any [situation]. The great point is to bring them the real facts, and beer.” – Abraham Lincoln

Crowdfunding – the involvement of a broad audience in financially supporting a project – has caught on wildly in markets ranging from consumer loans, to global micro-finance, startup support and the arts. It’s now the focus of nearly a dozen crowdfund websites for real estate investing, with the primary benefit being a low dollar minimum, typically $1,000 to $10,000 to hold your very own slice of an income- and equity-generating property.

Exactly how does real estate crowdfunding work, and what are the benefits and risks? This post will give you an introduction, with future posts diving into the details including my crowdfunded deal experiences, and interviews with crowdfund CEOs, developers and legal/financial experts.

Crowdfunding Examples

Crowdfunding has become an increasingly acceptance mode of business in a variety of markets. For consumer lending, Prosper and LendingClub allow individuals to back loans for home purchase, debt consolidation, education, etc, at interest rates of 5-15% (this is after accounting for write-downs). Google is a backer of LendingClub while the huge hedge fund Blackrock invests in Prosper. This sector was on pace to fund $2bn to $3bn in loans in 2013. Elsewhere,

  • Circle Up and and Grow VC provide access to early-stage venture capital deals;
  • Mosaic funds large-scale solar panel installations in return for an interest rate backed by those projects’ profits.
  • Kickstarter and Indiegogo crowdfund projects ranging from new technology and business ideas, to charities and musical/artistic creations. Kickstarter has raised nearly $400m so far.

RE Crowdfund Sites

In real estate, crowdfunding websites I’ve researched include: FundRise, Patch of Land, PRIMARQ, RealCrowd, RealtyShares, and Realty Mogul, and I’ve invested through several of these so far. There are another half-dozen companies in beta or beyond.

This hyper-growth was kicked-off by the Jumpstart Our Business Startups (JOBS) Act, which in 2013 first allowed companies to promote their private securities offerings to accredited investors. Accredited investors have minimum income requirements in the six figures or minimum liquid assets of a million of more.  Next, rules have been proposed for unaccredited investors to participate in crowdfunding, though with limits on invested amounts. While there’s debate over whether the law properly balances ease of access to opportunities for investors and offerers, against investor protections, so far over $2bn has been raised through this process. Read more at VentureBeat.

What are the benefits for real estate investors? To begin with,

  • Far more individuals are likely to gain access to a range of RE deal opportunities, without having to know the ‘right people’.
  • Returns are attractive on paper, ranging from 8-13% on a home refurbishment loan, to 12-20% internal rate of return on a commercial/rental property. This certainly beats average bond/stock returns, and compared to non-real estate crowdfund, investments are both better rewarded on average and better secured, via the property and developer guarantees.
  • Minimum investments for accredited individuals are relatively low, range from $1000 to $10K on many sites.
  • The crowdfund sites provide much of the due diligence, easing somewhat the need for the investor to be fully versed in real estate.
  • In sum, more individuals can incorporate real estate into their financial portfolio, without having to resort to the volatility and lack of transparency in REITs.

Risks are ever-present and need to be carefully evaluated by anyone getting involved. At a high level, these include:

  • The traditional risks with real estate remain: that these are ‘living’ properties, whose profits are affected by their developers, tenants, trends in the economy, issues in the neighborhood, etc.  Your principal investment is by no means guaranteed and, in the end, you can only look to yourself and your lawyer for responsibility to be comfortable with the due diligence.
  • Your capital is locked up in a deal from 6 months to 6 years or more. You choose the types of deals to be involved with, and all else being equal, longer lockups usually target higher return rate.
  • With some crowdfund sites and deals, the site operator has a stake in the deal or facilitates distribution of interest payments. If the site were to go out of business – far from rare in the web startup world – you need to ask what happens to your investment. (In many deals, though, you strike an arrangement directly with the RE developer and have no obligations from the website itself)..
  • There are multiple parties involved in a deal, much like a traditional RE syndication.  While the developer usually is the sole operating member of the deal’s corporate structure, in a worst case all the parties may tangle in voting or legal proceedings.

With all these considerations and more, real estate crowdfunding can be attractive in a number of situations: allocating a modest portion of savings to real estate; gaining access to a diversified set of properties, geographically and by property type; and learning more about real estate investing while preparing to serve as prime lender on your own deals.

There will be much more to follow as we look at individual crowdfund sites and the risk-reward considerations. Meanwhile, I recommend the real estate community discussions at Bigger Pockets to get a flavor of investors’ thinking.

Welcome to the Heartland real estate investing blog

“Be humble, for you are made of earth. Be noble, for you are made of stars.” – A proverb

Welcome, visitors.  This is the kick-off of a blog dedicated to small-scale real estate investors, getting involved with one or a few homes, rentals or small commercial properties. I will share my findings from live deals, interviews with experts, and number-crunching research, and I look forward to your opinions and questions.

In addition to the terms and outcomes of various investment opportunities, there are several subjects that will have special coverage. First and foremost is “crowdfunding“: where a broad community of investors put in relatively small $ amount each and gain access to a wide range deals in which to partipcate. As of this writing, the start of 2014, there are nearly a dozen web sites taking off in this market, and it has the potential to democratize RE investing just as crowd-funding has made consumer loans, startups and the arts more accessible to invest in.

Another special topic I’ll cover is the most effective use of online data sources to identify property buyers and investors and evaluate risks. Additional topics include: the potential for hedging one’s real estate investments, for example to offset some of the potential declines in the property markets by holding other types of financial assets; as well as devices/technologies that will make properties more ‘green’ or ‘smarter.’

As the quote at the top of this post suggests, there are few financial/business pursuits like real estate, which combine the grounding of earth & construction; the complexities of legal terms and financial analysis; and the aspirations of improving the community as well as one’s own prosperity.  I look forward to sharing experiences.

– Scott