Crowd Source Investing

[Joe Krug]

I am a physician. For years, I owned and self-managed or had a property manager for up to 5 SFR at a time. After a divorce, I sold all 5 properties and made money (1 was basically break-even). However, managing was time consuming. After doing what I thought was diligence, I decided to use several crowd sourced RE investment vehicles. I invested in 9 different investments across 3 different platforms.

So far....3 closed investments with complete return of principle making 9-12% annualized but taxed at short-term capital gains rates. 1 default with a 64% loss of principle (on a borrower who was a "repeat borrower" on the platform). 1 equity investment that in 20+ months has paid less than 2% and currently is looking to re-finance (and this was on a borrower who had "3 prior investments" with this particular platform). 1 pending closure with full return of capital. 3 investments that are paying between 3-9% annualized. 

There seem to be many who tout the benefits of this "passive" means of investing. However, my experience has been awful. 2 of the 9 have basically ruined the other 7 investments. Even with diversification being "the only free lunch" (Thanks Cramer) I have lost money. In addition, I am taxed at the most unfriendly of rates. 

Did I miss something entirely about this asset class? Do people have a better way of doing this? When my monies come back, I am done with this as a class. I could see hard lending for periods of >12 months to get long-term capital gains rates, but this is ridiculous. 

[Ian Ippolito]

Originally posted by @Joe Krug:

I am a physician. For years, I owned and self-managed or had a property manager for up to 5 SFR at a time. After a divorce, I sold all 5 properties and made money (1 was basically break-even). However, managing was time consuming. After doing what I thought was diligence, I decided to use several crowd sourced RE investment vehicles. I invested in 9 different investments across 3 different platforms.

So far....3 closed investments with complete return of principle making 9-12% annualized but taxed at short-term capital gains rates. 1 default with a 64% loss of principle (on a borrower who was a "repeat borrower" on the platform). 1 equity investment that in 20+ months has paid less than 2% and currently is looking to re-finance (and this was on a borrower who had "3 prior investments" with this particular platform). 1 pending closure with full return of capital. 3 investments that are paying between 3-9% annualized. 

There seem to be many who tout the benefits of this "passive" means of investing. However, my experience has been awful. 2 of the 9 have basically ruined the other 7 investments. Even with diversification being "the only free lunch" (Thanks Cramer) I have lost money. In addition, I am taxed at the most unfriendly of rates. 

Did I miss something entirely about this asset class? Do people have a better way of doing this? When my monies come back, I am done with this as a class. I could see hard lending for periods of >12 months to get long-term capital gains rates, but this is ridiculous. 

Joe, Sorry to hear about your bad experiences.

I have a seven-figure portfolio invested in passive investments including both Crowdfunding/syndication deals (crowdfunding is essentially old school syndications done over the internet). I’ve personally been very happy with the overall performance of my portfolio.

In my opinion, the most important thing to understand is that this is not like investing in the stock market where in a person can just blindly pick a few index funds and will probably end up fine. Doing proper due diligence on even just a single deal takes time. For me, as a conservative investor I will spend weeks and months on just a single deal before I invest. I do know others who use the "spray and pray" technique (invest randomly in alot of deals), but that isn't for me personally.

Here’s a list of things that I do.

For vetting a syndication, different investors do it differently because every investor comes from a different financial situation and has different goals and risk tolerance. For me, I'm a very conservative investor and may look through a hundred deals a month, and at the end of the year only invest in 4-5. So things that are a red flag for me may be fine for someone more aggressive. Here's how I do my due diligence:

1) Portfolio matching: (takes 30 seconds per deal)

a) Have an educated opinion on where you think we are in the real estate cycles (financial and physical market cycles)

b) Then only then pick the strategies, capital stack, and specialized asset subclasses that make sense for that opinion. For example, I think we are late cycle, so I lean toward the safest part of capital stack which is debt (or debt free equity). I won't go with the riskiest opportunistic strategies, and will stick to core and core plus mostly with some value-added. I won't be investing in the riskiest/most supportable asset subclasses such as hotels, and tilt my portfolio the ones that have historically been more stable such as multifamily and single-family housing. I also don't want refinancing risk, so any deals with only 3 to 5 year debt are out for me. For someone that's not as conservative, or a different view on the next recession, they might have a different opinion than me on all of this

2) Sponsor quality check: (takes about 45 minutes per deal)

I believe that a great sponsor can take an average looking deal and make it great, and that in mediocre sponsor can take a fantastic looking deal and make it bad (especially if there is a severe recession). So I start with the sponsor first. Again, others might disagree.

a) Track Record: Get the entire track record for the strategy. As easy as this sounds, it's not simple and usually like pulling teeth. Many times they will claim it's wonderful and then try to hide their worst deals by only showing completed deals. Make sure to get unexited deals. Or if they are doing value-added multifamily, they will show you their hotel experience. That doesn't cut it for me. I want a specialist that's an expert, and not a jack of all trades and master of none. Also, in a mainstream asset class like value-added multifamily, I see no reason to take a risk on a sponsor that doesn't have full real estate cycle experience and didn't lose money. Again, other might feel differently here.

b) Skin in the game: as a conservative investor, I understand that the dirty secret of industries that the waterfall compensation is in the line with me and incentivizes sponsors to take more risk. So I require skin in the game (average is 5% to 15%) to offset this. Contrary to popular belief, this is not set because I believe it will give me a higher return. I believe it tends to give me a slightly lower return, because the sponsor is going to be more careful, and if there is a severe downturn will prevent me from taking catastrophic losses. Someone that is more aggressive, may want lesser even though skin in the game. Also, if the sponsor is new, I am fine with less skin in the game as long as it is significant to their net worth. On the other hand if they are a sponsor that is experienced in stopping a skin in the game, that's a huge red flag for me.

c) how open to scrutiny are they? I always discuss investments with others in an investor club because other people might think of things that I might miss. And even though virtually every sponsor agreement allows me to share investment information with others who might be advising me on it (especially when club members are bound by an NDA), I still ask the sponsor if I can share it, because it's a test. Most are fine with that, but a few will have problems with it and claim there are legal issues, etc.. That's a red flag for me.

d) death by Google: I Google everything I can about the sponsor. I check the SEC, FINRA, ratings websites for inside information on the principals in the company. I also look for lawsuits and see what happened in them. Many times it's an easy red flag. Sometimes it's ambiguous, but even then, why should I bother with the company that has numerous unresolved lawsuits, versus another company that is virtually the same but has none. Again, others might feel differently here.

3) property level due diligence: (takes seconds to weeks per deal): here is where I drill in with the low-level details.

a) pro forma popping: I examine all the assumptions, and see if they are overoptimistic or not. I look at every single item in the pro forma and imagine that it is complete BS, and see if I can challenge it. If there's a hole, it may be a red flag.

b) sensitivity analysis: I examine all the assumptions, and make sure I can live with the worst case scenarios.

c) "Stall and see": if they are getting money over multiple years, and there is no penalty for investing later, I would usually wait so I get some real performance data, versus having to look at theoretical pro forma information.

d) Recession stress test: I will not invest in anything, until I subject it to recession level stress and see if I can live with the result. And I take the worst recession I can find in the recent past. Sometimes there is only great recession data, and that recession was pretty mild on some asset classes, versus previous recessions. So I will usually 1.5x or 2.0x the stress. If the deal collapses and I would lose everything, I'm out. Others might be fine with taking risk, but least by doing this a person can get an idea of what might go wrong.

e) Legal document analysis: it will usually take a few days to go through the legal document properly, as almost inevitably there are tons of gotchas that either have to be explained, or mitigated with a side letter.

That is the very short summary of what I do. If you want more information, p.m. me and I can give you a lot more details.