Ten Markets for Investors to Watch in 2016

While many investors aspire to own a piece of the skylines dotting America’s gateway cities, 2016 is the year of the secondary and tertiary markets, which are offering a better proposition value than most of the traditional “Big Six” markets. The Urban Land Institute (ULI) recently released its “Emerging Trends in Real Estate” report, which highlights some of the best markets to watch this year.

Issues found with larger markets, the report says, is that they have become so highly valued on a global perspective that pricing has risen to unattainable levels for a typical domestic investor. When ULI reconciled its survey results, it became clear that markets were moving in the rankings as a result of market participants’ need to take a more offensive approach to the market or to set up a desirable defensive position.

The cities in the top 10 are a combination of traditional higher-growth markets that offer favorable business conditions; markets that were slowed by the global financial crisis, but are now in a position where demographics may drive future growth; or new markets that appear to be positioned to move up a class in the investment strata.

ULI’s 2016 markets to watch, and the reasons they made the list:

  1. Dallas/Fort Worth – Impressive employment growth driving the local economy, supported by a business-friendly environment, attractive cost of doing business, and a cost of living that has allowed the market to enjoy many corporate relocations.
  2. Austin – Continued strong economic and real estate performance and a city that benefits from diverse job creation ranging from service jobs to higher-end STEM and TAMI positions. It remains an attractive place to live for all generations, but there is some concern the market is growing faster than local infrastructure.
  3. Charlotte – Good job and population growth, coupled with development of urban centers, has made this market attractive to residents. There is some concern that the concentration of the financial services industry may not offer the same level of growth as some of the more tech-oriented markets.
  4. Seattle – A diverse industry base that is benefiting from the growth of TAMI industries. While growth has been strong enough, the only potential risk is if it can sustain this current pace.
  5. Atlanta – Experiencing strong growth in key economic sectors without concerns of oversupply. It also offers a lower cost of doing business, which is attracting corporate relocations.
  6. Denver – Economic strength and a location and culture that attracts a qualified workforce and a growing technology sector. Further growth will be driven by a number of public and private infrastructure investments.
  7. Nashville – A once up-and-comer that has now arrived, adding to the number of 18-hour cities with a growing and vibrant urban core, yet offers attractive suburban locations. Similar to Austin, there is some concern that infrastructure won’t be able to keep up with growth.
  8. San Francisco – Even though this Top Sixer is seemingly at its peak in occupancy, rent levels, and valuations, respondents noted that if it ever drops, the chances are it will bounce back even higher—so they’re keeping this one on their top 10.
  9. Portland, Ore. – A market that may rise from secondary to primary status in 2016, due to its being at the forefront of what makes an 18-hour city. However, there is some room for improvement in public and private investment and the local development community.
  10. Los Angeles – Another Top Sixer to make the list, its pricing and fundamentals are strong, but relatively mild compared to those in San Francisco. There’s potential for future growth in select neighborhoods, and both multifamily and retail are undersupplied.

Real Estate Investment to Remain on Fire for 2016

As we head into the new year, investor sentiment toward commercial real estate remains positive, with many investors reporting that they plan to increase their allocations in 2016, reports the recently released Colliers International Global Investment Outlook. Overall, the U.S. remains the top destination for global capital, with global gateway cities the preferred investment target.

One trend the report noted was that while global appetite for real estate remains strong, rising uncertainty stemming from China, economic weaknesses in emerging markets, the tightening of monetary policy in the U.S., and geo-political events across the global has made investors more wary. Of the 600 investors surveyed for the report, 44% said they’re “likely” or “highly likely” to take on more risk over the next 12 months—a drop from 59% a year earlier, though this also may reflect that fund managers have taken as much risks as their mandates allow them. This trend was apparent across all types of capital, with the sharpest reduction in private equity funds, which dropped from 81% to 47% over the year.

When the report looked specifically at U.S. investors, it found that they have dialed back their intended investment activity from last year, with 21% of investors expecting to be net sellers this year, compared to none last year. Fewer investors also intend to expand their activity, while this group, as a whole seems to be moderately risk averse. Yield expectations among U.S. investors tend to be more bullish, with 68% of them expecting leveraged returns of between 11% and 20%, even though they recognize that finding the right yields has become increasingly challenging and further cap rate compression may be dwindling in some markets.

Given these trends, iFunding believes that crowdfunding will become a more popular investment vehicle for those looking to buy into commercial real estate opportunities in 2016.

Investors are reporting the opportunities provided through real estate crowdfunding have competitive risk-adjusted returns, high tangible asset value, attractive and stable income return, and are a good hedge against inflation. While there is always risk associated with investing in real estate, iFunding has the experience and capacity to perform due diligence on all our listings with the goal of minimizing risk and maximizing returns, whether in multifamily, office, industrial, retail, or hospitality.

The Most Popular Property Choices

According to Colliers, the most popular property choice for global investors in offices in central business districts at 61%, up from 46% last year. This followed by industrial and logistics (48%), developments (39%), and shopping centers (38%). Suburban office came in fifth and was one of the fastest growing sectors in terms of preference (32%, up from 21% in 2015), while multifamily felt the steepest drop, falling from second to sixth place this year despite continued interest from U.S. and Canadian investors. To read the full Colliers International Global Investment Outlook report click here.

 

Looking at Long-Term Housing Demand & Financing: Trends and Strategies

While many residential real estate investors closely scrutinize every deal they consider, not as many keep an eye on big picture trends. This long-term view is important, but not only for the professional real estate developer that finds greater demand from specializing in a growing niche. It’s also valuable for the limited-partner investor that wants to reduce risk by focusing their due diligence on a few types of projects.

At iFunding, we consider these trends when exploring projects to offer our investors. You can see that type of assessment where investments include condos built in mid-sized cities with growing tech/finance industries, and where starters and rentals are built for younger professionals, who view housing more as a service to lease than a lifetime mortgage to hold. You’ll also find the big picture view in mobile park home investments, suited for the service economy’s lower paycheck holders, and in lifestyle communities for the more affluent retirees.

This article touches on these long-term trends, including the residential shift to “echo boomers,” regional migration, and new sources of financing for homes.

From Retiring Baby Boomers to Changing Echo Boomers

An aging population will mean adapting existing homes for disability, where the owners wish to age in place. Others will want to move to convenient, low-maintenance communities which offer townhouses and condominium apartments, which should increase dramatically for this group as well as for the young who are just starting out.

The increasing demand for rental housing should continue through 2020 as Echo Boomers, those born after 1990, form new households. The trend towards job-hopping rather than the long careers of the Baby Boom generation favors the flexibility of renting, and Echo Boomers will likely be better educated, particularly women, which will mean a higher average financial position for this generation in the long-term.

After 2020, it is expected that this cohort will move toward home ownership, absorbing some of the single-family houses released by retiring Baby Boomers. Smaller houses will better fit the needs of the smaller households with fewer children that Echo Boomers seem to prefer, although the increase in minority home ownership, with higher average family sizes in some cultures, will offset this trend somewhat.

Home ownership remains the preferred housing choice until then, even among the Echo Boomers, with walking access to civic services a priority for many. As the economy recovers and credit balances return to manageable levels, we should see younger owners lead the remodeling market as they adapt older units to contemporary standards for sustainability and lifestyle. Investors will see this frequently in “infill” projects, where existing tracts are upgraded or rebuilt from the ground up, while benefiting from the historic ambience and/or small-neighborhood feeling of a particular area.

Locations for Growth

Although the “March to the Sunbelt” should be supporting a strong housing market, it is here that the bulk of the foreclosures occurred. As the recovery continues, the Sunbelt should see the highest demand for remodeling and renovation, as units are brought out of foreclosure and upgraded for resale.

Large cities offer many opportunities for renovated housing, including the conversion of vacated industrial buildings to desirable apartments. Smaller cities and towns with viable commercial areas, especially near transit stations, are also promising locations for housing renovation and replacement. However, the local job market is of paramount importance in making any investment decision, as the great burst of new construction and energy extraction activity in North Dakota–otherwise inexplicable–makes clear.

The Future for Mid- to High-End Single Family Homes

A segment of larger, free-standing suburban homes may decrease in value, as Baby Boomers release them for something smaller and easier to maintain. The Echo Boomers won’t be ready for such big houses for a while, and they have so far shown a hesitation about the isolation of suburban living, preferring the civic bustle of even small towns. Highest-value luxury homes, however, are in a class by themselves, and there is little reason to expect a decline in demand for them. There have been signs that tastes in recreation are changing, however, and that golf course developments, for example, may have trouble holding their value. Individual Investors and Family Offices becoming a new Financing Base As the US government explores way to change and reduce the roles of Fannie Mae (FNMA) and Freddie Mac (FHLMC), the private credit sector will play a larger role in providing credit to the nation’s housing market. Since 2008, much of the foreclosed/bank-owned housing stock has been purchased by hedge funds. Because the opportunities for the largest investment returns rebounding from the 2008-2010 housing implosion are diminishing, these hedge funds are now purchasing fewer of the remaining houses on the market. Demand is shifting back to individual home purchases, who are sticking with their planned housing budgets and looking for value more than ever.

This trend implies that the refurbishment efforts (which some call “fix-and-flips”) of individual real estate operators and modest-sized companies remain key for housing investments in the mid-term. However, not any type of house will do. It’s best to focus on housing trends like the ones above, pointing toward specific regions and cities, rentals & condos for young professionals, community living spaces for an older generation. Beyond flipping homes, other operators will find that running long-term rentals building – 1-4 family units, and apartment complexes – is the best way to develop a core competency while generating long-term income.

Meanwhile, the financing for such ventures needs to come from somewhere, if not the government –backed mortgage securitization agencies. Crowdfunding will be one of those fast-growing funding sources, in iFunding’s opinion. Our research into research about crowdfunding activities show that crowdfunding across all industries is growing 85% year-over-year, and is likely to reach $10bn in investments by 2017. Meanwhile, real estate has become the largest market for “private securities, publicly raised” (i.e., crowdfunded), with $60m raised so far in 2014, according to research firm Crowdnetic (http://www.crowdnetic.com/reports/sep-2014-report). Of $150bn in worldwide real estate transactions of all kinds (not just crowdfunded) in a recent year, $25bn were funded by accredited individual investors. Now, with regulations expanding access to non-accredited investors, we expect to see even further growth in crowdfunding. As a result, we recommend that investors familiarize themselves with crowdfunding by ‘dipping their toes in’ with modest early investments.

Sources:

U.S. Housing Trends: Generational Changes and the Outlook to 2050. John Pitkin and Dowell Myers, 2008

The US Housing Stock: Ready for Renewal. Joint Center for Housing Studies of Harvard University, 2013

Housing an Aging Population: Are We Ready? Center for Housing Policy: Barbara Lipman, Jeffrey Lubell, Emily Salomon, 2012

“Walk on By” – Using Walk Score to evaluate neighborhoods for home investments

One of the keys to successful real estate crowdfund investing is to get a sense of the property and surroundings, without necessarily visiting the site. One useful online tool to accomplish this is Walk Score (www.walkscore.com). iFunding (www.ifunding.co) has recently incorporated Walk Score into its residential investment listings.

Here’s how it works:

Walk Score® measures the attractiveness of a location based on distances to nearby restaurants, grocery stores and other amenities, plus additional analyses such as population concentration, block length and intersection density. A rating of 1 to 100 is generated where, for example, 90-100 is a “Walker’s Paradise” where nearly all errands do not require a car. A score between 25 and 49 means most errands require you to hop in your Prius or Chevy Suburban, and so forth. A separate Transit Score® measures accessibility via public transportation, and there’s a Bike Score® too.

City residents tend to think a lot about the accessibility of their neighborhoods, as do suburbanites. And it’s just as useful to individuals looking to buy or rent, as it is for those investing in home construction or fix-and-flips wanting to understand the ultimate buyer’s viewpoint.

For curious businesspeople and technologists, Walk Score is a progressive adopter of APIs (that is, computer/web interfaces) to make the data available anywhere. That’s how 20 million scores are being viewed each day, through partner sites such as Zillow.com and now iFunding. Livability data also is important for urban planning and targeting affordable housing in “inclusionary zones” within the local economic network.

iFunding is happy to see the available of more real estate evaluation data for investors, available through web interfaces for sharing across sites. We’ll cover more technology trends like this in coming blog posts.

A Crowdfund Platform’s Services – Allowing Real Estate Operators to Focus on Their Projects

iFunding receives questions about the activities that our crowdfunding platform performs as part of its services. The services benefit both the investors and the real estate operators, but it’s usually the operators that ask how the crowdfunding company helps administer the deal. iFunding’s intent is to perform most of the financial, legal and investor communication efforts, which allows developers and operators to focus on the quality and speed of their project.

Let’s look at some of the most significant responsibilities and costs we take care of for our project sponsors.

  • Entity setup: A series LLC is set up to hold the property, funds and document the relationship between all parties. iFunding inserts any specific considerations for a deal into the legal documents and works with our legal counsel to register  a Form D with the SEC. Our executive team is involved in a full legal and registration review. Once funds are being committed, additional steps are taken to register in each of the states in which investors live, where this is required.
  • Listing on the platform: For a project such as a home flip, we work with the operator to prepare and clarify the project documents, including the pro forma and listing description, and securely organize and present these documents online. This can take several days of effort. Our graphic designer edits the photos and video to have them display attractively on the site. Larger commercial projects require additional details.
  • Promotion: iFunding coordinates and hosts a webinar on behalf of the operator for investor Q&A, sends notifications to its registry of thousands of investors at the time the deal is listed, and writing updates weekly as part of our newsletter. We also often call investors with particular interests to highlight the project to them. For projects with special themes (e.g. particular locations or property types), we also may interview the sponsor and write a multi-page blog post promoting their expertise.
  • Potential investor interaction: Because many investor questions may be similar, iFunding handles the first line of support for investor inquiries, and updates the website description to cover recurring questions. As needed, we share new questions with the project sponsors and as needed arrange calls involving the sponsor and the investor(s). When dealing with scores of potential investors examining a deal, this first line of support can save the operator considerable time while they’re focused on preparing their permits and property for work.
  • Financial commitments and fund transfers:  We use a secure, online document sharing and signature service for each commitment by an investors and take care of the per-signature charges on behalf of the operator. Next, the secure transfer of funds from investors to the project during the commitment stage involves use of an escrow account. iFunding covers the cost of the escrow service, which is a percent of the deal raise, on behalf of the project operators.
  • Weekly investor reporting: Investors appreciate having the ability to read timely updates about their investments. iFunding writes and posts weekly updates in text and images and disseminates by email to investors. All updates also reside on a private website dashboard the investors can log into.
  • Tax reporting: Our financial team prepares K-1s to send to every investor for every project in preparation for annual tax submissions.
  • Due Diligence: There are numerous steps and research services involved in performing the initial due diligence on a property and a project sponsor. These increase investor confidence in your projects and help facilitate funding. They include use of due diligence services such as CoStar, which iFunding pays for on each deal. These will be covered more in a subsequent blog about services we perform on behalf of investors.

Because crowdfunding often involves more investors than a traditional real estate deal, each of the above steps requires extra effort. Fortunately, iFunding has the infrastructure to make these steps significantly more efficient than if a project operator was doing it on a smaller-scale, and iFunding covers the cost outlays in filing and transacting the deal. In fact, the administration fee charged to the investment project is effectively break-even for our crowdfunding service. iFunding believes enough in aligning itself with its investors and operators that profits to the platform mainly come from the last tranche of returns, after a project turns a profit for its investors.

In sum, we believe that many real estate sponsors seeking financing will find it faster, easier and more cost-effective to rely on a crowdfunding platform to reach large numbers of investors.  As many of our partners say, “crowdfunding lets my business scale.”

Single Family Flips and Social Media in Cincinnati – with Wendy Doris

Real estate investment opportunities come in big and small ‘packages’. For many investors, the small-to-medium sized, single-family house refurbishment, or “flip,” is often attractive due to the speed of the project. iFunding interviewed one of its real estate operators that specializes in quick-redesign flips and makes use of social media to promote her projects.  Wendy’s projects can be found at her customer facing page: www.facebook.com/dwellingstudio or her peer-to-peer focused account,  http://instagram.com/flippinwendy .

Q: Wendy, what’s your background in real estate? 

A: I’ve been refurbing homes since 2006 and have completed about 20 properties since then.  My mother had always been a DIY-er and money was tight, so that’s probably where I caught the budget conscious redesign bug. Right around ’06, some of the early house-flip TV shows appeared on cable, and after watching I thought I could make a go with my own projects. I started by doing cosmetic updates to my own home, then branched out from there.

Q: What types of properties do you invest in?

A: I focus on small, single family homes: 1,000 to 2,500 square feet, which in my Cincinnati area typically have an all-in, purchase and construction cost of $100,000 to $250,000.  They can take from 4 to 6 months from close (purchase) to close (sale).  That includes 3 to 6 weeks to renovate, 2 to 3 weeks on the market, and 45 days to close after going to contract.

Q: Given the projects are relatively straightforward, what kind of help do you rely on?

A: I often will look to wholesalers to locate properties with potential for a good return, then visit the sites immediately. I also use contractors for the on-the-ground demolition and construction.  My very first project was completely DIY but took 6 months of work, so I’ve since become a fan of investing in trusted contractors to speed up project turnarounds. In terms of selling, I will promote the home via social media, as well as turn to brokers for assistance. And finally, I have a young daughter who I just took with me when first looking at the property I’m fundraising on iFunding. She tags along with me to the job site when it’s safe. I like to say tongue-in-cheek that she will be my next assistant.

Q: You mention social media to market your projects. I notice you don’t have your own website up yet, but are prominent on Facebook and Instagram, as well as a few other sites. What’s your online strategy?

A: First, I plan to have my own website soon. But my first focus is on the quality of the projects themselves, which is most important to selling the homes at a profit. Beyond this, a number of the social media sites work quite while themselves. Bigger Pockets (https://www.biggerpockets.com/users/flippinwendy) is an excellent community to discuss real estate questions.

In addition, Facebook is a great way to promote fixed-up homes to potential buyers. You can target by location, age group, and interest such as HG-TV (www.hgtv.com), the home investing and design cable channel. I placed my first ad recently and received 5,000 click-through views back to my FB page (www.facebook.com/dwellingstudio). The click rate was close to 10%.

I use Instagram for connecting with other flippers and interior design pros.  Previously, I had written a blog (for travel) but found writing takes too much time, especially when I think about my projects more visually. Instagram (http://instagram.com/flippinwendy) provides a platform where I can share my work quickly, as well as get feedback from my peers. It has really been helpful in connecting with others in the same line of work.

Q: Let’s return to your project investing strategy.  Tell us more about neighborhoods, design approaches, etc.

A: I stay focused on Cincinnati and its suburbs, which I know very well (with the exception of the West Side).  There’s a particular district that has caught my eye, the “Over the Rhine” neighborhood. A few years ago it was more downtrodden, but now it’s turning into a hip, artsy scene.  You have to carefully consider these projects and think about the opportunity, street by street, but there’s potential for upside returns here.

My favorite part of the flipping is the design.  I try to make each bathroom and kitchen a little unique, to fit the space and the feeling of the house. Then there are common upgrades, like granite tops in the kitchen, that sell well.  I look very closely at tile patterns and at how all the home’s finishes from stone to wood complement each other.  Depending on the house, there may or may not be budget and timeframe for opening up the floor plan.  We examine the location of load-bearing walls and beams to make an initial decision on that.

Q: Finally, what’s one of the biggest lessons you’ve learned about real estate?

A: I’ve learned that staying focused on a style and size of house makes your projects more reliable and efficient.  I have put systems in place to make the entire process run more smoothly, within budget and complete on time. Early on in my real estate career, I turned a 2-family home into a large single family. The size added complexity to the design plan and I found potential buyers of larger homes tend to be more particular about layout and customizations. Since then I’ve narrowed my focused to modest-sized, single family homes. With more focus and a bit of luck, that hopefully will enable me to do 10 projects this year. I’m already on my fourth!

Flipping Multi-Family Properties

When most real estate investors hear about multi-family properties, they usually think of rentals, or cash-flowing investments. However, multi-family properties, especially 2-4 unit buildings, can be equally attractive as quick house refurbishments, or “flips.” As a flip, a multi-family project can generate high-quality, preferred-equity type returns in a relatively quick timeframe.

The purchase evaluation and property enhancement strategy taken by the real estate operator can differ from one-family home refurbishment. To explain the differences for our investor network, iFunding turned to Mr. Malico Watson of the Orange Group, a real estate operator based in Milwaukee. The Orange Group has funded four properties through iFunding in the last six months, with one fully-funded in under an hour. In the last two years overall, they have sold 35 properties, both multi-family and single-family, and will flip or buy-and-hold units. They also provide property management services.

Q: What’s the difference between refurbishing a single family home versus a multi-family property, in terms of investment criteria?

A: First, they are similar in terms of selecting properties based on a sound foundation, potential for improvements we can introduce, attractive neighborhood, and good value for money.  The difference however is in the buying. Most single family homes are bought by individual families, with a longer-term plan for residence and hopefully value appreciation.  The buyers of multi-families are investors or landlords themselves, with a focus on operating costs and multi-year rental income potential.

Q: How does this affect the refurbishment plan?

A: We find that residential, single family buyers, have a keen eye for the finishings. A marble counter-top in the kitchen, the type of wood used on the cabinets, and having two sinks in the master bedroom make a difference. Houses should fit a common style but it’s OK to have unique features. With a multi-family acquisition by an investor, they will pay more attention to the age and efficiency of the mechanicals like the boiler. We’ve done a few conversions from oil to gas energy, for example. The investor also will be interested in the insulation and heating bills if they are paying for them, and a layout that is suitable for a wide base of potential tenants, since they may turn over at some point.

Q: What is your turnaround strategy when you plan to flip a multi-family property?

A:  As you can see with the properties we have funded on iFunding, we refurbish the common areas and the units, then usually we’ll rent out the units ourselves, and finally sell the rented property to an investor. And, we’ll offer our property management services, which the investor can use turnkey, or they can choose their own property management. Our service, however, has an extensive track-record of upkeep in the same community. Having that available can significantly speed up the average sale time for a multi-family plot.

Q: How important are property management services for someone who is holding a property for a longer time period?

A: Property management is one of the most important decisions to get right. You want a service that has qualified staff available to visit a property at any hour of any day.  Those staff should have deep skills in repair and have proven that they’ll treat tenants with honesty and care.  And you want to be sure that the staff professionally handles the administrative side, such as collecting rent and paying common utility bills.

We typically offer management services for 7% to 10% of rent, plus $29/hour and materials for any special repair. This is a fair price for a quality service in our area. We tell investors to beware of services charging, say 5%, because they are likely skimping on how many people staff the office and how experienced they are. When issues can hit, for example during a flood or snow storm, you need a bench that can visit multiple properties at the same time.

We also do quarterly inspections of each property under management. We find that tenants take much better care of the premises if they know someone will be dropping by and compare how the place looked between, say, September and January. And they are that much more satisfied by the attention to upkeep from the landlord.

Property managers also can give an investor guidance at the outset of an acquisition, similar to an inspector but with a keener eye to operating costs. For example, we had a rental investor come to us with a property she had just acquired from another source, sight unseen. The returns looked fine on paper, but when our management team was asked to examine the property and provide a quote, we pointed out several factors that would affect her costs, including cracked pipes and water leakage. The units were showing their age and were going to cost more to upkeep than expected, hurting the cash-flow potential for her investment. If she had come to us earlier, we could have pointed her to sturdier and more profitable properties, including several we had on offer ourselves.

Q: What types of investors do you see purchasing multi-family units?

A: I’d say roughly half have significant real estate investment experience before. Others are first timers that may have inherited the property through an estate, or are just getting their feet wet and like the idea of income-generating properties. The lending banks also will refer business to us based on our history of operation in the state.

Over time, investors come to see the potential in multi-family units for scaling their investment. It’s one property to oversee, but generating income from multiple tenants. The Orange Group has kept to an attractive size investment- that is, 2- to 8-units – for a wide range of real estate investors.

Q: In your opinion, how do multi-family properties fit into the crowdfunding market and your relationship with iFunding?

A: There’s certainly a place for both single family projects and for multi-families, if the operator in the deal is experienced in turning multi-families around.  The other way to look at it is whether you, as an investor, are more interested in a flip with quick returns, or long-term cash flow. I think that the responses to our flips, including a recent two-family unit that was fully-subscribed very quickly, show strong demand for the quick refurbishments.

This particular two-family deal only required a small amount of investment, in the low five figures, and had a target turnaround time of four to six months. To entice tenants to rent as soon as it’s ready, we have used move-in specials that include 6 months of no maintenance to the tenant, and 6 months of guaranteed rent rates. Then with rentees and property management in place, our flips have been usually very quick to rent through our broker/agent service.

Some investors may be thinking of a fast return on investment through a crowdfunding site as much secure to them then a long-term hold, though both have their advantages. When you combine a low-investment-amount flip, with iFunding’s approach to offering preferred equity going first to the investors only, then profit-sharing on the rest of project, it’s compelling to look at equity-based flips of multi-family units as great crowdfunding investments. In fact, I’d like to do as many of these projects as I can with iFunding.

Preferred Returns – What’s The Point?

Often people that are new to investing think that real estate transactions have to necessarily be overly-complex and abstruse. After all, most private equity deals are laden with large operating agreements, private placements, subscription agreements and rather complicated legal documentation. There is certainly no denying that all of this documentation can be burdensome for a layman and thus the SEC and state securities commissions want to make sure that promoters must follow strict rules when soliciting investors for money. Investor protection is a paramount concern and the regulators despise the concept of guarantees or anything that smacks of an unrealistic amount of return a project can deliver.

Truth be told, no investor no matter their level of sophistication can guarantee anything. The world is simply too complicated and there are uncontrollable risks like the mortgage crisis, geo-political risks, currency risks, inflation risk, etc. that at times will drastically impact a given project in ways that the promoter could have never foreseen. If you examine a properly documented private placement it will specify tens or hundreds of things that can possibly go wrong. It is kind of like watching a pharmaceutical commercial where they spend 90% of the commercial telling you how perfect the drug is and the last 10% listing all of the side effects and what can go wrong.

So if a promoter can’t look into their crystal ball and tell what is going to happen in the future and they can’t guarantee anything what is the next best things they can do? Enter the concept of a preferred return. A preferred return is simply a benchmark threshold an investment must hit before the promoter is able to participate in any profits. So if the threshold is set at 8% this would mean that the investment has to return this amount before any participation would be realized by the promoter. It is then typical for the remaining profits to be split in some fashion among the investors and the promoter based on what was specified in the agreements.

One of the primary concerns you as the investor should have when investing in a syndicated real estate transaction is alignment. Heavy fees in projects can create misalignment between those supplying the capital and those utilizing the capital to invest in a given project. A certain grade school sense of fairness should be applied in all situations. A preferred return helps to create alignment along with fairness in a real estate profit sharing arrangement. The investor has preference to any pool of profits that comes from a project and the promoter is only allowed to participate if they deliver enough dollars on the money invested for there to be excess after the preferred minimum is paid. Thus promoters will only select projects with that will clearly clear the hurdle of the preferred return so they can maximize their chances of being able to participate in projects.

An investor that wishes to create additional alignment should carefully examine whether or not the fees to the promoter are paid before or after the preferred payments as well. Payment of fees prior to preferred payments could potentially incentivize the promoter to take projects that maximize their chances of making fees instead of the ones that will make the most money for the shareholders. This is a classical problem with real estate brokers who operate under straight commission. The true goal of those operating under this structure is to err on the side of making sure the transaction happens instead of making sure the project is the best one for those with the money at risk.
In summary, investors should seek maximal alignment between themselves and the promoter asking for them to invest their hard-earned money. There are many things that should be closely examined in complex real estate structures, but one of the primary things investors should scrutinize is alignment. Preferred returns help to create alignment as does making sure that the promoter largely gets paid at the same time as the investor instead of deriving much of their income from fees that are payable regardless of how successful the transaction turns out. Following these high-level guidelines when examining investments will serve to protect you when you choose among many investments available.

 

This article is a guest post from Bryan Hancock, head of the Acquisitions Department for Bullseye Capital’s Real Property Opportunity Fund.

The information contained in this article is not to be construed as constituting tax, legal, accounting, financial or investment advice.