Matt discusses the dynamic that exists between real estate entrepreneurs and passive high net worth investors.
I spend a great deal of time talking and meeting with both active Small Balance Real Estate (SBRE) entrepreneurs and less active (or perhaps more accurately, less directly involved) high net worth (HNW) investors interested in the SBRE space. The landscape that exists in the SBRE world today is highly fragmented, highly localized, and highly inefficient. The capital raising process operates sub-optimally in most situations with most SBRE entrepreneurs and most investors, though not all of course. Almost every time I talk to someone from either group about the things we are doing in the space, people seem to be intrigued with one aspect of another of our business model. In trying to truly understand why in order to further develop and improve our model, I have formulated a few theories.
Small Balance Real Estate as an industry encompasses a vast number of active entrepreneurs pursuing a wide variety of strategies to make money with real estate as the foundational element of the investment model. Almost every one of these SBRE entrepreneurs must raise capital from other people in order to execute on that strategy, and this is almost always the least favorite component of their business.
The people from whom they raise the money are often, in fact mostly, neither inclined nor equipped to do the work of the SBRE entrepreneur in terms of the active origination, underwriting and management of the assets that produce (or do not, as the case may be) the returns. They still want to participate and invest in the real estate space in some way but are often not certain what options are available to them, how to access them, and most importantly, how to assess the merits of those options.
Each party needs the other, but each may be wary. People on both sides are motivated by money, have varying levels of trustworthiness, and are often fundamentally conflicted in their interests on any given deal, investment or opportunity. A good structure, whether it be a syndication, a pooled fund, a joint venture, or otherwise, attempts to mitigate as many of the conflicts as possible, but it is impossible to eliminate them all. Due diligence, developing trust, and monitoring and oversight are all required in some degree. These can be very hard for many investors to perform adequately.
Done right, the active SBRE entrepreneur does the vast majority of the work on a deal and for that work gets some reasonable level of compensation along the way and ultimately upside if the deal goes well. The investor gets some preferred return on her money and often a return of capital to remove the risk and then splits the gains in some percentage with the party who generated, produced and effectuated the opportunity and results in the first place – the active SBRE entrepreneur. But the potential for misaligned interests, for abuse of trust, and for one-sided (on either side) deals is high. For HNW investors, finding competent, disciplined, and trustworthy SBRE entrepreneurs and separating them from the many others who are less so (but who look very much the same) is challenging at best. For active SBRE entrepreneurs, continually locating HNW investors who will reliably provide the capital necessary to enable them to confidently participate in the market and procure attractive deal opportunities (often whose timely closing defines their credibility) is also very challenging. These dynamics, I believe, are what fosters the high interest level from each party in our business model. Executed properly, it helps to solve the problems faced by each side.
There are multiple component parts to make this model truly work. To attract SBRE entrepreneurs, we have to be able to provide a solution that increases their chances of being able to effectively raise capital (and ultimately, from their perspective, one that ideally enables them to completely outsource this function) and which reduces as many of the administrative and operational burdens of managing the capital and investor side of their business as possible. To attract enough HNW investors who can and will be reliable capital providers, we have to be able to engender in them confidence and trust that the SBRE entrepreneurs and opportunities being generated have high integrity and attractive risk adjusted returns, all while not acting as a technical “investment advisor” to them. Neither of things can be done quickly or easily. Yet our goal is nothing short of creating a business that accomplishes these objectives in a very big way and solves the fundamental problems faced by each counterparty. While the objectives are very clear, there are many technological, marketing, sales, and operational variables to manage effectively to be able to truly achieve them. Add in the byzantine, confusing, and often conflicting regulatory requirements of this industry and it is even harder. But the foundational pain points of both sides present an enormous opportunity, and the confluence of the JOBS Act, the internet, and rapidly evolving technology are making it possible for the first time.
I believe this ongoing dance between SBRE entrepreneurs and HNW investors is what has fostered the proliferation of real estate crowdfunding sites on the internet. SBRE entrepreneurs are willing to try it because it represents a potential solution to their capital raising problems. It might be the easy button they have been looking for! Investors, even non-accredited investors with very small investment amounts, can access deal opportunities in a way they never could before. Glossy pictures, fancy spreadsheets, and slick technology can make almost any deal look appealing. I worry, however, that these things do not in and of themselves solve any problem without the concomitant discipline of underwriting the right sponsors and the right deals; a discipline that is widely varied. We have seen many deals on the internet that we would never touch. We have also seen a fewer number that are very, very solid. Knowing how hard it is to do real due diligence on deals, I wonder how the average investor has any chance of being able to truly discern the difference. The market has been moving in a single direction ever since the beginning of the existence of crowdfunding. It is going to take a bear market in real estate to see who is doing it right and who is not. What did Warren Buffett say about swimming naked?
My experience is that there is some percentage of SBRE entrepreneurs who are very disciplined in their approach to whatever their particular strategy is, who are highly competent in their execution, and who are highly committed to integrity in all aspects of their behavior, their deals, and their business. I believe the percentage of them with all three of these characteristics is not especially high. There are far more that are generally good, solid people but either their discipline, competency level and/or integrity are not at that elite level, and they can be very difficult to distinguish from the former group. There is another sizable group below that about which nothing further need be said here. No deal, no sponsor, no opportunity is without its risk, and nothing is perfect. That said, our goal as an investor (and the goal of any investor who desires good returns and good sleep at night) is to locate and work with those in the first category. Percentages dictate, however, that not every investor can do this as all of the other SBRE entrepreneurs are out in the marketplace also doing deals, seeking to raise capital, and getting their share of the pie. This is, of course, the way the market works. Locating and discerning the gems is difficult and time consuming work.
The group of elite SBRE entrepreneurs I describe above has fundamentally the same problem that all the rest do – namely that they must more or less continuously seek and procure capital and develop operational and administrative systems to manage investor communications, correspondence, and ongoing relations. To identify, engage, and support these SBRE entrepreneurs and then cultivate their capacity to do that effectively allows them to focus on what they do the best and what they love to do the most. If investors can believe and trust that SBRE entrepreneurs fit the description above, they are more inclined to provide the reliable capital these people need to do this. This is the dynamic we are pursuing that I believe resonates so strongly and so consistently in all my many conversations with people on both sides of this delicate balancing beam – one that requires an equilibrium in order to function optimally. We believe the future is now to do things in the SBRE private alternative investment space for the benefit of each party that were heretofore impossible. If you are one or the other, we want to talk to you about how we are making this happen.