Real estate is my favorite asset to build long term wealth. It is tangible, provides utility, and produces an income stream. Unlike stocks, which can go POOF in a downturn, real estate will hold its value much better. If you want to minimize underperforming investments, diversify and consider real estate crowdfunding.
However, sometimes, real estate crowdfunding investments can underperform or lose value. With COVID-19, there are certainly going to be some losses in the hospitality segment as well as others.
Let's look at how real estate platforms deal with underperforming investments or money-losing investments for their platform users.
Dealing With Underperforming Real Estate Crowdfunding Investments
Like all investments, there is risk of losing money or making less money than expected. Each deal on a real estate crowdfunding (REC) platform has a target Internal Rate Of Return (IRR).
If all goes well, the IRR will be met or beat. But sometimes, the Sponsor might make a late payment. Or they might not find the right buyer for the ideal price down the road.
Fundrise has a thorough due diligence process. They allow less than 5% of the deals they screen onto their platform. Fundrise and other RECs (real estate crowdfunding companies) also do a number of things to fight for their investor clients.
They don’t disappear after the deal is done. They are here to see it through. Otherwise their reputation and their platform will be at risk.
Steps REC Platforms Take To Help An Underperforming Deal
Nobody wants underperforming investments. But it takes risk to get rewards. And as a general rule, investors accept higher levels of risk in exchange for potentially higher return objectives.
Balancing Risk and Return Objectives
The less risky the investment type, the less likely that losses will be incurred in downside situations.
For example, senior debt stands first in line to be repaid, so it is the least risky position in the capital stack.
Every deal is different but it's always unfortunate when underperforming investments occur. When something does goes awry with an investment, a REC's Asset Management team follows a structured workout plan.
Ultimately, their goal is to recoup capital for investors. Different investments call for different approaches. Let's explore further.
Many real estate crowdfunding platforms offers three types of debt products: first-lien, second-lien and mezzanine debt. Both first- and second-lien debt are secured by the property. Mezzanine debt is not.
Regardless of the type of debt, the REC follow the same process when both principal and interest payments become late.
If the Borrower fails to make a payment, a REC's Servicing team reaches out via email. The borrower is informed that, after a short grace period, a late fee will be charged. Follow-up communications are pursued by Servicing for the next several weeks.
Investigation Of Underperforming Investments
After about three weeks, the loan is turned over to our Asset Management team. They order a title report and a broker price opinion (BPO). This is to ensure that there are no liens on the title.
In addition, they want to get a sense of the property’s current value. On approximately day 30, a default letter is sent and default interest begins to accrue.
After engaging with the sponsor, the Asset Management team corresponds with the borrower. They determine whether the default is due to a temporary cash flow issue. Sometimes this situation can be resolved promptly.
Next Step Options Are Assessed
Asset Management also gauges the sponsor’s ability and desire to continue to support the debt. Based on this information, a full array of options is assessed.
- Taking additional collateral in exchange for accruing interest
- Short sales
- Taking a deed-in-lieu of foreclosure
- Other potential loan modifications
- Foreclosure Proceedings
Sometimes the best option for the property involves foreclosure. If so, all pertinent information is referred to a special servicer that can process foreclosures in all 50 states. The foreclosure process generally begins with a series of hearings and ends with the sale of the property.
For vacant properties, a site inspection is conducted to determine whether the property should be repaired or sold as-is. Vacant properties can typically be put on the market 30 to 60 days after they are foreclosed; there is usually some clean-up required, and a broker must be hired.
For properties that are occupied, local occupancy and eviction laws must be honored. After the property is vacated, the REC platform follows the same process that they may use for vacant properties.
Selling Underperforming Investments
The REC's goal is to sell the property for more than the debt and interest owed. This allows RS to fully reimburse their investors. However, this is not always possible.
The REC's success also depends on market conditions, competition, and the physical characteristics of the property.
Selling a property for less than the total debt and interest has the potential to result in a full or partial loss of principal for investors.
Preferred Equity Investments
Debt and preferred equity are very similar. And most RECs similarly address late payments for these two investment types. The main difference is that preferred equity investments also have a “buy/sell” provision rather than the foreclosure right seen with secured loans.
In these cases, the REC will send out a notice promptly after a missed payment. It offers the sponsor a short window of time to determine if they wish to buy out the REC's investment.
An REC can also choose to offer them six months in which to sell the property. At which point they would then buy out the REC's investment. If the sponsor has not sold the property within six months, the REC can take over the management of the partnership and sell the property.
Change Of Control
Some third-party loan agreements have “change of control” language. This can cause a change of management without the lender’s consent to be a default event under that loan.
In such cases, the REC would need to negotiate with the lender. They have the choice of an immediate sale. Or if the REC wishes to perform minor improvements prior to the sale, another round of capital-raising.
RECs also recognize that there are circumstances like natural disasters that are completely outside of the sponsor’s control. In such cases, the REC can offer a workout program to the sponsor. This may involve a payment modification, an extension, or delaying or suspending payments for a short period.
Common Equity Investments
Common equity investments do not follow a set payment schedule. In these cases, distributions are provided based on the remaining cash flows after operating expenses and debt and other non-operating items (such as capital expenses) have been paid.
Provided there are positive cash flows, sponsors still have discretion as to whether to make distributions or to retain earnings. For example, to increase working capital reserves. That said, sponsors generally cannot take distributions for themselves until they have first paid investors their preferred return.
When it comes to common equity, there are no default mechanisms per se since many RECs invest alongside the sponsor. There are sometimes investment “end” dates. After which the REC can force a property sale to enable its exit from the investment. These are typically set a few years after the end of expected investment hold period.
What If Investors Are Not Getting Their Regular Distributions?
According to many REC's distribution structure, sponsors are incentivized to provide distributions to investors so that they can hit their IRR hurdles faster. If they are not providing distributions, typically there is a good reason.
If a sponsor chooses to retain earnings to reinvest in the asset, then such investment could ultimately increase the value of the property. The sponsor may also choose to build reserves to cover for an increase in a liability not previously anticipated. Thus avoiding a capital call.
Conversely, the sponsor can retain earnings because of a lack of sufficient positive cash flows. In these cases, the property may be suffering from poor operating performance.
In the latter case, the REC can closely monitor the performance of the asset. They can determine whether the property can generate enough cash flow to cover its operations and debt obligations.
Underperforming Investments Missing Payments
When an asset is considered at risk of missing payments, RECs conduct site inspections. They work with the sponsor to ensure that all measures are being taken to improve the outcome. This includes potential capital injections.
With equity investments for which the REC hold more than 50 percent of the total equity ownership, the REC can in some situations take over the management of the asset upon a sponsor’s breach. As with preferred equity, some third party loan documents may have “change of control” language.
For investments in which the REC holds a minority position, the REC would engage with the other equity holders to determine how to improve their ability to recover their investment. The REC might also try to sell their interest to another equity holder.
Common equity is thus the riskiest part of the capital stack.
Because it stands last in line to be repaid, common equity is sometimes called “first loss” position. By the same token, it can also be the most profitable. Since, as a partner, investors share the potential appreciation of the property.
Dealing With Underperforming Investments From Start To Finish
Real estate investments involve risk and are not insured. As a result, they run the risk of loss, including the loss of invested capital. Any underperforming investments or money-losing investment is no fun.
Therefore, before investing, you should carefully review the offering materials. Arrive at a realistic understanding of your own risk profile.
Fundrise and other REC companies follow a rigorous underwriting process. They create safeguards to protect investors. Nevertheless, some investments will still underperform. In these cases, their team of experienced professionals will aggressively pursue your rights and safeguards to protect your investment.
You can sign up for Fundrise for free and check out the various deals they have to offer. I'm personally diversifying away from expensive San Francisco. I'm investing in the heartland of America where valuations are cheaper. In addition, growth rates are potentially faster due to demographic migration away from coastal cities.
I like Fundrise because they offer eREITs and eFUNDs. These are portfolios of commercial real estate investments that provide less volatility and more stable returns. It's best to stick with a REC portfolio unless you have a lot of time or are a CRE expert.
For those who want to individually pick CRE investments, take a look at CrowdStreet. CrowdStreet focuses on real estate deals in 18-hour cities. They also allow you to invest directly with the sponsor.
About the Author: Sam worked in finance for 13 years. He received his undergraduate degree in Economics from The College of William & Mary and got his MBA from UC Berkeley. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $250,000 a year in passive income. He spends time playing tennis, taking care of his family, and writing online to help others achieve financial freedom too.
Sam started Financial Samurai in 2009 and has grown it to be one of the largest independently owned personal finance sites in the world.