Real estate is my favorite asset to build long term wealth because 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.
Dealing With Underperforming Real Estate Crowdfunding Investment
Like all investments, there is risk of losing money or making less money than expected. Each deal on a 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 might not find the right buyer to sell to for the ideal price down the road.
The main question investors have is what real estate crowdfunding platforms like Fundrise do to help make an underperforming asset perform. Besides Fundrise’s thorough due diligence process, allowing less than 5% of the deals they see 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
Balancing Risk and Return Objectives
As a general rule, investors accept higher levels of risk in exchange for potentially higher 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. When something goes awry with one of our investments, our Asset Management team follows a structured workout plan with the goal of recouping capital for our investors. Different investments call for different approaches.
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, our 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.
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) to ensure that there are no liens on the title, as well as 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, our Asset Management team corresponds with the borrower and determines whether the default is due to a temporary cash flow issue that seems likely to be resolved promptly. 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
If the best option for the property involves foreclosure, 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 follow the same process that they may use for vacant properties.
The REC’s goal is to sell the property for more than the debt and interest owed, which would allow 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—all of which are beyond our control. Selling the property for less than the total debt and interest has the potential to result in a full or partial loss of principal for our investors.
Preferred Equity Investments
Debt and preferred equity are very similar, and so is our approach to addressing late payments when it comes to 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 in which to determine whether they wish to buy out the 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, RS can take over the management of the partnership and sell the property ourselves.
Some third-party loan agreements have “change of control” language that cause a change of management done without the lender’s consent to be a default event under that loan. In such cases, RS would need to negotiate with the lender. RS have the choice of an immediate sale or, if RS wish to perform minor improvements prior to the sale, another round of capital-raising.
RS also recognize that there are circumstances like natural disasters that are completely outside of the sponsor’s control. In such cases, RS offer a workout program to the sponsor that 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 our 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 choose 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, if the sponsor retains earnings because of a lack of sufficient positive cash flows, the property may be suffering from poor operating performance.
In the latter case, the REC can closely monitor the performance of the asset to determine whether the property can generate enough cash flow to cover its operations and debt obligations. When an asset is considered at risk of not making its payment obligations, RS conduct site inspections and work with the sponsor to ensure that all measures are being taken to improve the outcome, including 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 that would require lender consent in such cases.
For investments in which the REC hold 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, it 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.
From Start To Finish
Real estate investments involve risk and are not insured; as such, they run the risk of loss, including the loss of invested capital. Before investing, you should carefully review the offering materials and arrive at a realistic understanding of your own risk profile.
While Fundrise and other companies follows a rigorous underwriting process and creates safeguards to protect investors, 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 into the heartland of America where valuations are cheaper and growth rates are potentially faster due to demographic migration away from coastal cities.
About the Author: Sam began investing his own money ever since he opened an online brokerage account in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $200,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies and writing online to help others achieve financial freedom.
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