The New and the Reliable
Rhys Phillips sits down with Garret MacGillvray, senior associate, origination, Trez Capital, to discuss the differences between traditional and fintech real estate financing.
Is Trez Capital a fintech firm or a more traditional approach to raising capital for development?
Trez Capital is a more traditional firm while [at my previous firm] we were attempting to do the crowdfunding model of getting capital for projects. Trez Capital uses the more traditional approach of getting money through debt funds. We pull money together and then use these funds to distribute as mortgages.
How would you define fintech in real estate and how is it disruptive and/or transformative to real estate financing?
The main disruptor I see is in the source and distribution of capital because of how fintech can really decentralize the marketplace by having a number of platforms out there where people have access to opportunities that they would not have had otherwise. What we were trying to do [at my previous firm] was give people the opportunity to see investment returns on commercial investment properties because, for the most part, all these transactions were done behind closed doors. You would have to know somebody involved in a commercial real estate transaction in order to have the opportunity to invest. By offering it online, it allows people access to higher risk investments which they can then use to diversify their existing portfolio.
So would I traditionally put my $60-80K with a wealth advisor who would then connect with Trez Capital and invest in one of your mortgages?
Yes, exactly. Your wealth advisor would connect with our equity-raise guys and would put a small sliver, say five to 10 per cent of your investment into our debt funds. Our funds are further diversified among our many hundreds of loans we have out there collecting a rate on the day-to-day. The difference with a real estate fund portal is it invests directly into a specific product. People give you specific information about a specific project development and then under your own decision-making process, internal or external, you decide whether or not to invest in that project.
There are pros and cons of this sort of approach. Because you are investing directly to an asset, you have greater risk because you are not diversifying. When you are investing into a pool of funds and one defaults you are still fine. But if your one investment defaults then you are in trouble because you can lose the entire investment.
What is the type of investor who would be involved in commercial real estate portal funded projects?
Just to back that up a little bit. The reason why some projects allow for the investment of nominal amounts like $6,000 versus say a $100,000 cheque is the regulations that surround it. There are now a few different methods that you can use to actually raise equity capital. One of the main ones is the Accredited Investor Exemption. In order to invest in the capital markets, which is where real estate transactions lie if it is not on the stock market, it is essentially a private capital transaction. In the private capital market, traders have to be exempt market dealers, that is regulated under IIROC (Investment Industry Regulatory Organization of Canada) covered by the OSC. [IIROC sets high-quality regulatory and investment industry standards, protects investors and strengthens market integrity while maintaining efficient and competitive capital markets.]
They use the Accredited Investor Exemption which means an individual must have either:
- An annual income of over $250,000;
- A liquid asset of $1 million (that is cash or cash equivalent), or;
- Assets minus debt (Net assets) of $5 million.
If an individual meets those specific thresholds, they are allowed to invest in those private capital markets. People who meet these criteria usually have a fair amount of wealth so the usual minimum investment is around $50,000, but their investments can be up around $500,000 to $1 million for a particular project.
The secondary exemption used is called the Offering Memorandum (OM). This one takes a lot more time and energy to use on a project. What it does is opens up the investment also to “eligible investors.” While it also applies to accredited Investors, an operating memorandum opens up the investment to eligible investors whose threshold is $70,000. Now an individual with this kind of income cannot throw around $100,000. So this way you see some equity investments that are open to $5,000-$10,000 because those are [appropriate for] the eligible investor thresholds. They are, therefore, not dumping their entire lifesavings into that single product.
As a financial advisor, you might not want to advise investing heavily in such a project; but an advisor can O.K. a manageable amount defined as a level that if the project was to go sideways, the investor would be comfortable in losing their input. As an advisor you have to let your client know that they must be comfortable with losing all their investment as that is a very real possibility with every investment.
Through this approach, some smaller projects are open to smaller investors and some are open to the accredited investor pool where individuals will invest in bigger projects, are wealthier and are permitted to put in more capital.
Is the Offering Memorandum the key tool under the CRE crowdfunding approach?
The offering memorandum is a harder to use tool because it requires a lot of money in order to implement. You need an audited financial statement. They are more capital intensive to acquire for a company as it [may] cost between $50,000 to $100,000 depending on the type of company. It is the most extreme type of audited financial statement. There are three levels of audited financial statements that you can get for an audit and this is the most expensive.
What then are the products offered through the crowdfunding platforms?
Typically, most of them rely on the Accredited Investor Exemption, which means high net individuals that put in huge amounts of change. Keep in mind that this is all for equity-based investments although there is an option to do what is call a syndicated mortgage (SM).
SMs allow individuals to invest any amount that they want with significantly less regulations surrounding it because you are not investing in the equity of the company; rather, you are investing in a mortgage which is a charge on the property itself. Now, however, SMs are probably going to be going through a bit of regulatory treatment because of the Fortress collapse. They are not regulated by OSC but by The Financial Services Commission of Ontario (FSCO). FSCO has broken off a piece of its own regulatory body into a new organization that will, I believe starting in May, take on more of the SM aspect of FSCO’s responsibilities.
Who is it that creates the syndicated mortgage? Is it the platform?
It is the platform through [unless exempt] its mortgage administer licence. This means you can create and administer a mortgage. Organization A accumulates the money to give to developer B. The paper on the mortgage would be on company A [fintech portal] who has acquired the money and who would then distribute the funds to builder B. Then, through the mortgage administer licence, they would administer the mortgage and collect the interest cheques, payments, etc. and then disperse funds to those investors. They would act as that middleman.
What was the major instrument that you used at your platform-based firm?
We primarily used the Accredited Investor Exemption. There are clearly a lot of individuals that need capital and the task is to determine the best products to put on your platform. You then slowly cultivate an investor base in order to gain their trust. It is a long term project, anywhere from one to five years. You want to keep expanding that investor base so you can invest in bigger and bigger projects.
Are we likely to see the larger financial institutions, banks and more traditional lenders buying up these start-ups and integrating this service into their operations?
No, not yet. Crowdfunding is definitely outside the scope of major institutions at this particular moment. If you look south to America, they are five to 10 years further along than us in terms of real estate crowdfunding. They have companies like Fundrise and Realty Mogul that are doing $100 million loans right now. They have a very significant techno-base with Realty Mogul having raised over $350 million for their venture capital fund. Whether or not these companies are truly profitable yet, is open to speculation at this point because it is a difficult model to get used to as it takes years and years of buy-in. Even if you look at the U.K. which is probably the country that did it first, with start-ups that have been around for 15 years, they still have not been bought out by major financial institutions.
What I have seen is that they have not become the cash cow that people had hoped they would eventually be. Once the technology becomes more recognized and [viewed as a] comfortable thing for people to invest in, then we will be there. People will then consider these portals in the same way they now use Wealth Simple of Borrowell. Traditionally people didn’t use these types of companies to invest until they got over the technological hump about having an online invest manager where you dumped your money into an internet web site hoping to receive funds back. The more and more people end up using a portal, the more and more people will trust it; and slowly that one user turns into two, and two turns into four which turns into eight. Currently, crowdfunding represents a very small proportion of the market place.
How much will commercial real estate financing be transformed by CRE crowdfunding platforms rather than being just somewhat disruptive but basically just an additional but niche option for the market place?
It is not going to transform things as rapidly as people hope. When you think of real estate, you think of it as not a cheap business. There are millions and millions and millions of dollars that have to be put into these projects and there are just not that many $100,000 doctor investors out there. How real estate plays out right now means there are only a few people out there that have huge amount of aggregate net worth that are actually doing the transactions. And these are more likely going to happen through joint ventures with one partner joining with another. While there will definitely be more options for people seeking funding, the majority of deals currently being done and will continue to be done in the future will be behind closed doors with cash-rich individuals.
It is difficult to get the capital but you can access CRE platforms although it works only for smaller transactions. Think of it is way: you are trying to raise $20 million but what if that doesn’t fly and you only raise $10 million? Then you have a ten million dollar shortfall. Where are you going to get that from? You are then in trouble. But if you are only trying to raise $500,000 its ok because any shortfall is going to be much less. The project will fail if you do not meet the minimum equity requirements.
Where do the start-up platforms make their money; where is their revenue stream?
There is a capital raise fee, a five to eight per cent fee of the money to be raised. That is typically how crowdfunding firms work as well. In addition, they will take debt on as well; you can then negotiate with the developer to obtain the debt brokerage fee. At that point, the crowdfunding firm, outside of the portal itself, will go out to seek lenders to get that construction/mortgage financing on the property as well. For the most part, for mortgage lending and mortgage brokering the fee is 50 to 100 basis points, depending on the size of the project.
Where do you see CRE fintech platforms going over the next decade? What regulatory issues will have to be dealt with?
Canada is fairly conservative in terms of monetary things and that is the way we like to keep them. The U.S. has a thousand banks because they deregulated the banking system. It is going to be a slow trend but it is going to be a growing trend because more and more people are going to be comfortable with it and more and more people are going to be willing to invest in it. There are also going to be some other cool technologies that are going to be coming up more along the lines of what you might call an eREIT where instead of just investing in a specific project online you can create a pool of projects where you can invest a small amount in different projects through the eREIT, which uses a unique variation of the offering memorandum.
There are a number of companies in the US that are actively trying to get that started. It is like a traditional REIT but it leverages technology as well as the transparency of the operating centre on the site itself. It will allow investors to choose from an array of projects by investing in small chunks but leveraging the fact you need only one offering memorandums for all those projects instead of an OM on a per project basis. It will require some tweaking and some legal work, but there is potential for the system to be adopted in the future — if the OSC gets comfortable with allowing it. It is all about pushing the envelope because as the OSC sees these technological innovations more, they will be prepared to take then under review and potentially bend some of the regulations to allow more free-flowing options. If more and more people get comfortable with it and more people want it, then there has to be ways the OSC can move to make it easier to push that capital around. I have heard from a security token start-up, but not verified, that the OSC now has a program for start-ups which allow them to operate with regulatory exemptions to test the markets as long as they work with the OSC.