AIPIS 213 - Crowdfunding Bonds & Loans for Residential Real Estate with Ray Sturm

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Hey, it's my pleasure to welcome Ray Sturm to the show. He is co founder and CEO at AlphaFlow and he's the former founder of of Realty Shares. We had Realty Shares on the show quite a while back. AlphaFlow has an interesting model within the crowdfunding space. Let's learn a little bit more about it today. Ray, welcome. How are you?

Great. Thanks for having me, Jason. I really appreciate it.

Yeah, it's good to have you on. So you're kind of like a crowdfunding company for crowdfunding companies in a way. I mean, is that a fair description?

You know, we definitely sit on top of the platform.

Yeah, yeah, yeah. So on the downside, Ray, it's like there's another middleman and you got to pay every middleman. You know, it's funny how back in the original dot com boom, they talked all about how the Internet was this disintermediation. You know, that was a word that I learned 18, 20 years ago. You know, disintermediation. I heard that a lot for the first time. In a way, it does disintermediate and people go more directly, but in other ways it actually creates more intermediaries and as long as value can be added along that supply chain, it's great. So tell us a little bit about what you do at Alpha Flow and how the idea came about.

Look, I think you make a great point, Jason. AlphaFlow is an asset manager and today we focus exclusively on real estate bridge loans. And as you mentioned, my background was one of the two founders of Realty Shares, which like a lot of the real estate crowdfunding platforms uses a marketplace model. And a big piece of that was, yes, disintermediating all of those middlemen along the way. What I found over time was that worked very well for a lot of people and it is working well still. That said, there were a lot of people out there, a lot of groups, both retail and institutional. That said, I'd like another layer to actually underwrite these investments for me. I don't want to come on and do that work myself. I don't feel like I have the time or the expertise. But I like the return profile. And they're willing to pay an asset management fee to groups like Alpha Flow to do that. That's where we step in. So what we do is we don't actually originate any loans ourselves, but we'll work with lenders around the country. Some of those are online real estate crowdfunding platforms, and some of them are traditional offline hard money lenders. We go to those groups, we look at the loans they've already originated, that they've already decided to move forward with. And we actually do our own underwriting at that point. Today we're actually saying no to about 93% of loans we review. But the ones we do invest in, we take those into our portfolio and then we use those loans to build what we call alpha Flow optimized portfolios for our clients. And what that means is if you're a client, Jason, you come on, you'd open an account, you'd make an investment with as little as 10k, and we basically turn that within a week or so into 75 to 100 different loans spread around the country. It doesn't work best for everyone, but for some people, that's the best way to invest in the space.

So would it be fair to say, well, you know, I guess the underlying crowdfunding company that you're, you know, doing the deal with, in many cases, they are already fractionalizing these loans and you're having Alpha Flow investors invest in fractionalized loans. But are you pooling money or how. Tell us about the securities implication, like what reg are you under?

Sure, yeah. We're using reg D, which is similar to a lot of what's being used in the space. These are private placements, ultimately. So what we did, especially in our early days, you're right, we were buying fractions of loans. We were buying maybe a $30,000, $50,000 piece of a loan. We're doing that less and less often these days. More often these days, we're actually buying the entire note. It's actually going into Alpha Flow's name. I think you're going to see that more along the lines because, yes, we would like to maintain more control as we grow of the actual assets so that you're only one layer away from that. But everything we invest in is first lien, so that we've got first lien protection.

Okay, so first lien, but drill down on the Pooling concept a little bit, if you will. Is it. There's two concepts going on here kind of at the same time. Sort of weird when you ask about this in terms of crowdfunding, because there's fractionalizing end pooling. Smoke that out a little more, if you would.

Absolutely. And so just to be clear, I'm not sure we think of ourselves as crowdfunding these days as much as, you know, at least at the alpha flow level, really, it's just an asset manager. But think of it this way. We have an entity, Alpha Flow Holdings. On any given day, Alpha Flow holdings is out there investing in loans that it likes. Some of that, like we said, maybe with online platforms and some may be just with traditional lenders. If we like a loan, we're going to buy it and put it into our inventory. If an investor comes on, this isn't a pooled vehicle like a fund where everyone is in everything. Really. What we're actually doing is our Alpha Flow holdings today, for example, has over 400 loans in it. But if you came in and invested, we're going to build you an individual portfolio of most likely the last 85 or so loans that we invested in. And we would slowly rebalance that over time to include some of the loans we'll invest in after you come in. And so really, we're building you an individual portfolio. The reason we did that versus a pooled vehicle is one of the real requests we got from our clients is the ability to create bespoke portfolios. Some of them had different risk return profiles, and some of them wanted to invest in different regions and actually exclude others. We had one client say, I own eight homes in New York State already. I don't need any more exposure to New York. We can do that over time by creating this type of model instead of actually having a pooled model in there.

Okay, that's interesting. So then it begs the question, how do you do that when you know someone's investing 10 grand or. Or even 50 grand? I mean, if you go to any of the typical Wall street criminals, do you like how I throw that in? Wall street is the modern version of organized crime. You know, they're not even going to return your call unless you're investing, you know, several hundred thousand dollars. And even then it's like you're no big deal to them. So, you know, how do you do that for such small investments? I mean, that's tiny. $10,000 minimum, and I guess your average is about 50 to 60,000, but the minimum is 10, you know, this is.

Really where the technology comes in. And I think it's something that I learned through my experience the first time around in real estate crowdfunding is you have to commit early to technology. It's not something that you can catch up on later once you're bigger. And you see that with a lot of platforms in the space today, and it's one of the areas where fintech is struggling is where they skip the whole tech part. On our side of the team, you know, we're a seven person team, we're very lean and half the team is engineering focused. And so really what this is is when you come in with 10k or you came in with 100k, on the one hand, we've got our traditional underwriting going on to actually put loans into Alpha Flow holdings, but once it's in there, algorithms take care of building your portfolio. I'm not doing more work with your 10k than I am with your 100k. It's the same thing. Technology is handling all of that portion and it's working really well.

Okay, all right, interesting. So when you say technology, I mean, do you care to elaborate on that a little bit? Like what happens? So you know someone. Yeah, they probably sign your documents online. I'm sure they're very long and complex and nobody reads them as usual. But you know, by the way, on another thing, you know, everybody needs to watch that documentary. I think it's on Netflix. It's called Terms of Service, I believe. And it's about how all of these websites we use and this is not, you know, anything to you, it's more about Google and Facebook and everything else. Right. You know, nobody reads those Terms of Service, of course, they're like a zillion pages long. And you just want to hurry up and start using the, whatever it is. You're using that SAS website. Right. I mean, how can this stuff even be enforceable? I think there needs to be a law that it's not enforceable if it's too long.

Yeah, because it just practically nobody can read all that stuff, you know, and.

Most people, it's someone else's Reddit. And if it's on there, it's okay. It's a lot of retail investors, a dentist, a doctor may not be reading our PPM or Private Placement Memorandum, but we also have a lot of institutional clients. We've got university endowments, family offices, hedge funds. I promise you, they read every word of that because their jobs rely on it. And so, yeah, and we've got Davis, Polk, and Wardwell as our counsel. So, you know, we've gone pretty heavy on the legal side of things to make sure we're doing things the right way. Because when. When you get to the larger investors, they scrub everything. And so we have spent a lot of time on that portion of it. But to go back to the mechanics of it, can I go back to the earlier part of it? So you would. Come on, you would sign up. And really, the longest portion of that is the two pieces. One, making sure you're reading enough of the information to get comfortable. And then second is just the accreditation, where we do 506C. So you have to actually produce documentation, approve your accreditation. Once you're on board, it typically takes two days to receive your funds. And from there, what happens is basically, our algorithm will put you into OneNote, and then we put you into what we call our optimizer, which is using nonlinear optimization to basically build you a portfolio that maximizes your diversification level over a certain period of time. That's really how our optimizer works. You're doing none of the work, but within a day, you're logging on. You can see every single loan you're in. You can see the details of those loans. You can see the cash flows projected. Not. We try and be very transparent, because going back to that same point, as we got more and more sophisticated investors, you know, a lot of family offices, for example, they were speaking to us in the real estate crowdfunding world, but they just simply didn't have the time to pick deal by deal.

Right. Yeah, I know. I agree. It's a problem.

Yeah. But what they needed to do when they invested with us was be able to tell their bosses that they can see each and every loan they're in so they can do the analysis. So that's all out there. That's for anyone to do. And we actually have a demo dashboard for any users that want to see what that looks like. They can see exactly what the experience feels like as an actual investor.

Yeah. Okay, so let's talk about the underlying loans. Commercial, residential, both.

So we're focused on residential loans. We'll do almost all single family residences. We'll do some multifamily, up to six units. We haven't gone above that because we've seen when you look at apartment buildings above six units, you start to move more into analyzing a business and how that's run versus pure real estate at that point.

Okay, all right. Why not commercial properties? Why not office buildings? And, you know, maybe Institutional apartments? Or are those loan sizes and deal sizes just too big? Or, you know, what about retail and industrial and so forth?

Yeah, I think we'll eventually move into some of these. Where we found the opportunity really with a mispriced asset class was in hard money residential loans. Banks weren't touching these loans. When you get closer to $15 million commercial loans, you get more bank participation. The sooner you see banks involved in a certain type of lending, the more you realize you're getting the bad loans that they've said no to versus hard money residential loans. They basically categorically stay out of this space. These too short term for them to sell off to Fannie and Freddie, which means it needs to stay on their balance sheet. And at that point, with the new regs under Dodd Frank, it's really punishing them to have these on their balance sheet. And so they decide just not participate. And that creates an opportunity.

So there you go, listeners. You just heard it right there from an insider. Dodd Frank makes availability of funds less. And that hurts the market and it hurts the overall economy. You know, another example of government regulation perverting the marketplace. I mean, it's just. It's just the examples are everywhere. But there's one more. Right? And usually these things don't protect the people they say they're setting out to protect. It's just the nature of the beast. You know, you said it was a mispriced asset class, and that's a great statement, by the way. And when you say misprice, do you mean in favor of the borrower or the lender?

I would say certainly in favor of the lender, which is where we come in at that point where you're coming on and you're getting 8 to 12% returns, depending on where you are in the country. On first lien debt backed by an actual house. This isn't credit card debt that goes to zero if someone defaults. Our average loan to value today is around 69%. So there is a lot of equity cushion to protect your principal if anything goes wrong.

Okay, now wait, wait, wait, wait. Hang on for a second. I gotta ask you about that.

Yeah.

You said 69% LTV loan to value ratio. Is that before or after repair value? Very important question. Right.

It candidly frustrates me that you have to ask it because it's the right question to ask, Jason. But too many people in the industry will write arv, but they'll put LTV next to it, which is after repair. What we're concerned about is at this moment, what does our exposure look like? And we've actually pushed a lot of our partner platforms to stop that practice. And you're seeing it less and less these days. But if someone ever goes and tells you that the LTV on a deal is one number and it turns out that's the arv, walk away, they're hiding something, and it's just not the right way to look at deals.

So 69% LTV on the purchase price.

Correct.

And the repair cost or no? Yes. Purchase price and repair cost, probably right. Rehab cost.

You may do it after them. But our exposure on that day, if they went and bought $100,000 home, we've only loaned them $69,000 at that point for a 69% LTV. Now, we may do some of the repair costs along the way, but that's going to be after they've already done. Then they're going to get reimbursed for the roof, for example, something like that. We'll participate in those type of loans. But you really want to watch out on your day one risk because things go wrong quickly in some of these loans. You can get underwater.

Okay, good. What else should we know about the underlying loans? Well, what is the interest rate that the borrower is actually paying on those deals? What it translates into for your investors is obviously different than what's being paid because, you know, the crowdfunding platform has to make some money and then your company has to make some money along the way. So tell us about the breakdown of those economics.

Yeah, you want to look at that. And so what you're seeing is whether you're going through us or you're going onto the platforms yourself directly to invest, you want to look at what they typically call the servicing cost. Sometimes you see these get as high as 250 basis points or 2.5%. We don't touch those loans. That's too wide for us. It doesn't make sense. What you'll often see is basically a 1% on servicing for them to actually take care of everything. And if you're not sure what that means, really what we're talking about is who's going to send the bill, who's taking care of making sure that the borrower is making their payments on time and actually is going out and checking out the property, making sure the work's being done on time. So you're paying them for real service and value add at that point where we come in is a 1% fee. We charge a 1% purely on invested capital. So if we haven't put your money to work yet, it's not costing you anything with us. And those are the fees that really our lenders and our clients are paying along the way.

Okay, good. So also listeners, one more thing just to go back to my comment about Dodd Frank and Ray's comment about Dodd Frank. You notice that all of this ultimately makes the price of the house to the consumer, whether they're a renter or a buyer of this property, more expensive. So you see how regulation is inflationary. Right. So there we go. Okay, good. What else do you want people to know, Ray? You know, maybe something I haven't asked you.

You know, one of the things we talk about a lot internally is there are a lot of correlations between markets around the US But I wouldn't get too caught up in ever thinking, if you want to get involved in this space, think in a nuanced way about real estate markets, where what's going on in LA may be very different than what's going on in Charlotte, North Carolina. So if you see things getting overheated one place, it doesn't mean there aren't good opportunities in other places. And that's, I think, where it helps us to have a lot of partnerships around the country so that we can shift from one to the other. I think that's one piece. And if I can give your clients maybe a couple pieces of investing advice besides going through us, if you're looking on your own. What we found is a lot of success with repeat borrowers. And that doesn't necessarily mean just experience. But if you're looking at a loan from fund that flip, try and find one with a repeat borrower that's actually gone through them. We found the default rate comes down dramatically at that point. And try and focus on purchase transactions, not necessarily refinances. You do those and you can really clean up a lot of the noise.

Clean up a lot of the noise. So focus on purchase transactions as opposed.

To refinancing, refinance transactions.

Okay. And why is that? Is the refi. The appraisals get funnier than on purchases. Do you think they're more legitimate, the valuations on the purchase side?

Yeah. One of the things, there's been a market clearing transaction, so we've got a better approximation of the actual value at that point. The other thing is you've got new money coming into this. If you're the borrower at that point you've just put equity into a brand new project. So that means something when you're stepping in, putting more capital in, as opposed to just a pure refinance where you haven't necessarily put in more money besides the fees, and you're making a guess on what the value of the project is. We found if it's a purchase coming in, the borrower tends to be in better shape because they've just basically made a big outlay of capital and they've made a big commitment to this project. And so we've looked through our basically extensive data at this point around the industry, and defaults are a lot lower.

If you focus, there's first liens only or you don't do seconds, right?

We don't do seconds. Just first liens.

Yeah. Okay, good. Good stuff. All right. Anything else you wanted to mention on that?

That's all it's great for. I really appreciate you having me. It's been great talking to you, Jason.

Yep, likewise, Ray. Thanks for joining us. And the website is alphaflow.com it is.

Thank you very much.

Sounds good. Good talking to you.

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