Discovering your allocation mix with Paul Kaseburg, Chief Investment Officer at MG Properties Group.
Paul Kaseburg joined MG Properties Group in 2010 and is responsible for the firm’s acquisition, disposition, and capital markets activities. At MG, he has been involved with the purchase of approximately 12,000 units totaling $1.7 billion in total consideration. Paul has 17 years of experience in real estate private equity investment, capital markets, and corporate M&A. Prior to joining MG, he held various roles in commercial real estate debt and equity acquisitions, development, and financing. He has a background in corporate M&A and venture capital investing at Northrop Grumman (NOC). Paul holds a Bachelor of Science degree in Mechanical Engineering from the University of Notre Dame, and an MBA in Finance and Entrepreneurship from the UCLA Anderson School of Management.
Paul is also the author of the book: Investing in Real Estate Private Equity: An Insiders Guide to Real Estate Partnerships, Funds, Joint Ventures & Crowdfunding (available on Amazon).
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RealCrowd – All opinions expressed by Adam, Tyler and podcast guests are solely their own opinions and do not reflect the opinion of RealCrowd. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. To gain a better understanding of the risks associated with commercial real estate investing, please consult your advisers.
Adam Hooper – Hey, Tyler.
Tyler Stewart – Hey, Adam, how are you today?
Adam Hooper – I’m doing really good. We’re getting close to the end of the year here, aren’t we?
Tyler Stewart – We are, it’s sneaking up on us.
Adam Hooper – It is. Well, we’ve got another one today. Who’s on?
Tyler Stewart – Paul Kaseburg, Chief Investment Officer at MG Properties.
Adam Hooper – Alright, I think this is our third.
Tyler Stewart – It is.
Adam Hooper – Our third with Paul, yeah. Always great information. We talked about a lot again today. I think we say that every time.
Tyler Stewart – We do say that every time, and again, it’s true.
Adam Hooper – It’s true.
Tyler Stewart – We did talk about a lot today.
Adam Hooper – Yeah, we started with some risk conversations. Interesting, you know. One of the things that we’ve always tried to figure out is, you know, looking at real estate, a lot of investors see it as a short term deal ’cause that’s all they’ve really been exposed to, but we talked about, you know MG’s philosophy is much more long term. It is.
Tyler Stewart – Paul made some really good comments about, when you’re looking at a long term, you know, cycles are going to happen. If you look at it over a longer horizon, where you’re at in that cycle becomes a little bit less relevant because you can kind of weather that and you have staying power. That’s right, yeah. MG Properties, they go with the rinse and repeat strategy. You know, it’s great to do well when the cycle is going up but if you can’t repeat that when the cycle is going down, you might need to focus on a longer term strategy.
Adam Hooper – Yeah. Really good conversation with Paul, touched on a bunch. I think it should be pretty good information. We talked about capital stack, we talked about–
Tyler Stewart – Investor mindset.
Adam Hooper – Yep, yep. What else did we talk about?
Tyler Stewart – Basically, anything you want to think about before you commit to an offer. Taking an investor from the onset of, what’s your allocation, what are you looking for, where do you want to be in the capital stack, what type of properties are you looking for? Paul went over it all, and it was great to have him on again to do this.
Adam Hooper – Oh, one key takeaway. Vintage timing of your actual investments, too. That was a pretty interesting point that not a lot of people give thought to.
Tyler Stewart – Yeah, to spread out, diversify the time in which you invest in your properties. You know, set an allocation for how many properties I want to buy this year, and then how many I want to buy in the following years.
Adam Hooper – Alright, well, I think that’s enough of us talking. We should probably get to Paul.
Tyler Stewart – Let’s do it.
Adam Hooper – As always, listeners out there, we love your feedback. Comments, if you have them. Please send us an email to email@example.com. We appreciate ratings, reviews, iTunes, Google Play, SoundCloud, anywhere else. We’d love to hear from you.
Tyler Stewart – And happy holidays.
Adam Hooper – With that, let’s get to it.
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Adam Hooper – Paul, welcome back, and thanks again for coming on the show here to round out 2017. We had you on earlier this year. What have you been up to at MG, and what’s the latest in the market right now?
Paul Kaseburg – Great, thanks for having me back. It’s a pleasure to be on again. We’ve been really busy this year. It’s been kind of an interesting year for us. I’m not sure if you’ve been seeing this with the rest of your groups. The market was really thin, but prices didn’t necessarily go down. It was just kind of an unusual year. Everyone is a little bit on edge, but at the same time, markets are going up and everyone is trying to decide what that means. For us, we’ve been really active. We closed over a billion dollars this year.
Adam Hooper – Wow.
Paul Kaseburg – Mainly, we’ve just had our head down trying to execute this year. That’s been great, and we’ve been buyers and sellers. It’s interesting to see on both sides of the market how transactions are unfolding. It’s definitely getting trickier as a buyer to find deals and secure them and increasingly, reputation matters and you really have to have a clear plan and be able to execute quickly to get deals today.
Adam Hooper – And now, are you net sellers in some markets and buyers in others, or are you transacting in the same market where you’ll sell a property in one market and buy in that same market, or are you taking that capital and moving it to other markets where there might be different opportunities?
Paul Kaseburg – For us, our dispositions are either usually driven by our debt maturity. We don’t operate with funds. Each deal is individually syndicated, which means, each deal has its own, we could really put long term debt on our properties, and so as that debt is coming through, there’s an opportunity to transact without a big prepay. Usually in cases where some of these deals are seven and 10 years old, we try to sell the deal and look for an exchange opportunity for our investors. For investors who want to stay in the allocation and in the deals, which is, for us, that’s about 90% of our investors. For those investors, they can continue to be invested, but for investors who might want to get out after 10 years, that gives them a chance to get out without getting locked in for a 20 year hold, which they may not have planned on. For us, it’s really about that debt maturity. We’ve been buying in almost all of our markets this year. I’d say there are kind of compelling things and not compelling things about each of the markets, and so for us, it’s really been about the micro strategy in each of those markets. You know, what sub market are you in, what is the specific pipeline around that property, and what’s happening with that specific property? As opposed to just a bet on a larger metro area. ‘Cause you know, all the metros are starting to see some development in the pipeline now, and so I think the differentiating factor is really property to property now.
Adam Hooper – Yeah, I think that echos what we’ve been hearing from sponsors out there, it’s not necessarily that there aren’t opportunities, they’re just different, right? They may be harder to find. Maybe the underwriting has had to come in a little bit. Pricing hasn’t really gone up tremendously. It certainly hasn’t gone down, but it’s kind of that slow progression. It’s been, fairly consistent across sponsors that we’ve been hearing similar response.
Tyler Stewart – Paul, you mentioned something, and we’ve had other sponsors say this too, that the market is tricky right now. What does that really mean?
Paul Kaseburg – It means that there’s a lot going on with new development, and at the same time, the economy is doing well. We’re in that part of the market where, as long as the economy continues to do well, most deals will be fine. But if the demand side starts to falter, that can really suck the wind out of some sub-markets and you can see some kind of disproportionately bad performance by some deals, if they’re impacted by that new supply. The supply itself is not a bad thing. In fact, that’s exactly what you want to see in the world, supply and demand, so rents have gone up. That means people build more product, that stabilizes rents, and that keeps everything working correctly. We’re starting to see some rents moderate, the rent growth moderate, and I see that as a healthy thing and that’s the way things are supposed to work. It’s not supposed to be a boom and a crash. But if you have that development pipeline, and then you have some sort of an economic pullback, then things can get worse. We’re just trying to be real careful about the sub markets that we’re getting into. The other aspect of the market being tricky right now is just, because the disposition volume is down this year compared to last year, there’s a lot of competition for new deals. Just being awarded a deal, it takes a lot of work and a lot of preparation and you really have to execute well and you have to have a good reputation to get those deals, and you have to do what you say you’re going to do.
Paul Kaseburg – Deals tend to not come back out if they go under contract. They tend to close. You don’t get a lot of deals, kind of, on the rebound. That’s what we’re seeing in the market right now. It’s definitely very competitive.
Adam Hooper – You mentioned, so long as the economy and demand stays strong, are there any leading indicators that you guys are watching that might be tips as to if that might falter and what those things are that you guys are identifying as some of those early indicators, if there is going to be some kind of reduction in demand or other economic issues?
Paul Kaseburg – In our space, we’re not really seeing indicators of erosion in performance. What we’re seeing really is just a moderation in growth. When the next downturn will happen, it’s really, perhaps, more of a macro question. I’ve definitely been wrong in the past about what’s going to cause a recession and when that’s going to happen. We probably all have. We really are trying to make investments that are going to be robust to those downturns. We’re seven to 10 year holders for the most part. Our assumption is there’s going to be a downturn at some point in those 10 years, whether it’s year two or year four or year seven, it’s probably going to happen. We just want to make sure that we’re doing deals that are capitalized right and that are in the right locations and they’re the right real estate. They’re going to ride that out and be successful long term. Because it’s going to happen at some point, and we just want to make sure that we’re prepared for that.
Adam Hooper – Yeah, and that’s a really interesting point. I’m trying to figure out the right way to phrase this. In our industry, so much of the early activity, investors first exposure to this asset class was super short term, hard money loans, fix and flips, six to eight month durations. On our platform, earlier on, there’s a lot of, two to four year value add, get in, rehab units and multifamily, and sell within two to four years. That’s a relatively short underwriting cycle based on how real estate, historically, has been looked at as an asset class which is a much longer term, that seven to 10 year underwriting where you have the ability to kind of float through some of those more short term market corrections and ride the longer trend over that period of time. Anything you can kind of touch on there for investors out there who are maybe, their only exposure to this asset class has been in the last four or five years where deals are typically looked at in that two to four year time horizon, how might they start thinking about, as we’re getting along in this cycle, maybe starting to look at it on more of a longer term wealth generation versus that kind of quick turn, high velocity deal cycle?
Paul Kaseburg – Yeah, when the market is going up, it kind of doesn’t matter. That really starts to matter when the market starts to turn. Again, we tend to be longer term holders. Our general view is that real estate is a long term asset. That doesn’t mean that you can’t go in and create value. We’re value add players, we do physical improvements, we do operational improvements, but we’re also here to hold real estate for the long term and generate income for our investors and generate long term capital gain. Nassim Taleb describes the short term strategy. It’s sort of like picking up pennies in front of steam roller. There’s a small probability of a very large loss and then a large probability that you do well, okay. That’s not really our game plan. As you start to get later in economic cycle, there’s more of a chance that there can be a downturn. If you’re over levered or if you have short term debt and the economy takes a dip, or anything just doesn’t go as expected with your investment, you could end up being forced to sell at a time when the market doesn’t have much liquidity or values are down. That is a strategy that can end up getting you in trouble. One of the ways we look at it is, in real estate, you want to really make sure you have staying power. Staying power means if the market is rough, you want to make sure you can ride it out and wait for a better day. If you’re buying good real estate, it’s going to be fine in the long term. You just have to be able to wait it out. But if you can’t wait it out and you have to sell,
Paul Kaseburg – or you’re having cash flow problems and you can’t make your debt service, the lender is going to take back your property, you’re going to lose everything. There’s this sort of binary situation, right? It’s path dependent. It depends, you pick your capital structure, and we’ll probably talk about that later, but one you pick your capital structure, you can’t change it and you’re along for the ride. If that’s not set up right and you don’t have the ability to hang in there, that’s when you could end up really taking some losses, even on a property that’s just fundamentally good real estate. You hate to see that happen.
Adam Hooper – We would all probably agree that we’re getting a little late in the cycle, right? We’re what, seven years, six and a half, seven years into the true recovery, kind of, 2010, 11 would be the kind of turning point, I think. Most of us would consider that true. We’re probably getting to that stage where you said over the next 10 years, there’s a high likelihood that something will happen, whether that’s in two years or four years or six years. Making sure that those deals are capitalized correctly with a sponsor that’s been through that, that knows how to get through those challenges. More important now, certainly, than it was in the beginning of the cycle where it was hard to lose money, almost. Buying deals in 2010, 11, 12.
Paul Kaseburg – I think about the real estate market as either being distressed or not distressed. When it’s distressed, everybody knows it. You cannot get debt, the terms are really bad, prices are way down below prior … In those environments, you just know they’re going to be good deals. In 2010, it didn’t matter what was out there. You just got these deals, and it was just a question of, you know, how do I buy as much of this as I can? Because I know that this is a great deal. That’s the distressed environment, and then there’s not distressed, and we’re in that environment of not distressed. What’s going to cause that next downturn and when that’s going to happen, I’m not quite sure, but it doesn’t feel like those distressed times by any means where you just can’t go wrong. We try to be a little bit more careful these days.
Adam Hooper – Okay, well, I think that’s a good transition into, you know, we kind of want to get into the meat of the conversation today, which is around, you know, different risk profiles, the capital stack, as you mentioned, and then how investors might start looking at different allocation models. We’re big proponents here at RealCrowd of risk first investing. If you don’t mind, let’s take a minute to kind of walk through the main risk profiles of deals, and that would be everything from kind of core, core plus, value add, opportunistic. Can you maybe just walk us through, for an investor out there, that may not even know what core or core plus is? Let’s take those and pick them apart a little bit, starting with a core investment. What would you consider is a core investment in today’s market?
Paul Kaseburg – Sure. There are basically four categories of risk profile. There’s core, which is the lowest, core plus, which is a little higher risk, value add, a little higher, and then opportunistic, kind of the highest. I’d say that’s kind of how most institutional investors break up the way they think about their investments. Typically, an institutional investor will go out and raise a specifically core plus fund or a value add fund or an opportunistic fund, and all the deals they do will be deals that fit within the bucket of what goes into that fund. They’ll sort of describe what’s allowed and what’s not allowed in each of those types. There’s not a perfect description for what makes up each of those. There can be some different factors, and sometimes, depending on market conditions, some institution will start to kind of stretch what is allowed in their buckets. But generally speaking, core is always the lowest risk of those four. Core means a great location. That’s going to be one of the major metro markets. You’re going to be in a downtown area, most likely, maybe a seat court, you know, the business district, downtown urban product or a very high quality location, with very high household incomes for instance. Core is going to be your best location, it’s going to be new, vintage properties, something that’s built recently where you’re not going to have risk from the roof going bad, for instance, or from the windows getting old, so you take away that physical risk. Core typically is tenant profiled, it’s highly quality. For instance, you have a major business in there
Paul Kaseburg – that has high credit. That’s going to be considered a must have for a core deal. Typically for core investments, you tend to have lower leverage, and that’s partially because that’s matching up with the lower risk profile core deal, but that’s also because you typically can’t get as much debt on core deals anyway because their cap rates are quite low. That’s kind of a core deal, and core deals, many of them are done unlevered. Many of them do have lower leverage. For instance, 50% leverage. You’re typically going to get yields in the unlevered range of maybe six, seven percent, something like that. Maybe you’ll get a couple extra percent if you have some debt on there, but they tend to be very low, long term return deals.
Adam Hooper – That 60%, how is that return broken up in terms of cash flow versus total IRR including appreciation?
Paul Kaseburg – For core deals, most of your return is going to come from the cash flow distributions as opposed to long term appreciation, in theory. In practice, it really depends on what part of the cycle you’re in. And in fact, core deals are not riskless either. When you’re buying a deal at a sub four cap, as you are in major downtown areas right now, and then interest rates go up, you can have an impairment to value, for sure. Core, in theory, we call it checking all the boxes. Good location, good product, good tenant,
Tyler Stewart – all those things that you want to see in real estate. But even when you have all those things, that doesn’t mean there’s no risk, but it does tend to mean that you don’t look as stupid afterward if a deal does badly because it was all good real estate. That’s kind of how I think of core deals. What’s the main driver behind the lower returns with core? Is there more competition because a core deal has all the factors someone is looking for in real estate, so do you have to pay a higher price to get it?
Paul Kaseburg – Exactly. More people want properties that have solid tenants, that are in good locations, and so they tend to be bid up. The returns of any real estate, it’s just a function of supply and demand. All else being equal, people will pay more for better located properties. Those properties tend to have lower returns.
Adam Hooper – We’ve seen recently a lot of international capital, this kind of flight to safety trying to get capital out of riskier home country environments from the capital market side into stable core assets here, certainly in the US, that that capital profile is almost return agnostic, right? It’s just about parking money somewhere that they know that asset is going to be there for generations without any real return expectations that you would see from a more institutional, someone that’s trying to deliver something to LPs. Very different capital profile, and we’ve seen that obviously impact prices quite a bit in those core markets lately too.
Paul Kaseburg – Absolutely, I mean, that’s a real factor. We see a lot of overseas money coming over and bidding up assets. That definitely can distort a market. Core in general, it tends to be the purview of the ultra high network investors and institutional investors. There aren’t as many opportunities to invest in syndicated deals in core, and a lot of that is because, Part of it is investors don’t demand that as much from syndications. Part of it is by the time you get net returns down and everyone gets paid, those returns get low unless you’re really dealing with large scale. And then part of it is, most GPs have a significant amount of their compensation, as we’ve talked about in the past, coming from an upside scenario where a property outperforms. The chances of that happening with a core deal are just that much lower.
Adam Hooper – And then timeline core deals, you usually see those as longer holds than shorter?
Paul Kaseburg – Typically longer holds. If you have a deal with an expected low return, there’s no real incentive to get in and out to maximize IRR. Much more multiple focused.
Adam Hooper – That’s core, and that’s going to be again, lowest risk but lowest expectation of return, stable, should have some of that in your portfolio. We’ll talk about that a little bit later, but there’s room for that in everyone’s portfolio. Stepping up from there, we go to core plus. How does that change from the core profile?
Paul Kaseburg – With core plus, really the difference is you start erasing one or two of those checks. Perhaps a deal is in a great location, but maybe it’s 30 years old, or maybe it’s an older deal but it’s in just a prime location. Maybe you have a really high quality property, but you have a tenant that’s a little shaky, they have a lease that’s going to expire in a couple of years and there’s some uncertainty about what’s going to happen. Things that just don’t quite check all the boxes, they tend to go into that core plus bucket. This is where the boundaries start to get stretched a little bit depending on market conditions, what’s considered core and what’s considered core plus. People start making exception when they can’t find deals. But core plus, generally you get returns that are maybe a couple percent higher than core deals, but still, even with leverage, core plus deals are going to be in the low teens type of IRRs over a medium term hold. Still good, solid, fairly low risk deals, but you know, just something about them that makes them a little bit riskier.
Adam Hooper – That would be, again, you may be retenanting, maybe doing some light renovations, refreshes on the units if it’s a multifamily deal. Not a huge heavy lift high value add kind of an opportunity where there’s just the light touch to improve the rent roll or maybe improve the condition of the property over the whole period.
Paul Kaseburg – Right, yep.
Adam Hooper – Are you seeing a little higher leverage amounts on core plus versus core deals?
Paul Kaseburg – Typically incrementally higher. Because the cap rates tend to be just slightly higher, you can also get a little more debt efficiently. You have a little bit higher debt, but still, they tend to be fairly modest leverage and usually medium to long term holds.
Adam Hooper – Okay, and then when you look at the breakdown of returns on that one again, still more weighted towards cash flow or appreciation or a decent mix of both of those?
Paul Kaseburg – It would be a little bit of both, but I’d say they still tend to be more cash flow oriented. Right now, in our markets, we’re seeing core plus deals that are in the six to seven, maybe eight percent cash on cash range over a long term hold, depending on how the debt shakes out, and IRR is in the nine to 11 range, net to investors over 10 years. Fairly stable, you’ve got most of the boxes checked, maybe a couple impairments or things to add value throughout that, but by and large, still fairly stable opportunities, stable markets, just a little bit higher risk than a core deal. Yep, next step up.
Adam Hooper – Okay, and then the next step beyond that, value add. Let’s walk through that one.
Paul Kaseburg – Value add, that’s where things get to be a little bit more fun as an operator. That’s where there’s an opportunity to kind of go in and do something interesting to a deal. For instance, in our space in the apartments, that’s where we have a chance to go in and renovate units, replace kitchens and flooring and lighting, maybe go into the common areas. You’ve got the leasing office and create a new space for people to come in and hang out and play games, things like that, so that’s where you go in and you really improve the property. Value add, just generally, that’s kind of the next step up in risk from core. Value add, for the most part involves some heavy lifting from the operator. You’re going in and you’re doings something to the property. Maybe it’s mismanaged or maybe there’s something physically wrong with a property. That’s where you’re going in and you have a business plan and a vision for what things are going to look like and you go in and make it happen. That’s kind of the next step up in risk from core plus and it requires a little bit more expertise, it requires a little bit more work. As a result, you tend to get higher returns from that. With value add, you’re a little bit more likely to be able to get more debt on value add deals and a lot of lenders, this is the kind of deal where a lender will come in and look at what you plan to do at a property and take that into account when they make their loan, so they’re not necessarily just making the loan based on past performance at property.
Paul Kaseburg – They may also look at what you have planned, make sure that you’ve set aside the money to execute your plan, but then loan higher proceeds based on your vision for that property. Value add tends to have a little bit more debt, a little bit more heavy lifting. Value add also often tends to be a little shorter term hold and as a value add operator, there’s a case to be made for, my strategy here is to go in and do something to the property and when I’m done doing it, I’m going to sell the property and go on to the next deal. It’s not uncommon to see shorter term hold periods for value add deals today.
Adam Hooper – And that would be in the three to five typical kind of a range, years?
Paul Kaseburg – Yeah, exactly. For most deals, it’s tough to really move the needle in less than two or three years. Usually, three to five year loading rate debt so you don’t have a prepayment and you can just get out any time and move on to the next deal.
Tyler Stewart – Does value add rely a little bit more on market timing or is this a strategy you can utilize throughout the various market cycles?
Paul Kaseburg – You can use it any time, for sure, and I will say, we’ve definitely had some deals that rode out some down cycles but ended up doing fine because we went in and added enough value that it kind of overcame that cycle. But when the market has a downturn, it just makes everything tough. It’s perhaps a little less tough if you are adding value, so there’s something to be said for that.
Adam Hooper – And then with value add, is that where we start to see the shift over in terms of composition of those returns from cash flow to more heavily weighted on the appreciation side?
Paul Kaseburg – Absolutely, and that’s kind of exacerbated because a lot of the time when you go in and you start ripping and tearing at a property and making some improvements, that doesn’t necessarily help your operations in the short term. Perhaps you’re renovating a lot of units. You may have vacancy that’s higher than normal. We just had a property where we replaced all the roofs, all the siding, tons of woodwork, your asphalt, landscaping, common areas, all at one time, and it’s just a cloud of dust at the property. Residents don’t love that. They appreciate that the property is getting better but they don’t necessarily love living through that. It’s tough sometimes to generate that cash flow when you’re doing that heavy lifting. They really tend to be a lot more weighted toward appreciation of the asset.
Adam Hooper – And then on those deal profiles, maybe your approach versus some others out there, are those improvements usually funded through cash flow from the asset or are they from equity reserves that you capitalize up front? Or is it usually from debt proceeds? Or it depends, in combination thereof.
Paul Kaseburg – Yeah, it kind of depends, and I’d say, that’s a really important question for investors to ask and understand about the investment they’re doing. To the extent that those value add improvements are being paid for through cash flow, if something goes wrong at the property, or just for whatever reason, that cash flow isn’t size expected, then you have this double hit of not only do you not have the cash you thought you had, but then you can’t make the improvements you thought you were going to make for the property. That’s when you can really get into trouble in a downturn. For us, for the most part, we capitalize our value add improvements by funding, by raising that equity upfront and funding it in to the partnership. It’s just sitting there, and we try to make those improvements as quickly as we can so that money isn’t just idling for too long. Sometimes there’s situations where money will need to be spent and it’s a couple years out and you hate to raise that money up front. For instance, I know I’m going to need a new roof in year six, and so we’ll kind of reserve around that or sometimes we’ll use supplementals to fund those things. But for the most part, for our near term value add, we try to just raise that money upfront and then we’re more agnostic to market cycles. We know that money is there waiting to be used.
Adam Hooper – And then, how much does the actual market the deal is in, again, with core, we talked about CBD, core plus. Maybe you’re in some of the better sub markets. This value add, can the market have a play in that too or can you do a value add deal in a CBD just as well as you can in a suburban location?
Paul Kaseburg – You can do it in a core location as well, but the returns tend to be lower. The location and the quality of the asset, those all get factored into your returns, but you can still definitely have a value add deal in a great location. In fact, we’re working on one right now that’s very well located, but we’re going to go in and renovate all the interiors. We’re taking, kind of, core plus returns for something like that because the location is so good. It all kind of factors in, and again, this is where there’s no real bright line between what’s core plus and what’s value add, but I’d say with value add, there’s an opportunity to go out to more markets. It’s more acceptable to go out to tertiary markets than it would be in a core plus allocation.
Adam Hooper – Got it. And now, moving on to the riskiest of the four. Maybe there’s more of a bright line between value add and opportunistic. What would you categorize as an opportunistic deal?
Paul Kaseburg – Opportunistic is just deals that have outsize returns and outsize risk. Things like development tend to fall into opportunistic, things like product types that are not one of the normal product types can often be opportunistic. If it’s an unusual use of real estate, if it’s a land entitlement play, that would definitely be in the opportunistic space. All those things that are not real estate that’s not operating on a stabilized basis already tends to be in that opportunistic space, and that’s where GPs are really adding value. They’re really going out and having a vision and creating something there. Maybe they’re using their contacts with municipalities to get something approved that other people couldn’t get approved, maybe they’re using their expertise in construction to build something unique. Those are the opportunistic deals where, you know, if things go well, you do really well, and if things don’t, then you do really badly. But either way, it’ll be interesting.
Adam Hooper – And those are generally little to no return coming from cash flow and almost entirely from that value that the general partners typically bring to the table, right?
Paul Kaseburg – Yeah, it’s really all about appreciation for the most part for those deals. With that, often you can’t really lever those up as much. Sometimes there are capital structures where you can go out and get hard money loans or unique lenders to really put a lot of debt into those deals, but sometimes you can be constrained in those, it’s not necessarily the case that they’re higher in leveraged, the value add deals.
Adam Hooper – Typically shorter term horizons on those, or across the spectrum depending on how heavy of a lift or how much value add there is on that deal?
Paul Kaseburg – Yeah, they tend to be shorter term, although there’s situations, for instance, land entitlement, that can just take a long time. Sometimes you’re locked into a longer term hold. Usually the investors in the opportunistic deals are looking for IRR, so the goal is to get in and do whatever you’re going to do, and then get out.
RealCrowd – Thanks again for listening to the RealCrowd podcast. If you like what you’re hearing, please visit RealCrowd.com to learn more, and subscribe at iTunes, Google Music, and SoundCloud. RealCrowd, invest smarter.
Realcrowd Review (Jack) – My name is Jack, and I’ve been in the financial services industry for over 30 years. I’ve done six different deals. When I first started doing these deals, I was looking for sort of core real estate, cash flow. I wasn’t looking for a lot of upside return. I wanted more immediate yield. I went conservative to start, and then as I’ve gone through, I’ve just looked at them, really the quality of the sponsors first and foremost, and their level of experience. Now, I’m trying to mix in different types of properties, different geographies. I wanted some core plus and a little bit of development, so it’s still a pretty, in my view, conservative portfolio. It’s mostly focused on sponsors and then looking at the projections as far as how much of the return would come from current income and yield and how much of it would be based on appreciation, and thinking through whether or not, you know, how much risk there is in the appreciation being realized. It’s really a portfolio approach for me, looking at different sponsors, different geographies, different property types, and even different types of properties as far as core or core plus or development. I’m looking for, I guess, I would start with a certain level of return because my investments are primarily in equities. I look at the direct real estate investing through RealCrowd as being diversification play, but I also want a pretty substantial return, so I typically look for properties that have a yield of seven, eight, nine percent current income, and then IRR
Realcrowd Review (Jack) – that’s in the mid-upper teens, low 20s, in some cases. I start with return, I focus on sponsor, I look for property types that I don’t have already invested in the portfolio, and then I guess, finally I look at geography. I think that diversification is important to any portfolio. I looked at a number of different crowd funding portals and I chose RealCrowd because I liked the transparency. I liked the fact that the sponsors pay a fee to be on the portal, and that there’s not built in fees for RealCrowd in the compensation structure of the deal. These deals are fairly complicated to understand anyway, because you’ve got to pay a management fee and incentive fee and things like that, and if there are embedded fees from the portal provider, it just makes the complexity so much higher. I think the key for me is the transparency, and I just think that direct real estate is a great compliment to a lot of other stock and bond portfolios. I think it provides inflation protection, current income, and appreciation potential. For me, direct real estate is better than REITs, which are more subject to market fluctuation and price. I just think with the minimums that are out there now and the quality of the sponsors, it’s a really good way for a lot of investors to access direct real estate without the hassles of property management on your own. I think it’s an important advancement for a lot of investors to diversify their portfolios.
RealCrowd – Thanks again for listening to the RealCrowd podcast. If you like what you’re hearing, please visit RealCrowd.com to learn more and subscribe on iTunes, Google Music, and SoundCloud. RealCrowd, invest smarter.
Adam Hooper – Those are the main four food groups as risk profile. What does that mean for an investor? That’s a pretty good overview, but getting down to, you know, something applicable. Investors are looking at platforms like RealCrowd and others or just deals they have from their network, how can they start to make sense of these different profiles or deals? What is the mindset, what is a healthy outlook for trying to figure out which of these deals to invest in?
Paul Kaseburg – For investors, it’s important to think about real estate as an allocation and not necessarily as a way to go in and just pick the highest returning deals so that you can make as much money as possible. My general outlook on investing in real estate is, everyone is good at something in life, right? For the most part, you make your money by doing whatever you’re really good at, and then you invest your money and try to diversify it in a way that’s an appropriate portfolio allocation. From a real estate investing standpoint, I would say, you start out by deciding how much you want to have in real estate, and then you start breaking it up across these different ways to invest in real estate. Because not all real estate is the same, right? You can invest in core, you can invest in core plus, each of those pieces, and you want to have some in all of them, probably. We’ll probably talk about this later too. You probably want to break it up across the parts of the capital stack. The more you can kind of diversify in the risk profile and the location and the product type and the capital stack, then the less you’re going to have too much concentration in one aspect that could potentially cause problems.
Adam Hooper – We’ve talked about it on this podcast and to the investors out there that’ve had conversations with Tyler and I, we’re very much centered around risk first, right? This should be the fundamental approach to building portfolios. One of the behaviors that we’ve seen is risk adjusted returns aren’t really considered as much as we’d like them to be, and so the pattern is just kind of pumping money into the highest yield deals without any real appreciation for risk tolerance or risk capacity. What can investors do as they’re looking at these to start getting a picture of what their acceptable amount of risk that they can take on is? How do they begin to think about that?
Paul Kaseburg – That’s a great question. The answer to that is, every investor is unique. It’s really important for everyone to really be honest with themselves about their own risk tolerance. When you go out and speak with an investment advisor, one of the first questions they’re really trying to get at is what is your risk tolerance, and what is your ability to withstand risk? There are a lot of factors that go into that. Probably one of the first important steps that investors should take is talking to their advisors. Talk to their investment advisors, talk to their tax advisors, talk to their attorney, and make sure they really understand their own situation before you go out and actually make investments. I would think about kind of a hierarchy of investing in real estate. It really starts with thinking about your overall portfolio. That’s the first job, and then thinking about your own investment mindset, your own timeframe for investing, your own need for liquidity, and really taking those all into account to decide what types of investments you can and want to make, and then, you know, once you decide that, you figure out, overall, how much do I want to have in real estate? Real estate as a bucket, right? Then, within that real estate allocation, how do I want to break that up? How do I want to break that up into capital stack among core, core plus, value add, opportunistic buckets, product types, location. What do I want that real estate allocation to look like? Then, going to identify managers who they want to invest with, and then picking the actual deal that you want to go into.
Paul Kaseburg – That’s kind of the hierarchy. My sense is, a lot of people approach it the other way around where they just happen to see a deal that sounds interesting and then jump on it, but that may not be the best decision overall for their portfolio, so you really have to think about it, from the top down and then work your way down to making decisions about an individual deal.
Adam Hooper – Yeah, I think that’s a really good point. Again, looking at it as not necessarily just, “Wow, this is a deal I have to get into,” but thinking through, how does this fit in with my overall goals, how does this fit in within my overall bucket of real estate? I think that’s a really good point. So, an investor, they’ve talked to their advisor, attorney, accountant, and they have some framework, I guess, of the risk that they’re willing to take on. For someone that’s new to this asset class, listeners that, you know, they’ve been listening to the podcast maybe but they haven’t made their first investment yet, are there any resources out there or any information that a non-real estate professional can start exploring or looking into to get more up to speed on some of these things outside of this fabulous podcast, of course? Any other resources out there that you can kind of help point people towards? Feel free to plug your book as well, if you like.
Paul Kaseburg – That’s right. I would be remiss if I didn’t recommend my book, Investing In Real Estate Private Equity, which is under the pen name Sean Cook on Amazon. Aside from my fantastic book, I’d say, really, the best thing is to take your time and look at a lot of sources. There’s a lot of information online. You guys do a great job about providing information for investors, and this podcast is a great example of that. Investors can find all kinds of information online about various types of investments. I think that’s important. I mentioned earlier, talking to your RA or tax advisors, your attorney, those are all really important things to do that can end up being a little bit expensive and time consuming up front, but really, you just kind of have to do that to make the right decisions. Then, I think it’s important to talk to other investors just to get their sense of their experience, both good and bad with different groups is great, and just investing in general. There are a lot of industry conferences and associations out there, and so, if you have a particular interest in a product type, attending a conference or getting involved with one of those industry groups can be a great way to get started on it pretty quickly. One great thing to do is just review a lot of PPMs. We’ve talked about this in the past. Those private placement memorandums are just a wealth of information about the market, a piece of real estate, an investment strategy, and also all the risks associated with deals.
Paul Kaseburg – By reading through a lot of PPMs, that can really give you a sense of the way different sponsors approach investing in real estate and the different risks associated with different deals. That can be kind of a good way to get up to speed.
Adam Hooper – Yeah, we’ve talked even on our prior episodes with you on. A lot of it is manager, manager, manager. Get comfortable with who these managers are, talk to them, ask them the tough questions, and maybe that’s a good spot. What are some of the tough questions, and we’ve gone over this a little bit in the past, but just as a quick refresh, what are some of those hard questions that an investor should be asking of a manager before they decide to make that investment with them?
Paul Kaseburg – Absolutely, if you can only pick one thing about your investment in real estate, it’s who you invest with. The market is going to do what the market is going to do, and who you invest with is going to determine how well or poorly that deal does in the context of the marketplace and it can make a big difference. It’s important to spend time choosing that manager up front, and the things you want to look for in a manager, you want to make sure that they have a long track record investing. Ideally, making money consistently is a great sign of success, but also just a long track record of investing in whatever niche they are focused on. That’s important because when a company has been around for a long time investing, that means they have relationships with other buyers and sellers which are going to help them when they’re transacting. That means, they’re going to get a better price. They’re going to get invited to bid on deals that don’t go out to market. Those relationships are going to set that company apart when they get the deals in the first place. Those are also going to result in them getting better terms on their debt, and because they have a larger portfolio, they are just going to have a lot more flexibility with lenders in general, so that helps out. Then, they’re going to have the history of underwriting all of the deals in their space. For instance, a lot of the deals that we underwrite, we’re underwriting it for the second or third time because we looked at it 10 years ago and then we looked at it five years ago,
Paul Kaseburg – and then we’re looking at it today. You have a lot of history with deals, and then you also have a lot of depth in your market to compare deals, you know, one to another and know, oh, well, this is a good deal in comparison with the last five they traded. I think all those thing are important. Obviously, the fee structure is important to take a look at. I know we talked about that in depth previously. You definitely want to think about that. Then, just kind of track record and history and making sure that they have performed well in the past and treated investors well throughout market cycles.
Adam Hooper – If you find a manager that you’re really comfortable with, you like, got a good track record, good network of buyers and sellers, they’ve worked with good lenders, a pool of lenders they can work with, do you just do every deal that they do? You know, once you find someone you like, just do every investment that they bring out to market, or do you still pick and choose which investments with that manager that you’re going to try to be in?
Paul Kaseburg – It depends a little bit on the investor. Question one is, stepping back in the list of things that you do before you make an investment. One thing you have to do is figure out how many deals you plan on doing, how quickly, and how they’re going to be broken up. It’s important to diversify across managers as well as geographies and product types too. Not one manager is going to be the best at office in core New York City locations and also suburban multifamily in Tulsa, Oklahoma, right? Those are generally not the same group. And so, if you’re diversifying, you’re probably going to be with a couple groups. I think that that’s important. Usually, you’re going to see enough investment opportunities that you’re going to have a chance to pick the ones that you personally like and don’t. If you’re diversifying across geographies, you may not know all of the locations or all the products but it’s nice to look in to each of them, and sometimes you’re going to like the deal, sometimes you aren’t. By default, you’re really trusting the manager to know the real estate better than you’re going to be able to figure out for yourself. That’s sort of part of inherently why you’re hiring a manager to do it, but at the same time, you’re seeing enough investment opportunities. You should still look into it and see which ones you like and which ones you don’t. That’s part of the fun of it anyway.
Adam Hooper – Yeah, that’s part of what we’ve enjoyed at RealCrowd, bringing in a ton of different opportunities to people that they wouldn’t really get to see otherwise. That is definitely a fun part. As long as it’s done responsibly and with adherence to some kind of fundamental allocation preferences then certainly, that can be the fun part of it, for sure.
Paul Kaseburg – The way I’d approach it is, you want to really start with your portfolio allocation and then kind of drill down. For instance, let’s just say you have a four million dollar portfolio, and you want to put 25% of that in real estate. That means you’re going to have a million dollars in there. Then, you need to think through it and say, for instance, I want at least 10 deals. That’s 100 grand a deal, right? That’s something you can probably pretty easily do in the private syndication space or on your site. The minimums are lower than that, so it’s possible to get enough deals to get the diversification you want, or at least to limit your concentration risk. Okay, I want at least 10 deals. Maybe I can get 15. I’m going to say, I want five of those to be, maybe two of them to be multifamily, two office, two retail, two industrial, two self-storage, and then the rest whatever I happen to run across. And then, you say, you know, one of each. I want one debt, one equity, and you break it up like that. Then, you can start to see, if you are breaking it up by geography, you pretty quickly can’t do too many deals that are exactly the same with each sponsor. That’s just something to think about. To the extent that you break it up and you really diversifying, it’s important to have a lot of options at your fingertips and I think that’s one of the real benefits that your site has, for instance. You can go on there and really quickly look at whatever you want in terms of product type and location.
Paul Kaseburg – There’s an ability to go out there and diversify a lot more effectively than you can just in your own backyard.
Adam Hooper – We’ve also talked in the past, and we’ll spend a little bit on the capital stack here before we wrap it up in a bit, but you mentioned also kind of managing vintage in the past conversations that we’ve had. What do you mean by that?
Paul Kaseburg – Vintage risk is the risk that you put all of your allocation into real estate at the top of the market and then all of your deals do badly at the same time. To the extent you can, it’s helpful to dollar cost average your way into your real estate allocation. You do a couple deals this year, and next year, and the year after, and you probably won’t get everything at the bottom of the market, you probably won’t get everything at the top of the market, but it’s really all about creating a long term allocation in your portfolio to an asset class as opposed to trying to market time and jump in at what you believe is the low point in the side goal or as soon as you can. And then, you have to think about that at the exit too, to the extent that your deals are being sold at the same time, you’re going to have to reinvest that or you may want to reinvest, and if you can do that on an exchange basis so you have tax deferred, money going into the next deal, it’s helpful if all of your deals are not selling in the same year too, ’cause then you have to reinvest them in the same year, right? To the extent that you can kind of create this ongoing series of investments that are going to be disposed of and then reinvested, and obviously you’re going to be limited in terms of, you have no control over when those are sold, so there’s some limitations to that. But it’s just nice to have a steady progression of deals that are being done over time so you don’t end up with everything being done at the top of the market.
Adam Hooper – Good. Now, as we kind of start to bring this to a close here, we’ve mentioned capital stack a few times. You know, diversifying your cross capital stack . Let’s get real basic. What is capital stack, and what does that mean for investors in the general real estate sense? Then, we can kind of pick apart the different pieces of it.
Paul Kaseburg – The way I think about the capital stack is, it basically describes where the money comes from to buy a deal. Real estate takes a lot of cash to buy, right? It costs a lot, and cash has to come from somewhere. You get some of that cash from different sources, and the capital stack describes how that works. I think about it kind of like a stacked bar graph where you have a bar from zero to 100% of your cash that’s going into a deal, and you divide it up vertically. The money that’s at the bottom of that is your senior debt, and that is the safest money, because the first money that comes out of an investment goes to pay off your senior lender. That tends to be the safest type of investment you can make. Senior lenders are the group that takes a loss last. After that, as you go up the stack, is capital that is junior to that lender and gets paid after the lender does. As you kind of divide up this capital stack, the higher you go, the more risky that investment is, but the higher the return generally is. And at the top of that capital stack is your common equity, which is the money that gets paid back after everyone else gets paid back. That’s how to think about the capital stack and how that capital stack gets sliced and diced can be very complicated. I tend to like to keep it fairly simple because when you have a lot of different groups who are arguing with each other about who needs to get paid, that tends to result in the real estate not doing well. It’s good just to have a nice, simple capital stack
Paul Kaseburg – but go and add value by making good real estate investments.
Adam Hooper – Yeah, and just to clarify, on RealCrowd, that’s how it’s structured as well. Most senior position of capital stack at the bottom, and then you kind of read your way up. There are different ways of displaying that. It’s just to make sure that when you’re looking for investors out here, when you’re looking at a capital stack, make sure you’re reading it the correct way. Usually, the biggest portion that you’re going to see in that capital stack is going to be your senior loan. Then, going up from there, in order of repayment, you’d have maybe your mezzanine or preferred equity piece, and then typically, you’d have the LP investors, and finally, you’d have the GP, the sponsored capital. Is that pretty accurate, Paul, of what you typically see out there?
Paul Kaseburg – Yep, exactly, that’s the typical stack.
Adam Hooper – And how do you feel about mezzanine or preferred equity, either the layering of that into a deal or investing in that tranche?
Paul Kaseburg – On the one hand, I like financial innovation and creativity just for its own sake. It’s fun to see what different things people can come up with, and it’s interesting to see how something simple like real estate can be sliced and diced and divided up between different investors who have different goals. There’s a time and a place for mezzanine and preferred equity investments. Like you said, those are investments that fall in between senior debt and equity, and so often, a mezz debt or preferred equity acts, especially mezz debt, acts like debt on top of your senior loan from the perspective of your equity folder. You have to pay your senior loan, and you also have to pay your mezz debt, otherwise you’re going to get foreclosed out of the deal. Preferred equity, sometimes, is a little bit more squishy. It’s someone who invests with you as an equity investor, but they have some preferences in terms of getting paid back first, and perhaps they split the upside with you. It can be a little softer and more friendly and fuzzy than mezz debt. Although, sometimes it’s more about the name than anything. But either way, those products tend to increase. It’s effectively increasing the leverage on a deal from the perspective of the equity investor. That means you either do better when things do well or you do worse when things do badly. I don’t think there’s any inherent right or wrong about using mezz debt or pref equity, but I do think, to the extent that you use a lot, it increases the chances that you get mark to market.
Paul Kaseburg – We talked about staying power before. You don’t want to have to sell at any given time. You want to have the option to sell when you want to sell. If you have preferred equity or mezz debt that’s going to force you to sell at a time that’s good for the mezz debt but not good for the equity holders, which is often the case when things start to go badly. You don’t have a great alignment of interest between those different parts of the capital stack, and so when it’s a good time to sell for the mezz debt, and they have the power to force it, they’re going to do it because they just want to get paid back. That could mean the equity’s going to do extraordinarily badly. There have been very unique circumstances where we’ve used preferred equity, but for 95, 99% of the time, we don’t use that. That’s not really our business strategy. We tend to try to keep that capital stack simple, and in general, I like that, because the more different classes of owners you have in a deal and claims on the cash that’s coming out of a deal, the more complexity there is, and the more complexity there is, the more chances there are for people to start fighting. That’s just generally not good. I tend to try to stay away from it if I can. Sometimes if there’s a really unique circumstance, it might make sense to go after it. But from an investor perspective, investing in mezz or pref equity, you’re in a little bit more senior position than the equity, so you could consider that a defensive play.
Paul Kaseburg – But you also have to think about the real estate too. You could be in a more defensive part of the capital stack, but you could be in a very risky piece of real estate but a risky strategy, and so you may not be as safe as you think you are. You really have to take into account all factors of the real estate in addition to the capital stack. They all work together.
Adam Hooper – One of the things that we’ve seen on platforms out there is, again, investments in either preferred equity or mezz pieces. When a deal goes bad and you’re in a mezzanine or preferred position, what does that look like for an investor as opposed to either common equity or senior debt?
Paul Kaseburg – Typically, the way that works is there’s going to be some sort of a transaction that needs to happen to liquidate the real estate, and when that transaction happens, the first group to get paid back is going to be the senior debt, and then the second is going to be either that mezz or that pref equity. And then after that, it’s going to be the common equity. The mezz and the pref equity is going to be in a better position than the common equity, for sure. But often when things are going badly, especially with the amount of debt that’s being used now and recently, it’s not totally unheard of for the property to be worth less than the senior loan. In which case, the pref equity doesn’t get anything back. It’s almost like it’s a waterfall, right? First money goes back to senior debt, and then the pref equity, and then the common equity. It just depends on how much money there is to go around.
Adam Hooper – And for non real estate professionals, lesser experienced investors that are looking at making maybe their first few investments in this asset class, is that something they should be considering, looking at debt versus equity in terms of how they’re allocating those dollars? Or is that something that’s more advanced after you have a little bit more knowledge or experience in the space that you can start looking at diversifying across the capital stack?
Paul Kaseburg – It’s overall a fairly small part of the market. I would say, probably, the simplest place to start would be with debt and common equity, and then work your way toward pref equity and mezz debt. Operators who specialize in placing mezz debt and pref equity, like other operators in real estate, they’ve been around for a long time, they’ve been doing it, they have an expertise. It has a place in a real estate allocation. It’s probably not the place, necessarily, to start out with, but I think it has an appropriate place for investors at some point.
Adam Hooper – Getting back to what you said earlier on, in real estate, you set the capital structure up front and for better or worse, you’re kind of stuck with that until a capital event, right? Making sure that if you’re investing in the different parts of the capital stack, you’re really aware of how that overall capital structure is being set versus focusing just specifically on that portion that you’re getting involved with. You have to look at the whole structure, the whole piece, and understand where you fit within that seniority of repayment and how that overall picture looks.
Paul Kaseburg – Absolutely, ’cause you’re stuck with it and you can’t change it. You’re locked in once the deal gets done. If things start to go south, this goes back to really being proactive with thinking about your comfort with taking risk. That’s a lot more important with real estate investments than it is with other types of investments because real estate is just so liquate and it’s so long term, right? You can’t decide a year from now that you’re taking on too much risk in your real estate portfolio if you’re locked in to longer term deals, because you’re just kind of stuck with that, you know?
Adam Hooper – Yeah, yeah.
Paul Kaseburg – You don’t want that sort of damocles hanging over your head and just waiting for it. You want to think about it up front and make sure that your allocation is appropriate for you and then it’s fun.
Adam Hooper – Yep, well Paul, I think that’s a really good overview of the risk metrics and thoughts around that. As we’re closing out 2017, heading into 2018, how do you see this coming to bear? Are we heading into a riskier time in the cycle? Are we heading into a riskier economic picture? Where are your thoughts, just kind of macro right now of where we’re at and what’s going to be coming here down the line in 2018?
Paul Kaseburg – You know, good question.
Adam Hooper – I’m going to force you with a crystal ball. You got to do it.
Paul Kaseburg – Great question. I guess the way we’re looking at the world right now, the economy is doing well. We’re seeing growth. Job creation is still very strong. I think as long as there’s not some kind of a macro economic shock, we wouldn’t expect a downturn. The trick is going to be, something is going to trigger a downturn at some point, whether that’s some overseas occurrence, whether that’s financially created with interest rates, whether it’s some sort of an orange swan, we just kind of don’t know.
Adam Hooper – It’s important just to be prepared for that downturn to happen at some point. What we expect in 2018 is, we’re not seeing anything obvious right now that looks like it’s unfolding that’s going to create some problems. So far, so good. But we’re cautiously optimistic, just as we always are. Like we said, it’s either distressed or not distressed and it’s, at the moment, not distressed. Perfect. I think that’s a pretty good overview, Paul. We appreciate you coming back on, as always. Thanks again for your time.
Paul Kaseburg – Thanks for having me, it’s been great.
Adam Hooper – Listeners, thanks again for another episode of the podcast. As always, if you have comments or questions, please send us an email to firstname.lastname@example.org, and we love those ratings and reviews on iTunes, Google Play, SoundCloud, and anywhere else you listen to us. Thanks again, and we’ll see you on the next one.
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