Chris Fraley - CIO at Realty Mogul

How Crowdfunding Has Changed Real Estate Syndication



...No matter how many investors you have or how many deals you've done before.

Chris Fraley - CIO at RealtyMogul

Chris first contacted me some months ago to discuss the intersection of institutional capital, institutional investing and real estate crowdfunding, and that’s what you’re going to hear about in today’s episode. When you step back and think about it, private and institutional capital are not really that far apart, coming, as they both do ultimately, from individuals either through direct investment, in the case of the former, or, in the case of the latter, via contributions to pension plans, insurance policies, or donations to endowments.
Private equity and institutional capital are entirely complementary. Deployed properly by sponsors they can reduce risk for everyone while enhancing total returns. You’ll hear more about that towards the end of today’s show.

What You're Going to Learn

  • Understanding the closed-end private equity fund model
  • How institutional investors accelerate investment into real estate
  • How growth in institutional real estate investment puts pressure on fund management
  • How crowdfunding gives investors direct access to institutional quality real estate
  • Why you need direct access to highly-vetted commercial real estate deals
  • RealtyMogul as a general partner
  • How the RealtyMogul crowdfunding platform is creating higher returns
  • How equity crowdfunding platforms facilitate quick capital deployment
  • Diversification is why institutions need to embrace crowdfunding

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Show Highlights



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Understanding The Closed-End Private Equity Fund Model

Adam Gower: What exactly is the closed-end private equity fund model that we're disrupting? Just describe that for the one guy out there.

Chris Fraley: Great question. So probably at some point in the nineties, the institutional world started trying to figure out ways of investing large sums of capital into real estate managers. And, that's pretty much about the time where this model came out. And the way it works is, a real estate fund manager would aggregate a pool from institutional investors and it's really a 10 to 12 year, maybe 9 to 12 year time horizon. The first year is spent raising the capital and then - and you can do some investing while you're at it. And then typically, the fund manager has 3 years to invest the capital. They have 4 years to create the value and then, you know, usually about 3 years to liquidate. So when an LP, a limited partner, such as a big state pension fund, they'll say, I'm going to put $50 million in X Y Z fund. You have full discretion to invest it how you want and I expect it back in, you know, 10 years with this return, that's it basically. And, it's closed-end rather than open-end. Open-ended means it doesn't really have a timeline. Typically, investors can go in and out. It's often difficult to go out, but there's not a very closed-end format to it, unlike an open-ended format.

Adam Gower: Ok. And it also has a cap - they decide how much is going to be raised to the fund.

Chris Fraley: Right.

Adam Gower: There's a time period, during which they, and once that finishes, now, they're into the like, completing the full lifecycle of the fund that goes full life throughout that 9-10 years. Whatever it is.

Chris Fraley: That's right. Yeah, they're usually - in the offering documents, they'll say, our target raise is "X" and they can often, if they go beyond that, if they're oversubscribed, they typically have to go back and get permission from the LPs to allow them to do that.


Institutional Investors Accelerate Investment into Real Estate

Adam Gower: Right, and what's interesting about this. And just to be clear, institutions we're talking about: pension funds, endowments, sovereign wealth funds, possibly insurance companies, etc. Massive funds that pool/aggregate enormous amounts of capital. So it's really.

Chris Fraley: Right...

Adam Gower: Plus you also have - and this is going to be very important as we get into this - it's some of your slides here. You also have professional managers who run these funds. Right? These are people who live, breathe and eat - commercial real estate underwriting and understanding what's going on underneath the hood of these deals. But, importantly, I think you said the nineties and this was thanks to you, I met Geoff Dohrmann at IREI. Right? And when he started, it was right at the beginning. It's very important for what we're going to be talking about. Right at the very beginning of the era that institutions started looking at real estate. Correct? It was - just give us a quick snapshot, ever so brief, because it's very important for what we're going to talk about later. They didn't invest in real estate, did they, until like the eighties? Was it even?

Chris Fraley: You know, it really wasn't considered a very institutional-quality class. There weren't, you know, institutional-quality mechanisms. I mean, a pension fund could own a lot of their own real estate, on their own book but that's very - then they would have to have their own investment staff to manage it. So, it really wasn't until, you know, real estate became an asset class that got a lot of attention within modern portfolio theory and understanding how it correlated with other asset types and so on. So yeah, that's really when it started.

Adam Gower: Yeah, and so we'll come back to that because it's very important because from 30 years ago to now, when institutions weren't investing, it went from close to zero to utterly dominating the commercial real estate.

Growth in Institutional Real Estate Investment Puts Pressure on Fund Management

Adam Gower: Ok. So, your thesis is - and let's look at these slides again, at least hypothetically, just for the time being, your thesis now continue your thought process about what started to change? Now we've got institutions in commercial real estate, dominating the industry, and then suddenly crowdfunding is born. Then what did you see over there, that you weren't expecting to see when you got into RealtyMogul?

Chris Fraley: Well, when the institutions, I mean, when - I was a partner at Rockwood Capital. A firm with, I think they're probably on their 11th fund at this point. And, you know, long history of institutional investing. Really using, mainly, the allocator model. One thing that, probably about 2002, I would say, you know, some of the - there started to be a lot of noise within the institutional world about what's called, the double-promote. And what happens with the fund is - so a closed-end fund, a fund manager, like a Rockwood or 50 others that are out there. They will charge, they'll charge a promote over a pref. So once a real estate developer - they'll provide limited partnership capital to a real estate developer. The real estate developer will, let's say they do a home run, and I have a chart there that shows the numbers. But, they have a home run. They have a big IRR. That capital will go into the fund and then the fund manager will take a promote off of the cash that comes in from the various operators. That's called the double-promote. And, it can shave 3-,4- sometimes even 500 basis points off an institution's return. And in some cases, you know, I mean, look, if there's a great fund manager, the theory is, well, wait a minute, you know. We're receiving 4 or 5% because you just got a 18-19% return, thanks to our investment selection. So it's - but at the same time, the institutional investment world said, well, wait a minute, that's - you're kind of skimming a lot off the top. There's a lot of allocators out there. You're not that special anymore. We want to go directly to the sponsors. So really, I would say the group that really led that charge was Yale - The Yale Endowment with David Swensen.

Adam Gower: Right?

Chris Fraley: Absolute genius. I think the world of him. And so David Swensen had the idea that, well, I'm not going to invest in a fund. I'm going to invest in a sponsor who is perfectly capable. They're  institutional quality. They're perfectly capable of managing my capital. I don't need a third party. So Yale poured hundreds of millions of dollars into Shorenstein, for example. They're a well known backer of Shorenstein. Also, they were a big investor in JBG, in Washington. So, there became this - groups that really relied upon the managers to act as fiduciaries. Some pension funds couldn't avoid it. They needed a fiduciary. But some felt that they could just invest directly into, you know - JBG and a lot of sponsors, they raise their own fund. They didn't need the allocators to provide the capital.

Adam Gower: Right. And then the other issue, of course, for institutions, is ones of scale. If you go to - you talk about allocator. But if you go to a private equity shop and I worked for one. And we did all of our own deals, but I know that there were those who would look for sponsors. That you - it's harder because you've got to find sponsors of scale. If you've got hundreds of millions to invest, you don't want to have too much of a concentration. You also don't want your sponsor to have too much of a concentration for you to be dependent. There are issues with that as well.

Crowdfunding Gives Investors Direct Access to Institutional Quality Real Estate

Adam Gower: So what did you see at RealtyMogul that, kind of, started ringing interest. Bells make it sound like an alarm, started setting off - wow. This is interesting signals, I should say.

Chris Fraley: Yeah, I mean, it seems in the long run, you know, crowdfunding tends to give investors really exactly what they were looking for. You know, institutional-like quality vetted deals. They can do their own diligence on, you know, all the information and data is there and it's just - it's a very efficient marketplace. And so, I saw - I envisioned a world and it's happening as we speak, where technology and access to deal flow disrupts. It provides the benefit that was being provided by the closed-end fund managers, which were making hundreds of millions of dollars off of, you know, the promotes that they receiving as investment fund managers.

Adam Gower: Now you have actually provided some very interesting charts here. And because this is also going to be audio, let's just pretend that everybody can see them. I can put them up on the screen if you want. But if you want to refer to them, as well Chris, and just kind of walk us through some of these concepts that you've got here. I'd love to hear about it because what I'm actually really interested in getting to. There are six - for those who aren't watching - who are listening. There are actually 6 different, I don't know, structures that you've described here. Actually, the very, very last one, I think is the most interesting. But I'd love to hear what the - what is the story that you are telling with these charts. If you can describe it rather than sharing, it be really helpful.

Chris Fraley: So, the first slide is really what I described about a few minutes ago. First of all, how do funds  get to the closed-end fund manager to begin with. And they can go either directly into the closed- end fund manager or, for the really big institutional investors out there, they have to go through what I call "gatekeepers". And the gatekeepers are Cliffwater, PCA Partners, Callan, ORG, Cambridge. These are groups that RFPs - responses to RFPs from fund managers. When, a pension fund will say, I need to invest $100 million in multifamily development and the funds will come in. And then the closed-end fund manager will invest in an operator, in the form of limited partnership investment and then the operator will buy the real estate.

Adam Gower: Right and just to be clear, they won't just invest in one operator. That closed-end fund will have a family - a farm of operators that they've screened, they like, they have relationships with, and so they will distribute that 100 million, maybe across, however many operators.

Chris Fraley: Yeah, that's right. That's exactly right. And you know, typically in any fund, you wouldn't want exposure to more than, call it 10%. So, if it's a billion dollar fund, you probably wouldn't want to invest more than a 100 million in one operator. That also gives the institutional investor some diversity as well. And then on the next slide - this shows RealtyMogul and frankly, the crowdfunding world, can disrupt that model, whereby an institutional investor can invest directly into the platform. Yeah, and I just want to be clear here, they're not - we're not the fund managers. We're not the -  we're really a technology platform.

Adam Gower: Okay. So this is a very important distinction. Because I was just about to ask. Aren't you now the closed-end fund equivalent? You're not.

Chris Fraley: No.

Adam Gower: But you are providing - so let's think about it this way. Let's kind of frame it in the world that we are. What the closed-end fund managers - call them the fund manager.  The fund manager did, was essentially aggregate information that institutions could come to one source and know that they had access to data across the entire market and able to invest in multiple deals. They didn't have to go out and find individual sponsors. They went to one fund manager and that one fund manager had relationships with dozens of sponsors. Now the model that you're describing on the slide here, which by the way is entitled "Direct Investing Model uses Technology to Create More Effective Capital Allocation Model to Adjust Immediately to Market Cycles".

Direct Access to Highly Vetted Commercial Real Estate Deals

Adam Gower: Now what they're doing is, they're coming to a central location. In this case, RealtyMogul, because RealtyMogul is a source of information and access to operators. Kind of in the same way as a fund manager was, but with a different function. So explain how that is different.

Chris Fraley: Yes. So the difference is, the institutional investors, or actually individual investors too. I happened to use this presentation for a group of Japanese institutional investors. So, it's a...

Adam Gower: Do you do it in Japanese?

Chris Fraley: What's that?

Adam Gower: Do you do it in Japanese?

Chris Fraley: No. No I did not.

Adam Gower: Next time ask me along and I'll do it in Japanese.

Chris Fraley: I did it in Japan, but I presented in English. So it allows the investors to invest directly into the sponsors entity. They're not actually investing in RealtyMogul. They're investing with the operator. So, you know, that doesn't work for all operators. Clearly, you've got to be institutional-quality to be prepared to do that. You know, the one buffer that RealtyMogul does provide is, in instances where we are a majority, we will aggregate the - some of the decision making authority of the investors going through the RealtyMogul platform. And they're not our investors. They're the sponsor's investors. I just want to make that clear. But, for example - we may have certain trigger rights, in the same way that, you know, a closed-end fund manager would. For example, if the operator said, we expect that we're going to have a 3 year hold program on this investment, there might be a trigger in the operating agreement that allows RealtyMogul, or I should, our admin manager - that entity to trigger a sale or force a sale of the asset. So, I'm probably going to0 deep right now.

Adam Gower: Yeah. It's interesting and it is important.

Chris Fraley: Not all platforms do that. We would only do that if we have a majority interest. And that's something that I think is not well understood in the crowdfunding world. So, maybe that's a topic for another podcast.

Adam Gower: And it's very important. I do have a slightly separate question. But let's just, kind of, underscore that point. The point is that by investing - so this first slide. The first slide that we've got. "Institutional Investors Invest in RealtyMogul. In fact, I'm not quite sure. "Invest Through RealtyMogul with Operators". But that's only if RealtyMogul also invests, is that correct? With the operator.

Chris Fraley: Realtymogul does not. We may be a co-issuer, but we do not invest. All of the investors invest directly with. Well, let me back up for a second because we do also have a REIT and there are times when the REIT will co-invest with the individual investors. So, thank you for clarifying that.

Adam Gower: But when you draw money into these, you negotiate terms that individual investors wouldn't be able to negotiate themselves because you are bringing so much capital. So, the operator is going to be more inclined to agree to certain trigger terms that individual investors wouldn't be able to get. But here's my question. I went back to the fund manager question. One of the big advantages to an institutional investor going to a fund manager is they don't have to do all the work to figure out who are the great operators, right? They don't have to do the due diligence. They only need to do due diligence on one entity, that is the fund manager - their confidence in the fund manager. They know the fund manager is going to do their homework. That's part of what the fund manager gets paid for. So in the same way, to what extent can institutional investors coming to RealtyMogul or looking at operators through RealtyMogul, benefit from...what about value, what extra value, do you bring in the same way? You vet sponsors? Do you underwrite them? Do you underwrite the deal? Like, what is it that institutions see in coming to you, that makes it useful for them?

Chris Fraley: Well, I mean, quite honestly - that was the other thing that impressed me when I joined RealtyMogul. The underwriting process is really not that different from what I was used to at Rockwood. I mean, very rigorous. You know, zero-based analysis of the sponsor model. Third part review of all third-party documents, property tours, legal diligence, background checks, you know, really the whole - really, the institutional-quality review.

Adam Gower: That's really interesting and that's very, very important. So when - because I really want to get to this last slide. I don't want to run out of time. But, when institutional sponsors come to you, they know that you are conducting. This is really the distinguishing difference between institutional-quality real estate and non-institutional. It's not the real estate... There are some aspects to it. It's got to be scale, certain criteria, et cetera, et cetera. The key is the due diligence that's gone in to underwriting and understanding it. This deal passes muster. That's the key difference. You see, so many people think, Chris, these days, "oh yeah, we've got institutional-quality deals". No you don't. They can't make that claim. Might be big, but it's not underwritten in the same way as an institutional-quality deal. That's the differentiating characteristic, isn't it?

Chris Fraley: Mm hmm. Absolutely. Sure.

RealtyMogul as General Partner

Adam Gower: And so the second part of this slide. You've also got institutional investors, all pointing to RealtyMogul, without an operator. So what's that's about?

Chris Fraley: Oh, yeah, that was - we do have a direct acquisition program also. Yeah, I don't think I mentioned that, but we do occasionally serve as general partner. You know, it's interesting how that evolved because sometimes we would see a transaction that, we loved the transaction, but we just couldn't get comfortable with the sponsor. You know, they just didn't have the right track record. So, what we would do is, we would often pair them with, you know, with some of our top sponsors and they would work out a joint venture relationship. And that had mixed results, really, to the point where we said to ourselves, well, wow, we could do a lot better job at this than they could. We have an asset management team. And so now, we've built out our GP program. We'll sometimes do co-general partner relationships where we will be the co-GP. We also have a group within RealtyMogul that acquires directly. And then oftentimes, you'll see on our platform, where we we acquire something as a GP, through our REIT, but we'll also make it available to individual investors through our platform.

Adam Gower: Fascinating.

Chris Fraley: So, we've raised probably, you know, I think we've raised about $30 million that way, supporting the direct GP this year...

Adam Gower: Fascinating.

Chris Fraley: So far.

How the RealtyMogul Crowdfunding Platform is Creating Higher Returns

Chris Fraley: The difference between the old model, which I'll call the closed-end private equity fund model versus the new model. In the old model - same deal. 20% return. The deal starts off at a 20%  return. The real estate operator takes their promote. Typically, it might be 20 over an 8 and then another hurdle getting all the way up to 50/50. And then, once the cash goes into the fund, the fund manager will typically a take 1.3, or 4% annual asset management fee in addition to the 20%  promote over an 8 or a 9% return. And then the gatekeepers, they'll charge a little bit. Not a lot. And ultimately 12 to 14% will actually filter through to the investor - to the institutional investor. In the new model, same 20% return, same 3 or 4% to the real estate operator, RealtyMogul or other crowdfunding platforms do charge, typically, annual asset management fees in addition to technology fees in the beginning for onboarding new investors and so on. But, you know, that savings flows through to the institutional investors or individual investors. So to think that, with this new model, you actually get higher returns than a $100 billion state pension fund was pretty exciting to me and that whole model could be disrupted.

Adam Gower: Yeah, it's fascinating, isn't it? And actually, kind of, approaching it from a slightly different angle. Let's go ahead and stop share. I'm going to force that. There we go. The other aspect of that - and that last slide was one that I was really interested in. I'm just going to look at it on this screen over here. Is that what you have now, you never had before, and this is what's so fascinating. Chris, seriously, this is what I think is what's really fundamentally changed in commercial real estate, capital formation, is..  So,, I've got to be careful because a lot of this is beginning to sound cliche, but let's really be precise on what I'm going to say. You now have access to institutional-quality deals. But what I mean by that, and this last slide, this last section here is what's so important. Is that, what you show in this last slide, is that you show quote institutional investors investing with and through RealtyMogul alongside, you've used the term to retail investors. Let's just call them individual investors. You've got institutional investors - I'm sorry, individual investors investing in deals with institutional investors and what's so powerful about that is that now you have, in your case, RealtyMogul doing due diligence but you know that the institution, that it's professional real estate, life-long real estate analysts and pros inside there who are fiduciaries to massive amounts of money and millions of people, ultimately, that you are also investing in deals alongside that. There is probably no better way to reassure yourself that you're investing in a real estate deal that has been well examined, basically. It's not random. That's the challenge of crowdfunding - is you can go online and there are so many people out there. That the ones that frighten me the most, the ones that - and it's ironic because this is what I do for a living. But the ones that are really good at digital marketing or marketing but actually know nat all about real estate. They just create really good personas online that kind of give the feel that they know what they do. And so, you know, hundreds of millions are going into deals like that. But there is no due diligence at the end of the day. No one's really checking their work. Unlike with you, right? That's the fundamental difference. That's what I was talking to Geoff about - Geoff Dohrmann over there, IREI -  Institutional Real Estate Inc., which I actually managed to get wrong in the intro so I'm just going to reinforce that as a credit to him. I'm sorry about that Geoff.

Equity Crowdfunding Platforms Facilitate Quick Capital Deployment

Chris Fraley: I was making that presentation to one of the largest institutional investors in the world. And they were trying to figure out how to access the U.S. market. And, one of their biggest concerns was timing. And the way these funds work is, if you think of it, let's say a typical real estate cycle is 8 to 10 years. The way that the money tends to go flooding into the closed-end private equity fund model just at the wrong time.

Adam Gower: Yeah.

Chris Fraley: So, when I was at Rockwood and, you know, we weren't alone. But, we raised a billion dollars in 2008. Well, in that case, we were very lucky. Right?

Adam Gower: Well, you were, because you actually could come into the market and buy up the bargains, but..

Chris Fraley: We close the fund with a big war chest of capital. But our fund before that, we also had a billion dollars in 2006. And I'm not suggesting that Rockwood would deliberately, you know, try to invest the cash quickly, but, the money goes flowing into the fund managers just at the wrong time.

Adam Gower: Look, it doesn't matter who, or what, or why. It's the basic structure.

Chris Fraley: Right.

Adam Gower: The structure is, that if you've got people who are running a closed-end fund or a private equity shop and they have capital, they are only going to get paid when that capital gets deployed. And they're only going to get paid when it comes out of the cycle. It doesn't matter if it's closed and open-ended. If you're aggregating institutional capital, that's how it works.

Chris Fraley: And they're investing for 3years. So the State Pension Fund is saying, I'm giving you $50 million to invest over a 3-year time horizon. I mean, maybe even a 4-year time horizon. It's very difficult to call that just right. With crowdfunding, or with the technology, allows you to invest immediately. You know, you don't have to have your capital sitting in a pool. And so, I envision a world where. You know, the institutional fund managers - I mean, there are now 4 or 5 different groups that have institutional-quality teams. They put institutional-quality projects up on their platforms to access the sponsors directly. And, they have institutional-quality transactions. So. with not a lot of staff. Because a lot of these groups, they might have a $100 billion dollars and 4 people on their team. So, they don't necessarily have the bandwidth to make 50 investments every year. But, you know, I would see a world where the institutional investors can allocate directly from, using the various platforms.

Diversification is Why Institutions Need to Embrace Crowdfunding

Adam Gower: The other thing is diversification and we talked about this a little bit before. The idea is that you would go to an aggregator and not an aggregator fund, right?  Fund manager, closed-end fund manager or a private equity shop, whatever it is, who would go out and then you wouldn't have more than 10% in any particular deal. But you could almost have 1%. You can always have half of 1%, spread it out. And the chances are overall, as long as there isn't any major macro impact. Yeah, you're going to hit some pretty - you could almost do it in, almost like a mutual fund, right? Invest so little and just aggregate it across so many deals that the chances of the entire portfolio. I mean, I'm just playing with ideas, right? But it almost leads to a different model altogether for investing very large sums of money. Ultimately, it's possible, right? I was actually coming at it from a different perspective, and that was. The idea that, because individual investors, ultimately pension funds, endowments, insurance companies... Chris, at the end of the day. They're investing individual people's money. You think of them as big - so, they're really investing the same money that you're raising from individual investors. It's the same people. Those individual investors are paying insurance premiums and, you know, and writing checks to endowments and et cetera, et cetera. It's actually all coming from the same place. You could almost see a balance. My thesis is. My theory is and what's going to happen is, insurance companies - sorry - institutions. Instead of rejecting the idea of crowdfunding, which a lot of sponsors worry about. Some of our clients, who have only got institutions as our investors. I'm worried that they're going to not like is going to the crowd. Well, on the contrary. It's beneficial because the institutional - let's not go too long on this. I've got three quick questions to ask you. But I want to make this point. The institutions now could look and say, look, go for it. We really encourage it. In fact, instead of, why don't you add an 35% percent - allocate an extra, instead of 30% equity to it or 20%. Do 25% or 35%, go to the crowd and now we're actually servicing those people as well because they're getting the benefits of our due diligence, our analysis. All the research we're doing. It's better for them and they can diversify. They'll have investments through us, right, and their pension funds, which is the low risk, lower down the capital stack money. And they can have a flutter at the higher risk equity side, knowing that we've underwritten the deal. You know it's - so I just think ultimately that's what you're going to see happening. Do you see a marriage between these two parts of the industry?

Chris Fraley: Well, I thought I had thought of everything, Adam, but I had actually never thought about that. So, bravo.

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