U.S. Commercial Real Estate and Understanding the STO’s “Failure to Launch” in 2019 – Part 2
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Part 2 of 3: The real estate private securities market – A prerequisite to understanding
While there have been a few successfully funded STO’s in 2018 and 2019, they have primarily been Technology Companies who focus on developing blockchain technology and online platforms to service the anticipated STO marketplace. There have also been successful venture capital fund STOs that focus on investing in blockchain technology companies. From the point of view of those who invested in these companies, they were investing in early stage innovative blockchain infrastructure companies. Not unlike early investments in Uber or Wework or other Unicorn companies. More importantly these early investments were raised via the traditional private placement marketplace. The fact that these early investments were digitized as STOs was nothing more than a proof of concept and played no role in the decision to invest or not.
The purpose of this article is to understand why the “intended” customer (the security issuers) of U.S. commercial real estate deals and their “intended” investors have not been investing.
Understanding Commercial Real Estate investments in the U.S.:
REITs (Real Estate Investment Trust) were first created in the U.S. in 1960. For the first time the benefits of commercial real estate investments were available to all investors via the public markets. Prior to REITs commercial real estate investments were only available via the private placements markets, hence only available to the wealthy. In order to be listed on a public exchange a company has to be a “C” corporation, which was and is subject to double taxation; first at the corporate level then again at the investor level upon receipt of dividend income. The REIT was a new form of corporation that could be listed on the public exchanges, and if 90% of the profit was distributed to the investors, it would not be taxed at the corporate level.
The REIT concept has been spreading all around the world ever since. As a consequence commercial real estate is commonly thought of as an income producing asset, on the public markets.
However, there is a very large private marketplace for commercial real estate investments in the U.S. and these opportunities are still generally available only to wealthy individuals and institutions.
This is a key point. It is the primary benefit and objective of the STO marketplace, to provide small investors not only in the U.S. but from around the world, access to private market investment opportunities and over time to provide liquidity as well.
The current state of the U.S. commercial real estate market:
The purpose of discussing REITs in the public markets is to point out the similarities and differences with the private real estate investment markets. Ever since the advent of the REIT, all real estate investments are universally considered income producing assets. All private real estate investments are structured as pass through entities so as to avoid double taxation.
The primary difference between the public and private real estate investment markets, are who has access to the investment opportunities. Obviously anyone in the U.S. can invest in the public market; there is no minimum wealth criterion. However, in order to invest in the private real estate market each investor must be an “accredited investor” as defined by the SEC, with a minimum net worth of $1 million dollars, excluding their primary residence.
Another important difference is the SEC filing and reporting requirements. All public companies are required to file financial reports with the SEC either quarterly or semi-annually depending on their size. Private companies are not required to file with the SEC unless they have 2,000 or more investors. Knowing this, it is no surprise to learn that private companies with access to wealthy investors will always elect to have a smaller number of investors each with a larger investment amount. Thereby these companies avoid the expense associated with the SEC filing and reporting requirements.
Publicly traded companies are all perpetual companies. All Private [placement] real estate companies have a pre-planned exit or end to its existence.
The reason it is important to understand these public and private market differences is because private companies will structure themselves to be successful in the private [placement] market. The structures they choose are entirely different than the structures required to be successful in the public markets.
Simply put, U.S. real estate companies seeking private investors structure their deals to attract the wealthiest investors who will write the largest checks.
Who are the Investors?
The investors that dominate the private securities market are: high net worth individuals, single family offices, multi-family offices, sovereign wealth funds, foreign wealth funds, etc. These are the people with all the money. They are constantly inundated with all kinds of investment offers. As a result they have built walls around themselves so that only trusted advisors, who understand their needs wants and desires, have access to present investment opportunities. These trusted advisors are the gatekeepers. These investors have a great deal of money to put to work. Because it takes just as much time to conduct a thorough due diligence on a $1 million investment as it does for a $10 million investment. They will very often have minimum investment requirements, sometimes as high as $5 million, $10 million or even $50million, before they will even look at an offering. If the investment is in an industry with which they have some expertise, they very often want to be the lead investor with a high degree of control over the project. In short, they do not need the benefits offered by the new and upcoming STO industry.
Who are the Gatekeepers?
Sometimes a gatekeeper is also a wealthy individual who has decided to establish his own business of evaluating and investing in all kinds of projects. Because he is a peer of others like himself, he has personal access, and since he is investing side by side with his friends he has their trust. Many family offices and multi-family offices have been started like this.
Most gatekeepers, however, are licensed wealth management firms, brokerage firms and their employees. They are licensed by either FINRA at the federal level or by a state level authority that allows them to provide investment advisory services or money management services for a fee or commission.
These people spend their careers developing relationships and trust with their wealthy clients. Their employers and licenses strictly limit to whom and what advice they can offer. The limitations are stricter for private offerings than they are for the public markets. More importantly these people make their living by listening to what their clients want, bringing it to them and earning a fee. They live by the moto “the customer knows best” and rightfully so.
Who are the Real Estate Issuers or Sponsors?
The professional commercial real estate issuers or sponsors of private placement offerings in the United States, currently fall into two categories.
Existing fund managers, who have been around for a long time, have assets under management (AUM) worth hundreds of millions of dollars and have a great track record with their existing investors. They also have a deep database of existing and prior investors, along with established relationships with many gatekeepers to access new investment money the traditional way. In short, they do not need the benefits offered by the new and upcoming STO industry.
Experienced developers, who have been around for a long time and have a great track record of success building projects and creating value for their joint venture partners and investors. As mentioned earlier, their projects are what the traditional private marketplace investors and gatekeepers are all looking for. One of the key investor characteristics that these issuers are looking for are: the smallest number of investors that can write the largest investment checks. The reason for this is, once a company raises more than $10 million and has more than 2,000 investors, the company then becomes a non-traded public company. Which means it now has to comply with the quarterly financial filling requirements of the SEC. This is an added burden and expense that they do not want. In short, they do not need the benefits offered by the new and upcoming STO industry.