Realty Mogul: Our 2019 Deep Dive

Founded in 2012, RealtyMogul is the grandfather of crowdfunding real estate sites. They started as a platform for single investment opportunities. But they’ve recently shifted focusing their two REITs.

RM has an impressive track record. It has financed 350 properties with zero principal loss as of January 2019 (though several loans have defaulted).

But past success does not guarantee future success. We deep dive into their REIT offerings to see how RM stacks up.

Basics of REITs

What are REITs?

A real estate investment trust (REIT) is a fund that owns a portfolio of real estate properties. The fund raises money from investors to buy properties. In return, REITs disperse the rent it collects back to shareholders.

REITs must distribute 90% of their earnings back to shareholders to qualify for preferential tax treatment. That’s why they tend to be good investments if you seek cash flow.

Special Properties of RealtyMogul's REITs

RealtyMogul’s two REITs have a few features that differentiate them from the large REITs traded on the New York Stock Exchange, like American Tower and Public Storage.

They are Externally Managed

REITs can either be externally managed or internally managed. In the US, 76% of REITs are internally managed (though externally managed REITs are more common in Japan, Canada, and Singapore). This new generation of eREITs bucks the trend: Fundrise, Rich Uncles and Realty Mogul are all externally managed.

What Does That Mean?

An internally managed REIT is like a corporation. It has employees on its payroll who manage the portfolio. In contrast, an externally managed REIT pays fees to another company (often affiliated with the same team behind the REIT) to manage its portfolio.

In Realty Mogul’s case, the manager is RM Sponsor, LLC, a separate legal entity that is owned by the Realty Mogul team.

Why Should You Care?

The investment community thinks externally managed REITs are less investor-friendly than internally managed ones.

External managers typically collect a fee that is a percentage of assets under management. They profit by raising large funds and buying many properties, even if the properties don’t perform well.

That’s not to say you should avoid all externally managed REITs. They’ve actually outperformed internally managed REITs over the past five years, according to SNL Financial*.

The Shares are Non-Traded

Unlike most REITs, Realty Mogul’s REITs don't trade on a public stock exchange like the New York Stock Exchange.

Once you buy shares, you hold them until Realty Mogul:

  • lists its REITs’ shares on a public stock exchange

  • merges or is acquired by a traded company

  • sells off their real estate portfolio

RM advises in their Offering Circular, “You should view your investment in our shares as a long-term investment with limited liquidity.

Why Should You Care?

Non-traded REITs have garnered a bad reputation from years of high commissions and questionable practices.

Since the shares aren’t listed anywhere, investors can’t just log onto TD Ameritrade and buy shares the way they do Apple shares. Before this generation of eREITs, you had to go through brokers or financial advisers, who charge anywhere from 10% to 15% in commissions. That means when you invest $100, only $85-$90 goes to the fund.

High upfront fees are the main reason non-traded REITs have underperformed traded REITs, according to Dr. Chris McMann from the Securities Litigation and Consulting Group. Dr. McCann found nontraded REITs have an average annual return of 4%, while traded REITs return 11.3% over the same time period (from 2000 to 2015).

RealtyMogul's Share Repurchase Program

RM offers a limited share repurchase program for investors who’ve held onto their shares for at least one year.

Every quarter, they’ll purchase up to 25% of shares back from investors, with a 2%-3% penalty in the second and third years. According to SEC filings, management reserves the right to terminate the redemption program at will.

REIT I and REIT II Characteristics

REIT I (closed to new investors)

RealtyMogul positions REIT I as a conservative, income-oriented REIT. The goal is to generate a safe, consistent dividend to investors.

The fund makes debt and preferred equity investments.

Investment Strategy

RealtyMogul’s REIT I differentiates itself from other REITs by only investing in properties with existing revenue so that: investors can collect rent from day one the investment is de-risked because no new construction needs to take place.

What's In the Portfolio?

For REIT I, RealtyMogul favors a strategy that targets senior and mezzanine debt.

They estimate that approximately 55% of the fund will be invested in commercial mortgage-related debt that is secured by commercial real estate, such as senior mortgage loans, subordinated mortgage loans, mezzanine debt, etc.

What’s Not in Their Portfolio?

  • new construction

  • hotels (too cyclical)

  • markets that are heavily dependent on single economic drivers

Target Return

  • 8% annualized dividend, paid monthly
  • No anticipated capital growth

    Since it doesn’t take equity positions, the fund doesn’t seek to make money from property appreciation. In an SEC filing, Realty Mogul writes, "There is usually little opportunity for appreciation in the underlying investments."

Leverage

  • Maximum 25% leverage

Current Portfolio

According to their latest quarterly update ending September 30, 2018: The fund holds 14 investments, totaling over $41M.
The type of buildings in the portfolio range from shopping centers, to office buildings, to apartment complexes.
Seven are debt investments, 7 are preferred equity.

West Coast, Best Coast

Four of the 14 investments are for properties located in California. Investments in California properties account for 41.2% to the fund.

The manager explains why they favor the region, writing, "As we seek optimal risk-adjusted returns for our investors, the strong metrics in the Pacific sub-region have guided our investment strategy. While we are not limited to investments in this location, we are encouraged by the continued strong sub-region metrics since these investments were acquired as justification for our investment methodology"

REIT II

Investment Strategy

Realty Mogul wants to implement a “value-enhancement” strategy on 50%-70% of the multi-family homes they invest in.

The strategy is to acquire under managed, stabilized apartment complexes, and making “superficial” renovations to the buildings (upgrading cabinets, putting in new floors, buying new appliances etc) in order to increase the rent.

Risks

  • Delays in the improvement process

  • Higher than expected improvement costs

  • Properties may not produce revenue when undergoing improvements

  • Property improvements may not result in higher rents

Our Evaluation of RealtyMogul's REITs

1. Fees

eREITs like RealtyMogul and Fundrise purport to save investors money by cutting out brokers. RealtyMogul raises capital by selling shares directly to investors through their site.

There are still costs associated with fundraising such as paid Facebook ads, Realty Mogul caps marketing costs to 3% of gross proceeds.

Our Take

While we’re happy to see RM cap its upfront fee to 3%, this isn’t as big a differentiating factor as they suggest.

Since the SEC introduced new regulations targeted at non-traded REITs in 2016, commissions have decreased across the asset class.

For example, Oaktree Capital Management is rolling out a non-traded REIT with sales commissions between 3%- 3.5%, depending on the share class. And Blackstone BREIT’s commissions range between 0% to 8.5%, depending on the share class.

You shouldn’t invest with Realty Mogul just because they offer a lower upfront fee. You should invest based on your judgment about the quality and strategy of their portfolios.

2. Management Lacks "Skin in the Game"

Ideally, you want a manager or sponsor with substantial equity in the fund. We call this the “skin in the game” factor. Buy owning shares in the fund, sponsors have a monetary incentive to make sure they buy profitable properties.

Unfortunately, RealtyMogul doesn’t do so well by this criterion. As of June 30, 2018, they only own 250 shares of REIT I, worth $2,500. This is a drop in the ocean for their $50M fund.

They have more skin in the game in REIT II, where they bought 10,000 shares for $100,000. That’s about 1% of the $10,769,830 they’ve raised in the fund as of August 2018.

To be fair, there can be many reasons for owning so little of their two funds. It is likely that Realty Mogul is only allowed to use the money they raised from venture capital to invest in their operations and build their platform, not to co-invest in their own REITs.

3. REIT I has a High Payout Ratio

To determine how safe the dividend is, we look at the FFO payout ratio. The ratio is meant to reflect the percentage of cash flow being used to pay the dividend.

The higher the percentage, the greater the risk that rent won’t be enough to cover the dividend. When this happens, the manager either cuts the dividend rate or pays it from borrowed money or proceeds from selling more shares.

REIT I Dividend Coverage

A quick back of the envelope calculation shows the FFO payout ratio for REIT I is 100%. Every dollar they are collecting in rent, minus the costs of operating the fund, is paid out to investors to cover the dividend.

For the six months ended June 30, 2018, REIT I collected $1.7 million in rent. They incurred $336,000 in expenses, which includes the asset management fee and administrative expenses.

This leaves just under $1.4M in cash for shareholders, which is exactly how much REIT I had to pay out to shareholders to maintain the 8% annualized dividend. While they are able to fund their distribution from rental income, they don’t have any room for error.

REIT II Dividend Coverage

A quick back of the envelope calculation shows the FFO payout ratio for REIT I is 50% as of June 30, 2018. REIT II paid out approximately $150k in cash distributions from approximately $330,000 in gross cash from operations.

User Reviews

While we weren’t able to find any reviews about their REITs, the reviews for their private placement properties (which are individual investments) are a mixed bag.

High Default Rate

  • One investor complains that 2 out 10 of his investments defaulted, but adds that “Customer service is excellent.”

  • Another investor reports experiencing a 26% to 32% loan default on his portfolios of over 30 investments since in September 2018. He writes, "This has essentially diminished my investment return to a NET LOSS."

  • One user complained on Reddit, "RealtyShares has a nice diverse array of deals (debt v. equity) but the performance of my investments has been a mixed bag."

After Ian Ippolito published an article in The Real Estate Crowdfunding Review calling attention to two defaults, RealtyMogul reimbursed investors for the full principal in both cases. However, making up for losses with their own capital is obviously not a sustainable way of handling defaults.

Lack of Communication

Like many crowdfunding platforms, RealtyMogul falls short in the communication department.

  • "Made one investment with them, starting to see some interest payments. Their post-investment communication has been terrible. They went months without updating the investment status on the website and didn't give me great answers in email. I'll be shocked if there's a quarterly status update on it."

  • "Many investors in the last year have been telling me that they are unhappy with their customer service. Lots of complaints around tax time about incorrect tax documents and frustration dealing with non-helpful staff. And also lots of complaints about inadequate communication (and questioning if they are doing proper oversight) when things go wrong."

Happy Customers

  • One investor reports having a mostly positive experience after investing in 35 loans. He writes, "My experience has been very positive. RealtyShares has been very professional and responsible."

  • "Based on my experience, RM does better due diligence on sponsors and after investment monitoring. However, I don't invest through them anymore due to the fees they charge and quality of sponsors on their platforms."

Taxes

Dividends from REITs are taxed at ordinary income rates. Even if you choose to have your distributions reinvested, you’ll still be taxed on the income allocated to you.

Realty Mogul does let you invest funds from a self-directed IRA which results in tax-free dividends.

Our Verdict

We’re struggling to understand the value proposition of RealtyMogul’s REITs.

There are many REIT options are the market. If you want to invest in a REIT, it is safer to find one with a long and proven operating history; preferrably one with a track record to dates to before 2008 so you can see how it performed through a major recession.

Non-traded REITs are especially risky because there isn’t a guaranteed market for you to sell your shares. You'll need to decide if the illiquidity trade-off is worth the couple points bump on your yield.

If you decide to invest with RealtyMogul, we would go with REIT II over REIT I. REIT II focuses on equity investments which offer more potential upside. Realty Mogul also owns more share of REIT II, which we interpret as a vote of confidence in the fund. It is leveraged more aggressively, so conservative investors should look elsewhere.