Ray is the founder of RealtyShares which is one of the industry’s top platforms for real estate investing. He also co-founded AlphaFlow, which is his current focus and most of the conversation today is focused on AlphaFlow. One unique aspect of AlphaFlow, along with having investments for you, they are one of the very few, if not the only investment platform that is also certified to give you financial advice. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Ray Sturm Real Estate Background:
– Co-founder and CEO of AlphaFlow
– Prior to launching AlphaFlow, he founded RealtyShares, one of the industry’s top platforms for real estate investing
– First and fastest-growing automated real estate investment service
– Applies best practices of professional investment management like diversification, rebalancing, institutional-quality
– Based in San Francisco, California
– Say hi to him at https://www.alphaflow.com/
– Best Ever Book: The Hard Thing About Hard Things
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Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I'm Joe Fairless, and this is the world's longest-running daily real estate investing podcast. We only talk about the best advice ever, we don't get into any of that fluffy stuff. With us today, Ray Sturm. How are you doing, Ray?
Ray Sturm: I'm great, thanks for having me, Joe.
Joe Fairless: Well, I'm glad to hear it, and nice to have you on the show. A little bit about Ray - he is the co-founder and CEO of AlphaFlow, and prior to launching AlphaFlow, he founded RealtyShares, which is one of the industry's top platforms for real estate investing. He is based in San Francisco, California.
He applies the best business practices of professional investment management, like diversification, rebalancing and institutional quality data analytics with AlphaFlow. With that being said, Ray, do you wanna give the Best Ever listeners a little bit more about your background and your current focus?
Ray Sturm: Absolutely. Joe, I started my career on Wall Street in pretty traditional finance; I worked in investment banking and restructuring through the downturn, and then I became an investor working in private equity for a little bit. From there, I moved to Silicon Valley and really just got into the fintech world, and realized there were ways to open up investing to a whole lot of people. With the jobs that are coming out in 2012 there was really a big opportunity, so in 2013 - you mentioned RealtyShares - I launched my first company. That was one of the first real estate crowdfunding platforms, and that's more of a marketplace model. That's still going today, but investors can come on, look at their own deals, choose their own deals, do their own underwriting, and I'm happy to talk about that.
Then a couple years ago I launched AlphaFlow, which was I think the next generation of fintech. It is something more aligned with the rest of the investment world, where it's a passive approach for investors. We do all of the work, we build a diversified portfolio, but it's really about fintech and opening up asset classes that people never had access to before. It's really an exciting industry to be in these days.
Joe Fairless: What is the difference between AlphaFlow and RealtyShares?
Ray Sturm: RealtyShares -- most of the rest of the crowdfunding market is similar. Think of a marketplace model closer to eBay, where you come on, they've got a lot of offerings for you, but you've gotta choose what you wanna do. They can't give you financial advice; I don't think any other player in the space is a registered investment advisor like we are, so they're legally barred from telling you what's a good investment and what's not.
They need to actually just give you the information, you need to do your own underwriting, but you can see everything from debt deals, to apartment equity deals, to office buildings all around the country. So it's still exciting. With AlphaFlow though, we realized that there's a large group of investors that want access to this asset class; they want this in their portfolio, but they really don't have time to do the work, and especially to do the work the right way.
What I mean there is I think it took investors a little bit of a cycle, a year or two to figure out this is tough to do the right way, and it's pretty easy to pick numbers that look great, and 20% returns, but when you dig in, when those returns aren't actually produced, there's a reason why you have professional managers picking these deals.
So AlphaFlow was really launched to try to bridge that gap, saying "You want these returns... If you're willing to pay a small fee to us, we'll pick those deals for you", and I can tell you we've just crossed our one year birthday of our automated platform here, and we've got a delinquency rate that's about 5%-10% of the industry's average... So it's pretty low.
Joe Fairless: Wow. What is the industry average?
Ray Sturm: You see anywhere between 8% and 11% around the industry. One challenge - when I say "our industry", just to be clear for your listeners here, AlphaFlow is focused a little more narrowly on residential bridge loans; think of these as short-term 8-12 month loans taken out typically by developers to fix and flip a home. They're gonna use our debt; I'm not actually originating the debt, but I'll work with lenders and buy their loans off of them.
So these are pretty short-term vehicles here. This is a hyper-local industry. This isn't something banks are doing, these are local lenders. And the result of that, Joe, is that it's really hard to get full industry data, so it's hard for people to understand what delinquency rates are, where the dangers are, how to underwrite these well... By partnering with a lot of these lenders, I think we've pooled together one of - if not THE largest - the largest data sets in the world on this asset class. We're using that to underwrite better, so our delinquency rate as of March 6th - I need to be specific on this as a registered investment advisor - was 1.66%... So that was pretty low.
Joe Fairless: Do you all work with crowdfunding website to pull in their deals and then have that as part of the portfolio that people who are in AlphaFlow invest in, or do you have only your own deals?
Ray Sturm: We do both. We don't do our own deals, but what we do is we work with online lenders, like RealtyShares, Fund That Flip, LendingHome, PeerStreet - these type of groups. So we work with them... We also work with local hard money lenders around the country, and we're doing more and more business with those guys these days. They are not online typically; they're someone that -- you're out of Cincinnati; we work with lenders in Cincinnati that only work in Cincinnati neighborhoods they know very well.
We'll come in after they've already made these loans, and we look at their loans and we decide which ones we wanna buy, and we get to cherry pick the ones we like best. That's what's been working so well for us.
These days, our rejection rate is pretty high - it's about 92%-93% of the loans we review - but the results have worked well. It just means we can't grow quite as quickly as you might want, otherwise you've gotta give up quality, and just at this point we're not willing to do that.
Joe Fairless: Will you take us through the process, from start to finish, just so we have a full understanding of what you all are doing and offering? Can you do that?
Ray Sturm: Yes. So from the loan side, you've got a borrower that goes to a local lender. Let's just say that they go to ABC lending in Cincinnati, and they're gonna take out this loan, and most likely this lender and this borrower know each other well and they've done a lot fo deals together. Once that deal is closed, we might come in at that point when that lender calls us and says "Hey, I've just made in loan. Are you interested in buying this?" Our analytics team goes to work there. We've got an analytics program that we built in-house here; we put in the information on the borrower, we put in the information on the property, and then we start underwriting everything, from the actual home itself, to the wider market, to understand what's going on there, to the borrower, and understanding what he/she has done in the past - track record, creditworthiness...
If we wanna move forward with that loan, we'll then go purchase that from the lender. Now, we're doing that day in and day out, all around the country, so we're building a portfolio for ourselves. Now, as clients come in on the other side of our business, and our clients are anything from high net worth individuals, although people can put in as little as $10,000 to start with us... But we've also go hedge funds, family offices, the University [unintelligible 00:07:40.10] is investing with us... So everyone's on the same turns, it's simple.
What we're doing is once clients come in, within a few weeks - our PPM says that we take 45 days, but the reality is these days it's typically 1-2 weeks - we build them a portfolio within our loan inventory, of slices basically... It's 75 to 100 different loans.
There was someone we allocated last night - this individual, for example, is in 26 different states across 85 different loans. So you get a lot of diversification, we do all of the work handling that, and we algorithmically build all these portfolios to maximize your diversification, and on a daily basis we're rebalancing those to make sure you stay diversified. That's really where we come in.
Joe Fairless: And they're optimizing for diversification, not necessarily risk and returns?
Ray Sturm: Correct. So we've got thresholds where what we shoot for is an 8% to 10% net return for our investors. Everything that goes in the box is basically above our standard. Like we said, our rejection rate is pretty high, it's over 90%. So within those, we consider all of those as worthy. Within those we haven't now delineated between what's risky and what's not, but we've got a pretty conservative view at this point.
Over time, what we've been asked by a lot of our clients is can they take a little more risk for a little more return - shoot for 9% or 10% to take more risk... We just haven't built that out yet, for what we might call an aggressive portfolio strategy. Today it's all the same strategy.
Joe Fairless: So instead of investing in one deal on a crowdfunding platform, you're investing in bits and pieces of 75 to 100 loans that you've prequalified through your underwriting, so it's a diversification play - is that accurate?
Ray Sturm: I think that's correct. Before 2012 if you got involved in this industry, this was very much a country club industry where you probably needed six figures, and a lot of our clients still do this locally, and they'll loan a couple hundred grand on one deal, so you're pretty heavily concentrated.
What real estate crowdfunding did was bring that bar down to about $5,000 per deal, and that was a big step forward... It's just a lot of investors wanted to put 10k-20k to work, and that only meant 3-4 deals, so what we've done is even expand that further and offer massive diversification, and candidly, just better underwriting.
I think that's one of the things people have figured out - even clients that had large portfolios said this is too much work, and it's pretty hard to actually figure out the insights of what's a good deal and what's not. It's been pretty incredible as we've met with some of our institutional clients and put two deals up and ask them "Can you tell which one's a bad one and which one's good?" It's a lot harder to do than you think... We didn't know a lot of this beforehand, but as we've started to dig in with machine learning, artificial intelligence, to really dig into huge amounts of data to understand where the danger points are - that's what's brought our delinquency rate down, and I think that's really what our clients pay for with AlphaFlow.
Joe Fairless: What are the danger points?
Ray Sturm: One of the big things that people I think underestimate is that new borrowers, people doing this for the first time, have a much higher delinquency rate even if they have a great credit score, than the other way around. But if someone's experienced and their credit score is down a little bit... The reason for that is a lot of these projects - they're not cookie-cutter. So if you're removing a wall, a lot of things can go wrong, and if you're an experienced contractor, you know how to deal with that; you know how to go get the new permit to take care of that. You've got a subcontractor to call that can come in and fix that.
If you're doing that for the first time, that might double the length of your project, which pushes it out of profitability and changes the whole dynamics around the loan. So I think that's one thing that might sound obvious, but for a lot of new investors when they see that they can get a couple more point investing with someone who's brand new, they'll go for that, and that really ends up hurting your returns in the long run.
Another insight that we've figured out here, Joe, is that there's three main use cases for these types of loans. One is an acquisition of a property. So they're gonna go buy the property and they're gonna use your loan.
The second is a refinance. They've already got a loan on there, and they're gonna refi that loan out. The third one is a cash-out refinance. So there's no debt on a project they already have. They're gonna cash it out, they're gonna take your loan onto it, and they're gonna use that money elsewhere.
Those in the industry aren't treated differently... When I say "treated", meaning it's not really priced in, but there's a difference in risk in those, yet our modeling has shown that there's tremendous differences in delinquencies and performance between those, and that if you really focus on acquisitions with experienced borrowers, your delinquency rate can go down a whole lot just with that.
So if your listeners ever wanna do this on their own, either offline or even online on the crowdfunding platforms outside of AlphaFlow, that's one tip to suggest for you guys - focus on acquisitions with experienced borrowers; even if the rate is a little lower, it ends up paying for itself.
Joe Fairless: Okay. Out of those three categories - acquisition, refi and cash-out refi - what's the riskiest? Cash-out refi?
Ray Sturm: Yeah, exactly, cash-out refi, for a few reasons. One, you don't have a market clearing price, and you've got that with both refi and cash-out refi. You've got an appraisal, but we've learned in 2008 how janky those can be. They're not always reliable. So you don't have a market clearing price, and you also don't have the borrower putting new capital into the project, and that's got two negative signals. One, you don't know if the borrower actually is in a good financial position. They could be using it to pay off credit card debt, and such.
And two, they're not demonstrating that they believe in that project, they're really just pulling cash out... So you could be catching a falling knife with a cash-out refi. That's always the most dangerous project.
Joe Fairless: That's very helpful, not only for individuals who are investing with crowdfunding platforms or AlphaFlow, but also people who are lending money to someone local, just to know that story and assess that risk. You mentioned you bring in other crowdfunding platforms and you buy their loans, and then you also work with local lenders, and I'm not asking you to name names, but just any well-known crowdfunding platforms that you started underwriting their deals to buy, but then it was like, "Oh... Not working out. No, thank you. They're not doing it the right way."
Ray Sturm: Yeah, I think we've had a lot of those, and we go through cycles there. Honestly, it can be even a little more nuanced, where we do some of their deals, but we've got one lender - I won't name them, but their top tier borrowers, the ones they consider the most reliable, they do almost 100% financing of purchase for those borrowers, because they find them as worthy, and to us, that's using a crystal ball on the market, and saying that if things go wrong in the market, it won't happen during this loan, even though you've got no skin in the game from the borrower. We're not willing to do those, but we'll actually buy what they see as a little bit riskier of loans, and we see as less risky from that borrower.
There's something else to watch out for... It's a little maybe harder for your listeners to hear, but we've got a little bit of a ear to the ground, especially in the venture community. One of these online platforms is trying to gear up for a venture capital round. Anyone that's ever raised capital and that was showing growth before that - it always helps you convince investors and get them excited.
There's a really easy way to grow in this industry in the short run, and that's lowering your underwriting bar. If you can manufacture growth, pull in more... So we've often seen diminishing quality on some of these platforms, and I know the founders - I'll often try and help them raise their capital, and I see that happening and I call it out, because it's very obvious.
You also see it a little bit after a raise, where someone announces a huge raise - well, that new investor that came in, all of a sudden they're pushing their feet to the fire about "You've gotta grow, grow, grow, and get that going", so often that means the same things, returns go down. So before and after a venture capital raise we're always a little bit wary of the platform.
Joe Fairless: And with AlphaFlow have you done a venture capital raise to get your company up and running?
Ray Sturm: We have. We've done a couple of little ones. It's one big difference--
Joe Fairless: So what shortcuts did you take? ...no, I'm kidding.
Ray Sturm: [laughs] Yeah, exactly. I think what we decided to do, and I think my approach for it was different than RealtyShares and some of the others in the industry is our team is tiny compared to most of the other players. A lot of these players have 75 to 100 different people in there. We have 8 full-time employers, except everyone is pretty high caliber. Most people came from somewhere else in the industry, so we were able to recruit them away from the platforms. Our director of investments, for example, came from LendingHome, the largest player. He was employee number 12 there, I think, and helped set up all of their operations with servicing, so... Key industry people that can really [unintelligible 00:15:56.24]
I think that's a little bit of our shortcut there - really telling people here in the office "You're gonna work a little bit more as a founder." I'm gonna give them more equity than they normally would at these other platforms, but the results are pretty strong when you've got a group of high caliber people with real ownership over this. No one here talks about volume; we're really talking about delinquency rate and about culture. There's a culture of credit over volume, and that's been working for us, and that's allowed us to raise a lot less venture than a lot of these platforms.
Joe Fairless: You mentioned some of your clients are hedge funds, you have [unintelligible 00:16:30.21] and individuals... How did you get a [unintelligible 00:16:34.10]
Ray Sturm: As much as you hear about these huge entities, underneath them are individual people, and in this case the first one we got - we started out with a person that had been following the industry and knew RealtyShares, knew of this space, was a big fan of the returns in the space, however didn't wanna access it through the marketplace model... So once we started AlphaFlow, he followed the news of what we were doing, reached out, and he sits on the advisory board for this university, and got this university set up with us.
It's a little bit slower of an approach and we haven't been as proactive with it, but the reality is if you do a good job in this industry, eventually you start to build a pretty strong reputation, and that's happened to us over the last six months or so... It has really picked up.
Joe Fairless: Do you personally invest in deals?
Ray Sturm: I do. Prior to launching our automated platform last year, we ran three different closed-end funds, really just to see if this concept would work for people interested in it, and most of my liquid net worth is in those three funds... So I'm invested exactly in this asset class, like everyone else is here.
Joe Fairless: Are you able to invest in AlphaFlow?
Ray Sturm: The company itself, or the platform?
Joe Fairless: The deals on the platform.
Ray Sturm: Yes, exactly. So those three funds are AlphaFlow funds.
Joe Fairless: Oh, got it, got it.
Ray Sturm: Yeah, so most of my liquid net worth is in those.
Joe Fairless: Based on your experience as a real estate investor and entrepreneur, what is your best real estate investing advice ever?
Ray Sturm: Oh, man, I think something that doesn't just narrow down to real estate, but investing as a whole, from investing in companies, startups etc. is listen to your gut. It's pretty incredible over time, the sense you get underneath the surface of if something's off... And you can't always explain why, and it's really easy to talk yourself out of it, because you see a big headline number that's very attractive... But when you deal in the debt world, your upside is pretty much fixed at your coupon rate, so you're worried about the downside... And if something inside of you is telling you that something is off -- I can't tell you how many times I did a deal when something just felt off and it just doesn't work out... You've gotta listen to that voice inside of you. It's a big thing.
Joe Fairless: Can you tell us a story about one specific example?
Ray Sturm: Yeah, there was one where we were looking at a deal -- I'll just say on the East Coast, not to narrow the lender down too much... But the scope of work felt -- with every one of these projects they've got a scope of work (SOW) that just lays out all of the adjustments they're gonna make... Are they doing paint and carpets, or are they actually gonna tear down the wall, rebuild the house...? And we were looking at this, and it was a really experienced borrower, but it just didn't make sense with all the work they were going to do - it just didn't seem to match up with how little money they basically were estimating for this... And it's one of these deals where we ended up walking on the deal for reasons -- very experienced borrower, the lender was telling us he has done this a million times, he knows the path, and we ended up walking on it and had some tension with the lender because he thought it's a loan we should have bought from him... And it turned out that there was fraud in the deal. The guy was under the gun on something else, and he needed to pull out cash to solve one of his other problems. These sorts of things happen.
Joe Fairless: How did you find out there was fraud?
Ray Sturm: The lender told me, in the end. We've got a good relationship, and it's someone we kept working with, and he came back to me and basically openly told me "I screwed up on that one, sorry about that." He got burned from it himself.
That's something that will get fixed through other channels, but the reality is this is a funny industry where there isn't a big database of how everyone's done, who he worked with... It's a hyper-local industry, so the more information and the more local expertise you can pull in, the stronger it is. Without that, it's hard to underwrite these deals. On the surface, they just look too good to be true.
Joe Fairless: We're gonna do a lightning round. Are you ready for the Best Ever Lightning Round?
Ray Sturm: Sounds great.
Joe Fairless: Alright, let's do it. First, a quick word from our Best Ever partners.
Break: [00:20:17.03] to [00:20:57.11]
Joe Fairless: Alright, best ever book you've read?
Ray Sturm: The Hard Thing About Hard Things, by Ben Horowitz. It's startup-focused, but I recommend it for any business owner. It really doesn't talk about when things are going well, but when things are going bad - great advice on specific situations.
Joe Fairless: What's one thing you've implemented from that book into your business.
Ray Sturm: When you let someone go, there's a specific phrase in there... They need to lose their job, but they don't need to lose their dignity. If you're working with professionals, there's a right way to do things, and that's something I've taken to heart every time I've needed to let go of someone.
Joe Fairless: Best ever deal you've done?
Ray Sturm: Oh, man... We've now done over 700 of them. I would say it's probably from the RealtyShares days; we did a high-end fix and flip, but we were on the equity side of things, in a high-end part of L.A., and it ended up earning basically over 20% over eight months, so great deal there, but hard to find though.
Joe Fairless: What's a mistake you've made in business?
Ray Sturm: Letting personal relationships get in the way of numbers that are right in front of me, that are telling me that a deal is not right... Sometimes relying too much on "I've known this person for years; he's a good guy, he knows what he's doing", even if the numbers are telling me otherwise. That's something I've gotten away from doing, both with trying to work less with people who might bring that out of me, and also just listening more to the numbers and the relationship side of things.
Joe Fairless: Best ever way you like to give back?
Ray Sturm: I am a big fan in the startup world of how much help I got along the way, of acknowledging that, so to me I think on a pretty consistent basis I try to meet with new founders, people starting businesses for the first time... And you'd be amazed how much little advice, everything from raising money to how do you get an office, to how do you build a team [unintelligible 00:22:34.05] to me is always very gratifying.
Joe Fairless: And how can the Best Ever listeners get in touch with you or learn more about AlphaFlow?
Ray Sturm: They can go to AlphaFlow.com, or they can check us out on Twitter at @alphaflow, or myself at @ray_sturm. You'll hear lots of information about what we're doing and what we're building at AlphaFlow. I'd love to have them on.
Joe Fairless: Well, Ray, thank you so much for being on the show, talking about your company's business model and why you created it, the unique value proposition of diversification among many different types of loans, and then having really a second layer of underwriting... Because in theory, the first loan that you bought was underwritten (in theory), and then you all are doing another level of underwriting, and then just giving your investors a sliver of that, but then 75 to 100 slivers of it makes up the portfolio for an investor.
Then the practical tips also, for - as you call them - the danger points that you look for. One is people underestimate that new borrowers have a much higher delinquency rate, even if they have a higher credit score. And then two, the three main use cases of borrowing - either 1) acquisition, 2) refi or 3) cash-out refi. The least risky is acquisition, the riskiest - cash-out refi. These are just some things to keep in mind.
Thank you so much for being on the show. I hope you have a Best Ever day, and we'll talk to you soon.
Ray Sturm: Thanks, Joe.