Yields, Risk, and Unusual Investment Structures
Part 1: The Hunt for Yield
Any real estate fund is inherently going to have a significant cash position, and Reawaken is no exception. We’ll have funds yet to be deployed, income from operations, and a rainy day fund for unexpected repairs and things of that nature. We therefore are constantly seeking out the best ultra-low risk, high-liquidity investments that would generate reasonable returns on our idle cash. The default for this is a money market fund, which has a risk profile which approximates zero; the yield on the Vanguard Federal Money Market Fund is currently 4.25%. Most people consider the “risk free” rate of return to be the yield on the 10-year US treasury, which is currently 4.50%.
I was therefore somewhat intrigued when I saw an offer for what seemed to be real estate-backed bonds yielding 8.5%, from a company called Compound Real Estate Bonds (CREB), with the liberating slogan “unlocking financial freedom for everyone.” It is offering bonds with a fixed 8.5% yield, $10 minimum, and near-immediate liquidity. This is very obviously a retail-oriented product, with a $10 minimum buy in and a website quoting Warren Buffet while providing a notable lack of detail except for this graphic with almost imperceptible fine print saying that their allocations can change based on market conditions and opportunities:
That said, we would like an 8.5% yield on our idle cash. That is a potentially good deal if the risk profile is low. Even B-rated corporate bonds only offer a yield slightly under 7% right now (per the ICE BofA Single-B US High Yield Index) and any liquid index fund or mutual fund comprised of bonds would be subject to interest rate risk; should interest rates increase, the value of the underlying bonds would decrease. In theory, CREB’s product has no such risk. It just pays out a flat coupon no matter what.
All of this didn’t add up to me. An 8.5% yield in real estate isn’t all that hard to hit if you are knowledgeable and manage your investments well, but 8.5% is hard to hit while also being fully liquid and having little to no downside risk. If there was an opportunity to get an 8.5% yield with very little risk, lots of people would take that trade! In doing so, the yield would decrease. Again, the going “risk free” rate is about 4.5%, and 8.5% is a lot more than 4.5%! My question therefore became: what is the catch? More specifically, where is the risk, and are the 8.5% returns commensurate with the risk?
The CREB website has no prospectus but does have a bunch of SEC filings and upon contacting them I was offered a meeting with a “bond specialist”. ¿Por qué no los dos?
Part 2: Due Diligence
Looking through Compound Real Estate Bonds’ SEC filings, we notice a few key things. Note that their most recent report was for the reporting period ending June 30, 2024 and filed on September 30, 2024, so it is somewhat dated but it’s the most up-to-date information that we have and can be certain of.
It is registered under Regulation A, which allows it to sell up to $75 milling in securities to the general public without the formal registration processes required by, for instance, an IPO, and allows it to avoid registration with state securities regulators. There is nothing inherently wrong with that, but it confirms that the target audience for CREB is the general public. This is not a product aimed at sophisticated or institutional investors.
Its parent company provided CREB with a total of $89,070 in funding. This appears to be all the investment it has received (aside from selling the bonds). This can be seen in their most recent semiannual report in note 8 on shareholders’ equity on page F-22)
The first report in which bonds show up in their financial statements is their 1-SA semiannual report for the period ending June 30, 2023 (note that they are only required to file semiannually). It shows that they had $1,014,839 in outstanding bonds.
Fast forward to their most recent report, a semiannaul report for the period ending June 30, 2024. There are a few very concerning items in this report. First, they state: “As of August 31, 2024, we had a total of $4,864,082.64 in Compound Bonds outstanding (principal and interest), plus an additional $60,758.18 in other current liabilities and a further additional $29,981.73 owed to related parties, but only $4,032,528.20 in liquid assets.” In other words, they were $922k underwater. Their liabilities were already 22.8% greater than their assets. Secondly, they state: “From January 1, 2024 through June 30, 2024, our only revenues were $8,695 in interest earned on cash and cash equivalents as well as from our Treasury Bonds.” In other words, they had no real estate investments and revenues which were a small fraction of their expenses ($393,798) as of June 30, 2024, over one year after they started selling bonds which they immediately had to start paying interest on. They were only becoming more indebted over time.
What do you call an investment scheme where early investors are paid - and can only be paid - because of continued inflows from later investors? We’ve heard this one before…
Furthermore, if investors suddenly seek to redeem, there could be a bank run-type of situation, where there are simply not enough assets to cover their bond liabilities. This isn’t simply a matter of liquidity, as is the case with traditional bank runs, but actual assets. The money just isn’t there and the last ones out could be left holding the bag.
To be clear, I don’t think that Compound Real Estate Bonds is intentionally running a ponzi scheme. I just think that they aren’t honestly representing what investors were getting themselves into. This was not an investment into real-estate backed bonds. There was no real estate! This was an investment into a money-losing real estate startup.
When viewed through that lens, 8.5% is a very poor rate of return! No VC would fund a startup and expect only an 8.5% return. Even large-cap companies with less-than good credit pay a coupon of well over 10% for their bonds (the ICE BofA US Corporate C Index is currently 11.43%).
But hey, sometimes audited financial statements don’t tell the whole story. In fairness, their June 30, 2024 statement did state that they were under contract to buy $1,050,000 in mortgages (of an unspecified nature). It seems like there will be some real estate after all. Perhaps the “bond specialist” could shed more light on the situation.
Part 3: Awkward Assurances
Greeted with my deep skepticism, the “Bond Specialist” made some generalizations and odd claims. Here’s a few noteworthy ones:
The advertised investment allocations “vary based on market conditions”.
They are currently primarily investing in senior secured short-term mortgages with 6, 9, or 12-month terms and 50-55% loan-to-value ratios (“LTV”)
Their cash is mostly parked in US treasuries. The amount of their assets which are cash or cash equivalents fluctuates between 30 and 65% but was, at the time of our call, about 50%.
When I mentioned that they had literally zero real estate investments as of their last audited report, the bond specialist suggested that could have been due to day-to-day variations in their short-term holdings, which is awfully close to a flat-out lie (which, in the context of a conversation about a securities offering, could constitute securities fraud).
This all adds up to some interesting math.
Short-duration US treasuries currently pay about 4.3%. We’ll be generous and call it 4.5% for easy math. If they are 50% in treasuries and 50% in real estate, they would need to make 12.5% on their real estate investments just to pay the coupon on their bonds. In reality it likely needs to be even higher since they also need to pay operating costs (although the bond specialist assured me that they will have additional revenues from things like mortgage origination fees). Again, for simplicity let’s say they need yields of around 12.5% on their real estate portfolio and other revenue sources will cover their operating expenses. This is probably a generous assumption.
There is almost no possibility that in the current market very short-duration, low-LTV, senior secured mortgages in the United States or Canada will yield 12.% or more! Mortgage interest rates go down with shorter duration and lower LTV, and secured mortgages of 1 year or less and 60% or less LTV would be considered extremely safe. Cursory Google searches find that commercial mortgage rates with multi-year durations are around 7%.
The “bond specialist” didn’t seem to know that much about current mortgage rates, as he assured me their yields were higher than this. He mentioned them having access to private credit deal, but private credit yields aren’t that high, either.
Part 4: Conclusions (or Lack Thereof)
The only people who could possibly know what Compound Real Estate Bonds is up to are the people working there, and from my conversation with one of their Bond Specialists I’m not sure all of them do. Everything in their SEC filings thus far is concerning, and nothing the bond specialist told me in our call made much sense. I fear they are concealing a great deal of risk from their retail investor audience.
I sincerely hope everything works out well for CREB. My well-wishes aren’t for CREB itself - I think they have been acting very unethically - but for their investors. CREB has very little skin in the game, but they have millions from retail investors, many of whom may not have done thorough diligence and possibly did not realize that they were making a highly risky investment into a startup. I unfortunately don’t have confidence in that outcome.
My only definite conclusion is that we’ll be keeping idle cash in those boring, safe money market funds.
