As with all investment articles on this site, I’ll just warn that I’m not an investment professional, and this should not be taken as advice.
In my recent monthly status I mentioned that I’ve begun a new experiment in my ever growing portfolio of alternative investments. Before I go into the details, let me explain how I got here.
Several months ago, I began a partnership with a local real estate investor who was seeking money to purchase a distressed house. I invest the money, she does the work, we split the profits. An distressed house is now a livable one, and a family gets a beautiful new home right next to the elementary school. Everybody wins.
I like this idea, but there are reasons why I may not want to increase my investments in it. For example, on this project we estimated that renovation expenses would be $33K. It was closer to $40K. We assumed 4-6 months to sell the house around $140K, but we don’t know what will really happen (currently we’re listed at $145K after 2 months). Also, it’s in my partners best interest to hold out for full price, while I would gladly take a smaller profit since it’s my money that’s tied up (her ROC is infinity, whether it sells today or it sells 5 years from now). Don’t get me wrong, I’m still happy with our partnership so far, but as I look to scale my investments I may want a better situation.
This desire led me to look at private hard money lending. Hard money lending is when private investors lend money at high rates to a real estate investor looking to rehab a home. Rates generally range from 12-15%, with some upfront points paid out (usually 2-3%) and the loans are generally good for 6-12 months. All these variables change based on region, market, etc… The loans will usually cover about 70% of the ARV (after repair value), so the home acts as a solid collateral. If the loan is defaulted, you get the house at roughly a 30% discount. This all looked good, so I did more research. I talked to a woman I found on biggerpockets.com who has been doing this for 20 years, and has been very successful. It was all great except for one thing: doing it right will take a lot of work. Work that I don’t have time for right now. I would want to meet with prospective borrowers, view their house and plans, look at comps, get references, meet with a lawyer and draft up contracts, and more. It all sounded really fun, but also very time consuming.
Finally, this led me to the discovery of private equity companies that do hard money lending on a larger scale. They usually charge a 2% management fee, but they cover all the work I described above. They work with borrowers and build long-term relationships, they study the local real estate market, they work with the lawyers and have established contracts. And above all else, they offer instant diversification that I wouldn’t be able to get as a small-time hard money lender because they pool in millions of dollars across multiple investors like me.
After some online research and asking around with a few local real estate investors, I found a private equity LLC that I decided to invest in. Here are the business details:
The fund lends at a 14% rate. They will lend up to 70% of ARV, and they charge 4 points up-front. The term is for a maximum of 9 months, with no early payment penalty. The fund pays it’s investors 8% preferred dividends, the manager gets paid 2%. The remaining money after paying all fees (lawyer fees, etc) then get paid out to the investors above and beyond the preferred dividend at 8%.
As an investor in the fund, I have to purchase a minimum of $25,000, and can reinvest in $5,000 increments. The fund will pay me 8% APR on a monthly basis. This is a preferred dividend, which means I get paid first, even before the fund manager. Every six months, all outstanding profits beyond the 8% (my payout) and 2% (fund manager’s pay) are given out to the investors (me). Over the past 5 years that this LLC has existed, the total payout has hovered around 12% APR with very little volatility. I think most people will agree that 12% with little volatility is a nice return.
As with any investment, there are benefits and risks. Let’s explore those.
- High Return on Investment
- Unlike REIT’s, the fund value will not move up or down based on the Federal Reserve interest rates. So volatility is low
- Short term loans are not heavily dependent on the local real estate market
- The loans are backed by a physical house worth more than the loan itself (70% ARV). Leins are always in first position, so a default means the house belongs to the fund, and in many cases this actually increases profits
- The private equity fund leverages the experience of a RE investor with 20 years of experience in REI, specifically in the local market (Denver metro area)
- The fund diversifies your investment across dozens of outstanding loans, with a smaller minimum investment than you could achieve as a private money lender
- Investment is mostly liquid. If I decide I want out tomorrow, they will give me my money back in full as soon as they have the capital. In most cases, this is immediate
- Both the investor and borrower are making money on the deal. The neighborhood looks better, and some family gets a beautiful new home that was previously unlivable, rather than having a cheap new house built deeper into suburbia. It’s good for my investing soul.
- Default by borrowers – The equity fund loans very conservatively at 70% ARV, with a first lien and a deed of trust. This reduces the likelihood and impact of a default. However, multiple defaults could result in the fund owning several houses and reducing ROI. A loss is unlikely.
- Reduced demand for rehab loans – If no one wants to borrow the money, then it’s earning 0% interest. If this happens, the equity firm will hold a meeting with investors to consider lending in new markets, reducing interest rates, or returning money to investors.
- Too much demand for rehab loans – The private equity company I chose has a very high reputation in the REI market. If they don’t have enough funds to meet the needs of borrowers, they will lose reputation. If this happens, the company will open an additional offering and raise additional funds. This risk, and the one above, require a good balance.
- Mismanagement – If the fund manager just sucks at what he’s doing, then he’ll give out bad loans to bad RE investors, and returns will drop. Or, if he takes more investment money than he can keep active, then returns drop. This is why I chose an established fund, and one that came with independent references.
- Taxes – Not really a risk, but taxes are at your marginal tax rate rather than qualified dividend rates or capital gains rates. This would kill my profit since my income is still high, which is why I invested inside the shelter of my SDIRA
I’ve started out with an initial investment of $40,000. This means my preferred payment will be paid out monthly at $267/month. If the fund achieves it’s goal of paying investors 12% APR in total payout, then that will result in $400/month. I will likely increase my total investment to $60,000 over the next few months and perhaps as high as $100,000 by the end of the year if things continue to go well.
Anyone out there involved in a similar investment? I’m sure I’m not the only one that would like to hear about your experiences.