I spent some time recently thinking about and discussing real estate lending funds and I thought it might be useful to share a few points. This is going to be mostly a generic discussion about the asset class itself, although we will dive into the specifics of one unnamed fund. Mostly, I just wanted to share a potpourri of random thoughts I've been having.
These Guys Don't Like the Term “Hard Money Lending”
One of the interesting things I've discovered as I've talked to various lending funds is that they all hate the term “hard money lending” and go to great lengths to distinguish themselves from whoever it is that they consider “hard money lenders”. In truth, hard money lending just means that you are loaning money backed by a hard asset, such as the value of a piece of property. So, by that definition, private real estate lending funds clearly ARE hard money lenders. However, the term has a negative connotation to it. It probably comes from two places. First, the terms on these loans are not awesome. They charge a high-interest rate and points on top of it. So you can see why a borrower might feel like they were working with a loan shark instead of a partner trying to help them succeed. Second, it seems that the classic “hard money lender” was primarily focused on the asset itself, rather than the business plan. They were perfectly willing to take the property off of the borrower's hands in the event of default.
The modern “Private Money Lender” is much more interested in the success of the developer and more willing to work with them to finish the project. They are more relationship-based than asset-based. They want the repeat business. The good ones still know what to do with an asset if the borrower just mails in the keys, but they really don't want the property. They just want their principal, interest, and fees. Whether this is better for the investor or not, I have no idea, but that's the way the industry has moved.
Why I Like This Asset Class
I really like debt real estate. I don't like how tax-inefficient it is (basically all gains are ordinary income), although that has improved since the Tax Cuts and Jobs Act of 2018 when at least they have the option to “go REIT”. But I love it as a counterweight to the pessimists out there that think stocks are going to return 1-3% real long term. “If you really believe that stocks are going to provide you a 3-6% nominal return,” I ask them, “Why wouldn't you just invest in a real estate lending fund that pretty reliably generates a 7-12% return all while backed in first lien position by a valuable, sellable asset?” This asset class provides a stock-like return and, while it isn't insulated from the overall economy, it certainly has very low correlation with ebbs and flows of the stock market. Stock-like returns. Low correlation with stocks. Reasonable risk level. What's not to like? It certainly seems worth a 5% allocation of my assets.
REIT Tax Treatment
Since 2018, these funds have been rapidly converting themselves to a REIT structure. There are two huge benefits to doing so. The first is that the investors no longer have to file returns in all the states the fund is lending in (which was not uncommon for these funds). The other is that REITS qualify for the 199A deduction. So basically, you get a tax deduction equal to 20% of your income from the fund. Now that doesn't magically turn this from a very tax-inefficient investment into the Total Stock Market Index Fund or a municipal bond, but it does make it slightly more tax efficient. If your marginal tax rate on this income were 40% before, now it is only 32%! Beats a kick in the teeth.
Finding Funds I LikeThen it went public. That wasn't all bad, I got a nice big boost in the first month after it went public. I sold, as having it be publicly traded actually defeated one of the purposes I bought it for, but overall had a fantastic return on the investment. This was one of the Broadmark funds, now a publicly traded debt REIT. I've had a number of other debt investments including a DLP fund I bought through CityVest, one of the Arixa Funds, and a bunch of crowdfunded loans bought both individually and via an RIA that functioned somewhat like a fund. But basically what I want isn't that complicated. I want another Broadmark fund. I want 10-11% returns, all the loans in first lien position, REIT tax treatment (unless I put it in a self-directed 401(k) or IRA), the ability to reinvest the income automatically, good communication, and reasonable liquidity.
Interviewing a Fund Manager
Since I'm interested in investing, and specifically on the lookout for good funds in this asset class, it was no surprise that I ended up ski touring with somebody involved in a local lending fund. It took us an entire year to finally close the loop and get around to the nuts and bolts on the investment, but I had a recent phone discussion with the manager which you might find interesting. I'll include some of what we talked about in a Q&A format. While this particular fund isn't really an investment I can make available to my readers, hopefully these questions will give you some help in doing your own due diligence in this space.
What is the minimum investment?
What is the liquidity?
2 year lock-up, then we have 120 days to get you your requested partial or full withdrawal. Typically, it takes us less than 60 days to get you your money. However, in times of severe economic stress, we can close the fund to redemptions entirely.
Do you allow investment through a self-directed IRA or 401(k)?
Yes, but the fund does have some UBIT (Unrelated Business Income Tax) (which could make some of the income taxable in a Self Directed IRA).
How big is the fund?
How many loans are typically in it?
80-90. Typical loan size is $1-25 Million. We consider ourselves “mid-range” lenders. We can't do an $80 Million project, but we're not doing Joe the Home Flipper loans either.
Retail, industrial, storage, and residential. We'll even do single-family homes, but only through large developers who are more sophisticated.
How much of your money and that of your employees is in the fund?
$4 Million. $10 Million if you include close friends and family.
Are you a REIT?
Yes, just became one last year to get the 199A deduction for investors.
Any plans to go public?
No. We like the way we do things and have no plans to change.
Who are the other investors in the fund?
Some are high net worth business owners like you, but mostly family offices with some fund of funds.
You seem to stress the relationship aspect with the borrowers. How many of your borrowers are repeat borrowers?
70%. We really want our partners to succeed and, because of a long relationship of trust, are quite likely to work with them if there is an issue.
How long have you been in business?
This particular business has been around since 2011, but the principals have been in the industry since before the 2008 real estate debacle.
How long are the loans?
Typically 12-18 months. We charge too much for a borrower to use for longer than that without eating into their profits too much.
How much do you charge?
10-12% plus 2-3 points. It seems high, but we can fund very quickly and with a lot less hassle than “long-term money” from banks.
What have the returns to investors been historically?
10-13%. We expect to be between 10.5% and 11.5% this year.
We charge 2% a year and then split profits 85/15. However, unlike many funds, with our fund 100% of the points and fees paid go into the fund, not to us. That means our investors do better than a fund that charges 1% but keeps those fees and points. We also see the 85/15 split as better than the typical fund that uses an 80/20 split.
What tax forms will I be sent? How many states will I need to file in?
We send you a K-1, but you'll only have to pay in your state.
What is the Loan to Cost ratio?
What is the loan-to-value (LTV) after improvements ratio?
~65%. We feel these ratios are low enough that if we have to foreclose we can get our principal back out.
What percentage of the loans are in first lien position?
95-97%. If we go into second lien position, we demand that the total LTV including our position be below those ratios.
How often are distributions paid?
How many loans have you done?
How many have defaulted.
You have to be a “Qualified Client.”
What would happen in a 2008 scenario in the fund?
We would go into “principal preservation mode”. Yield would likely drop and may disappear entirely. We would work with borrowers as much as possible to weather the storm and get them over the finish line. But we're not afraid to take over on projects. Both of the principals were involved in companies doing just that during the Global Financial Crisis. We have the contacts and resources to finish projects and get them sold, although we would probably be working through third parties. However, it is entirely possible that we would choose to hold assets for years rather than liquidate them at fire-sale prices.
So in some ways, it is a debt fund until bad times come, and then it could be a debt and equity fund?
I suppose that's true.
When can I invest? How is my money called?
We briefly close the fund a couple of times a year when we have more cash than needed so we don't dilute the returns of the current investors. This is one of those times, but we expect we would take money again within a couple of months. Your money would be called all at once.
Are you looking for more investors? Would you be interested in an affiliate agreement with The White Coat Investor? Would you allow a lower minimum for those investors as most docs would have trouble coming up with a $250K minimum while maintaining a diversified portfolio?
Not really. We're still mostly word of mouth from one investor to another, but I suppose that sort of thing could be possible at some future date. We like the $250K minimum and we have quite a few investors that are there, but also plenty that are at the $1M+ mark.
Many of my readers aren't aware of the various differences between these three categories of investors. While anyone who can meet the minimum investment can invest in a mutual fund, private investments often have a higher barrier. This is intended to ensure the investor is more sophisticated and, probably more importantly, financially able to weather a more significant loss. You frequently see an elderly couple in the newspaper that was scammed out of their $75K life savings. These regulations should prevent that sort of scenario. There is less regulation in this space (for better and for worse), so it is always caveat emptor. Be a sophisticated investor and not just a high-income investor. At any rate, here are the basic definitions:
An investment is considered a security and so federal securities laws apply. According to the Investment Company Act of 1933, a fund (including a Limited Partnership or Limited Liability Company) must EITHER register with the Securities and Exchange Commission (SEC) OR find an exemption to registering. The most common exemption is Rule 506(b) of Regulation D, which basically says if all of the investors are accredited investors, you don't have to register with the SEC. An accredited investor has:
- Individual income of at least $200K ($300K joint) for at least 2 years with reasonable expectation that income will continue OR
- Investable assets of at least $1 Million
In order to charge the performance-based fees typical in a private equity, venture capital, or hedge fund, at least for registered managers or those in certain states, investors in the fund must all be qualified clients of the manager/advisor according to Rule 205-3 of the Investment Advisers Act. Now you know why your mutual fund manager just charges an AUM-based expense ratio instead of sharing risk with you. A qualified client:
- Has investable assets of at least $1,000,000 with their advisor after this investment OR
- Has investable assets of at least $2.1 Million OR
- Is a “qualified purchaser” OR
- Works for the fund (either as an officer or has been there at least a year)
Most private funds are exempt from registering as an investment company because of two exemptions in the Investment Company Act of 1940. The first exemption is Section 3(c)(1), which says if the fund is owned by fewer than 100 persons and not making a public offering, they do not have to register. The second exemption is Section 3(c)(7), which is less frequently used, but requires that the fund be owned exclusively by qualified purchasers. In that case, the fund can have up to 1,999 investors. A qualified purchaser:
- Has investable assets of at least $5 Million
So in case you were wondering why all of these private real estate funds only have 99 investors, now you know.
While this post was a collection of random facts and potpourri about this asset class, I hope you found it interesting and worthwhile. I did end up buying this investment and am enjoying the returns. If you want to learn more about our current real estate partners, you can do so here. If you would like to get an email every time an opportunity like this comes up, sign-up for the WCI Real Estate Opportunities email list.
What do you think? Would you invest in a private real estate lending fund? Why or why not? What do you like about it? What do you dislike? Do you think the regulations about who can invest in these things are appropriate? Comment below!