Howard Klemmer
[Editor's Note: This is a guest post from Howard Klemmer, ([email protected]) who is a partner with Royalty Lending Financial Services, LLC. We have no financial relationship. Financial professionals submit guest posts like this both to educate readers about financial products and opportunities, and of course because they hope to build their business by recruiting investors or clients. I always try to ensure these posts are heavy on the education, and light on the sales, but be sure to let me know what you think about them by email or in the comments section. I thought this opportunity for a private investment was pretty interesting, and perhaps even worthwhile for a small percentage of a portfolio, but you should be aware that I have not done any due diligence of any kind on Mr. Klemmer's company, nor invested a dime with them. Don't take the publication of this post as some kind of endorsement. There are lots of good private investments out there, but it's on you to separate the good from the bad, if you want to use them at all. They are certainly optional.]
There is an alternative to Peer to Peer lending; a process I call Royalty Based Lending (“RBL”). It is an investment vehicle that doesn’t risk a large amount of cash, has no correlation with the stock market or most alternative investments and is easy to understand. RBL loans are made to owners of oil and gas mineral rights who are currently receiving monthly royalty payments from oil and gas companies. RBL is akin to buying lottery winnings at a discount; in this case RBL loans high interest cash and is repaid from oil and gas monthly cash royalty payments.
The investment instrument is a Limited Partnership consisting of a General Partner (“GP”) and Limited Partners (“LP”). LPs make investment in the Partnership/Fund; the GP finds borrowers, does due diligence, prepares paperwork and manages the cash repayment of the loan. Most RBL companies are generally small specialty loan companies or family funds. The loan pool is from personal or close family investors; when the loan pool is fully exhausted, the operation goes into a suspense mode till principal can be replenished. Few if any of these operations offer a Limited Partnership for investors to earn a high return.
Our RBL company does invite investors at large, and has a target return of 12% annually; cash distribution of interest is paid each quarter and principal is reinvested. Although 12% is not a guarantee, the typical RBL business model definitely supports it.
Mineral Rights Ownership – What Is It?
The most fundamental level of mineral ownership (MRO) is a “fee mineral interest.” This is an absolute and perpetual ownership of the minerals beneath the surface of a tract of land. In virtually all countries around the world, the owner of the surface estate – be it a house or farmland – has absolutely no rights with regards to the mineral estate. Generally, it is the central governments or monarchs who own such rights.
Not so in the USA where private citizens can own both a mineral estate and a surface estate. In a large number of instances, these two estates have been separated (“severed”) from each other so they may be bought and sold separately. Where the estates have been severed, the MRO’s right to drill and explore for minerals overrides the land owner’s surface rights, meaning the MRO has an almost unfettered right to explore and seek his mineral rights revenues.
Mineral Rights into Royalties
To bring oil and gas reserves to market, the mineral rights are leased to oil companies through a lease contract with an MRO. The MRO and the oil company agree to certain terms regarding the rights, privileges and obligations of the respective parties during the exploration and possible production stages.
Usually, in exchange for providing the oil company the right to drill for a period of time, the MRO gets an up-front lease bonus payment plus a royalty percentage of the value of any production. If no drilling occurs, the lease simply expires.
The duration of the lease may be extended when drilling or production starts. This enters into the period of time known as the secondary term, which applies for as long as oil and gas is produced in paying quantities or commercial quantity.
Oil and gas royalties and the underlying minerals rights are valuable property in addition to being an excellent source of consistent and reliable income. In fact, these properties are commonly bought and sold through the Internet at specialty auctions for oil and gas properties. These auctions provide a lively secondary market to further promote the liquidity of these mineral properties. It is not uncommon for mineral properties to sell for 50X to 80X the average monthly cash royalty payment.
Borrowing Money Against Mineral Rights
The market for RBL is made up of MROs who have urgent cash flow needs such as medical issues, vacations, large purchase, home remodel, school debt, etc. They don’t necessarily want to sell their royalties (but will in a pinch), but are willing to pay a high interest rate for a short term loan.
Historically, banks do not recognize the collateral value of royalties earned from producing oil and gas properties. For most banks, there is a substantial amount of paperwork involved with a royalty loan that also requires an appraisal or valuation of the royalty. Such valuations are specialized and require resources outside of the bank's normal reach. Consequently, it usually is not a cost effective loan product and is not offered by the majority of banks.
In contrast, RBL companies do not require a credit report or personal financial data; they only require from the borrower:
- verification of the monthly royalty payments, well history, multiple royalty sources
- validation of a clean title to the mineral rights and documented audit trail of ownership and
- willingness of borrower to assign cash royalty payments to an RBL company.
LPs invest in a loan pool; the GP makes loans from the pool to MROs who assign their mineral rights and monthly royalty payments to the Limited Partnership; the GP uses this monthly cash payment to pay down the loan balance until the loan is satisfied; then the mineral right and cash payment is reassigned back to the MRO. Typical terms and specifications:
- Royalty collateral is valued up to 25 times the average monthly cash flow; loan to value (LTV) is 50%; the maximum term is 36 months, although a 4 year amortization with a balloon payment at the end of the loan is possible
- Since the loans are investor financed, the interest rate is 18%; with compounding daily interest the effective interest rate is 19.72%. [Ed. Of this 18%, the GP gets 1/3 and the LP gets 2/3, thus the 12% returns.]
- A 3% loan origination fee is charged to cover the costs of legal expenses associated with the loan, document recording, delivery services and other due diligence costs. The origination fee does not cover the cost of county and state transfer taxes if they apply.
- The first two months re-payments are withheld from the loan proceeds, as it frequently takes this long to get royalties redirected to the RBL Company from the oil and gas operator.
Once the loan is approved and the borrower agrees to the terms, the borrower will execute the following documents:
Borrower Documents to Execute
- Promissory note
- Deed of Trust which will be recorded in the county where the minerals are located. If the state does not recognize deeds of trust a Special Warranty Deed conveying the Mineral interest to the lender will be recorded in the county where the minerals are located. In this case, a letter agreement specifying that the minerals will be returned when the loan is satisfied will be provided.
- A letter to the operators, informing them of the loan and directing them to send borrower’s royalties from the oil and gas company to RBL company until the loan is satisfied.
- As soon as the loan is paid-off, The RBL company will release the Deed of Trust (or convey the property back to borrower, if previously deeded it to the RBL company) and inform the royalty payors that the loan has been satisfied and instruct them to make payment back – directly to the borrower.
The RBL company also anticipates some loan defaults – and with default – the company ends up owning the property at a potentially below-market cost. With defaults, the investors will normally have the option of selling their interest in the foreclosed property or having their share of the royalties and minerals deeded directly to them.
Risk of Borrowing Money Against Mineral Rights
The largest risk in the RBL model is the loss of cash flow to repay the loan. The could occur from (a) drop in oil and gas prices or (b) loss of oil and gas production that generates the cash flow. What is the likelihood of these risks occurring?
1) It is highly likely that the price of oil will fluctuate. However; according to oil-price.net and others it is unlikely that the price of oil will drop below $80 per barrel since that is the price necessary for the leader of OPEC, Saudia Arabia, to maintain social stability within its population; and
2) The price of natural gas can also fluctuate. It is currently above $4.50 and based on aggressive marketing of natural gas as an alternative to coal and gas-guzzling cars it is likely natural gas at a price of $4.50 or so seems a continuing reality.
3) Loss of production can occur when the well is forced to shut-in (stop for repairs, etc). Most shut-ins are planned and have no ultimate revenue effect. Occasionally an unexpected shut-in will occur and can lead to full stoppage of that well’s operations (closure), but this is not a common event.
You can mitigate against these risks by ensuring:
1) Multiple sources of monthly cash from prospective borrowers to guard against production loss,
2) Proper valuation of the collateral so that monthly installment repayments are not affected by a drop in prices, and
3) Verification of the collateral cash flow and the clean title to the collateral.
The Bottom Line on Mineral Rights
Oil and gas investing will be around for many more years. RBL is a boutique business that takes advantage of and lends against the oil and gas revenue streams.
What do you think? Do you invest in oil and gas? How do you do so? Would you consider loaning money to someone with only their royalty payments as collateral? Comment below!
How does one go about investing if interested?
I currently have a small amount of my porfolio in ownership of mineral rights for Oil/Gas. Similar to real estate, it provides a monthly royalty check with basically no hassle. It is good in the fact that essentially all of this income is not taxed due to the ability to take depreciation on the investment. Although I was hoping for returns in the 10-20% range based on past performance so far I have only been seeing about 7-8% returns. Another factor to consider is this is a depreciating investment. With times returns will typically decrease as the oil/gas reserves are used up. Fracking has decreased the risk but of course not eliminated the risk from this type of investment. The upside is you can see 10-20% returns for the first 5-10 years and they will continue paying out for 30+ years in the right situation. They can also be gifted just like other forms of real estate. I am just a novice in this field but I think it does offer a nice diversification from the market.
May I ask how you acquired those ownership rights?
A friend works for a company (publicly traded under BECC so the SEC is watching) that is using passive investors and acquiring massive amounts of mineral property in multiple different shales in the US. It is a similar process to “fractional multifamily real estate” if you are familiar with past posts on that. A few other things to keep in mind. It is a very non-liquid market so it is not easy to get your initial investement out although it can be done. It is also a depreciating return that has typically been thought of as “high risk” as oil and gas wells can “go dry”. Eventually the royalty checks will stop if there is no oil or gas being used/produced. This isn’t likely for 20-30 years. However, with the fractional component of the investement and the techniques of fracking it is much less risky because you are not dependent on one well, but instead many wells over a large area. Interestingly there are very creative and legal ways to use a Roth or other IRA to invest and then keep your royalty checks in the IRA to essentially compound the return of the mineral royalty on top of your market return. The up front investment is more signficant but if you already have a good portfolio and want another area of diversification then it is something to consider. I have no financial interest in this but have used it and do think it is a good area of diversification to consider that most doctors are unaware of.
What type of minimum investment is required in this class?
Interesting article and definitely worth publishing WCI, thanks for the variety. The biggest concern I have for including loans in my portfolio whether they be real estate loans, lending club-like loans, or in this opportunity, royalty based lending, is that interest income gets taxed to the hilt–no tax deferral, marginal tax rate, extra medicare tax, extra investment income tax, and reduced deductions, which cuts the return in half (or more). The only reason I would consider such an investment is if IRA money could be used to invest. If the author could comment on whether investments can be made with IRA money, it would be helpful.
You’re absolutely correct. Like P2P Loans, this asset is terribly tax-inefficient. There’s always a bit of hassle using IRA money for this sort of thing (but it’s usually doable through a self-directed IRA), and of course it will be very rare to be able to use 401(k) money for it.
So what is the purpose of presenting this article too us. This seems like an elaborate way to potentially lose money. I am confused why we present a high risk option like this but then talk against chasing higher returns using an advisor or buying anything other than Vanguard index funds.
There are lots of ways to lose money, including investing in Vanguard index funds. While the majority of my invested money is in index funds, not all of it is and it’s okay to invest in things besides Vanguard index funds. But you still want to follow the important principles of investing- low cost, broad diversification etc.
I agree with RP. Even knowing about this stuff is beneficial to most,if not all physician-readers here. Remember 2 key principles – keep it simple and tune out the noise.
I mean NOT beneficial
You guys are really going to hate an upcoming post on managed futures. 🙂
I hope the upcoming post won’t be more noise. I only skimmed this Royalty Based Lending post because I know I won’t be investing in this class of assets and I honestly don’t have time to learn about it. I hope this site doesn’t turn into one for finance nerds rather than busy *doctors*. Remember who is your target audience or they (I!) will tune out. Mr. Bogle’s investing advice might well apply to blog authors too – When all else fails, fall back on simplicity. Tune out the noise. Stay the (original) course.
I would have to disagree with DTSC. I enjoy the variety and learning about new things even if I don’t invest in them. There is only so many ways you can rehash the same topics.
I learned a long time ago I’ll never keep everyone happy, but I hope readers find the mix of articles useful. More complex ones discussing “optional” topics can be skipped of course. I am certainly not under the assumption that every reader, even regular readers, reads everything I write.
One good reason to delve into these more complex topics (like cash value life insurance) is that they get pitched to doctors all the time, so dissecting them to show docs how they work is useful. Instead of 5 posts on the myths of whole life insurance, it would be one sentence repeated over and over again- don’t buy whole life insurance, which would probably be right for 95%+ of doctors. But it doesn’t help the doc who owns one or the doc who is semi-convinced it is for him because all the information he has about it comes from a salesman.
Jim
I read this one and it didn’t fit for me! It may be a viable option but I am skeptical. Bob
It won’t be a fit for most.
a brief response here, especially for the doctors who reside in the town of Baloneyville located in in the state of Confusion. I am not too concerned here about the physicians who read these posts that appear to be conservative, prudent, and careful with their investing style. This little commentary is directed towards the physicians that are more aggressive and enjoy taking risks. The following is a quotation from today in the local paper in Pittsburgh, Pennsylvania. Some food for thought here, especially in regards to what level of honesty or trust is necessary for this alternative, high risk investment.
“A former manager of Consol Energy’s land management department has been charged with stealing $440,000 in gas royalties from the company through a leasing scheme involving parcels in West Virginia and Illinois.
Scott Hamilton, 37, of Houston, Pa., was charged today by the U.S. attorney’s office with 60 counts of mail fraud.
Federal prosecutors said that in 2009, Mr. Hamilton set up a fake company called PRH LLC, using his home address on Irwin Avenue, and then supplied bogus names and the forged signature of a notary to transfer Consol’s interest in the two parcels of land to his shell corporation.
Companies that handled the gas and oil royalties for the parcels then mailed checks to a PRH bank account Mr. Hamilton had set up. Each of those mailed checks constitutes a count in the charging document.
The U.S. attorney’s office is seeking a forfeiture of $440,000 from Mr. Hamilton as the proceeds of the scheme.”
just another little wrinkle to consider when elevating the risk level of your investments, especially among the clueless docs that may be interested in this.
With kindest regards,
Family_doc
“It is highly likely that the price of oil will fluctuate. However; according to oil-price.net and others it is unlikely that the price of oil will drop below $80 per barrel since that is the price necessary for the leader of OPEC, Saudia Arabia, to maintain social stability within its population; and”
Wow, this guy was incredibly wrong. Just four months after this was published, the current price per barrel is hovering under $50. This just goes to show you that risk exists in every investment and you shouldn’t take anything for granted.
I will be sure to diversify when I finally pay off my loans and start investing.
Making predictions is tough, especially about the future.
In Sept 2014, White Coat Investors published an article I wrote about Royalty Based Lending. At the time the article was published, you and some of the readers had some questions, some doubts and reservations; all perfectly reasonable. In fact, the feedback from the White Coat Investor’s readership proved helpful in re-examining some of our assumptions, our model, and intended operations.
This follow-up is sort of thanks for the inputs and a recap report of our progress. It been a year and a half since the article and Royalty Lending has just finished its 2nd full lending year; the results are shown in the attached Fact Sheet.
Some questions that helped us tighten our model had to do with (a) crude pricing and its volatility, (b) can an investor get his money out if necessary, (c) is a 12% possible without big risk, (d) what happens if borrowers default.
(a) In the article discussing oil price volatility, I quoted from an Oil-Price.net statement …”price necessary for the leader of OPEC, Saudi Arabia, to maintain social stability within its population.” That generated several questions from the readership which led us to produce a review process to determine:
• Negative amortization crossover point in each loan by mapping % change of oil price vs valuation/LTV lending guidelines,
• Allowable % change in oil prices for each loan to stay in a safe region: safe region is where all the interest on the loan can be paid and if foreclosure in necessary the sale of the mineral rights recovers the entire principal invested the loan.
These steps tightened the lending process and of the 39 loans, no foreclosures, no defaults and only one loan close to negative amortization at the end of 2015. Although a hard focus on oil price volatility seems obvious, our process got toughened by the push from your readers.
(b) Getting money out of limited partnerships is usually very difficult. Our limited Partnership Agreement was no different. Lessons from the 2008 disagreements between investors and fund managers over withdrawal produced more investor friendly agreements. We made similar changes to become more investor friendly.
(c) Twelve percent (12%) return, is it possible without big risk. It was a good question. In fact, our answer is much like the answer you gave in the Student Loan Debt online forum to the question “Should medical students be paying 6.8% interest on their student loans? Given that medical students historically have low rates of defaulting …I believe you answered that refinancing lenders fill the gap below the 6.8% and cherry pick the borrowers that most likely will repay, namely doctors.
12% is possible because we can charge 18% and get high probability repayment (subject to oil price volatility as I discussed above), from the royalty check each month that covers the loan payment. We can charge 18% because no one else will lend to mineral right holders because the due diligence is so specialized. For example, the process to redirect royalty payment, reassign deed ownership, understand the lease agreements, be able to project cash life of the oil stream, etc. Royalty Lending has such skills.
(d) It’s likely, we will have a default and when it happens we are ready. Most of our loans are in Texas; we already have the deed and will arrange to keep the deed in lieu of foreclosure with the affected borrower. We can sell the property outright or continue to receive royalty checks and pay back the principal. After the principal is repaid, the continuation is all potential income to investors for whatever time the partnership keeps the property. In normal market conditions, the property sells for 25 to 50 times the average monthly royalty payment, so the investment can be recaptured (subject to the oil price). Most loans are calculated at 25 times the average royalty payment.
The Fact Sheet calculates returns based on the time investment funds are actually used. The calculation is a simple weighted average of the funds available in each quarter.
The Sharpe ratio, according to Investopedia, is the average return earned in excess of the risk-free rate per unit of volatility or total risk. I show it here only as a means of demonstrating the return per unit of risk is high because the risk measured by the funds standard deviation of returns is low. The volatility of the oil prices have been already baked into the returns we have reported. You can request a copy of the Fact Sheet by sending a request by email to [email protected].
Royalty Lending’s next step is to work with financial institutions/wealth management firms to grow the investment base.
If it’s Ok, I’d like to check in with you from time to time and report our progress.
Sincerely,
Howard Klemmer
I am interested in a RBL and would be a perfect candidate. Need $40,000 for property taxes, medical expenses, and to make improvements on my house prior to selling it. My royalty checks average about $4,500/month and have been consistent. Who can I contact about such a loan? You can contact me at the above email address.
Or you can call 303 638 8649
Why not try the link/email address at the top of the article?
Frankie please contact me. Thanks Don Skotty