As I write this in the summer of 2020, considerable downside risk exists for asset values over the next 12-18 months. COVID-19 rages across the world with America making up an outsized percentage of cases per capita. Besides the enormous human toll, it has also laid bare a number of socioeconomic issues that could impact asset values. The Federal Reserve, Treasury, the Executive Branch, local, state, Congressional and foreign actors responses to the pandemic and to one another will also alter future asset prices. Uncertainty reigns.
A recession, a depression, a new Cold War or even a Hot War are inherently negative for asset values. Markets embed expectations about future cash flows, future inflation rates etc. into their current prices. But they don’t all get them right all of the time. The problem for investors today is that markets such as treasuries, residential and commercial real estate are not baking in a gloomy future, despite a gloomy future’s very real possibility. To varying degrees, markets are expensive, discounting a rosier future than I foresee. Treasuries are what James Aitken of Aitken Advisors would–tongue in cheek–refer to as “administered markets.” In other words our government and other foreign actors are bidding on enough treasuries to, for the time being, suppress their yields. They don’t even try to hide what they are doing. It’s literally called yield curve control. Both residential real estate and commercial real estate are to varying degrees inefficient markets. This inefficiency matters today because they can be slow to discount both positive and negative economic developments.
An Alternative to Owning Real Estate What do we do when we believe the risk of owning real estate outweighs its rewards? My preferred tactic is to move up the capital structure. By moving from being the property owner to the lender, I reduce my risk. You can’t short real assets, but by making a loan secured by real estate you’re doing the next closest thing, because the payoff structure of your investment mimics the payoff structure of selling a cash-covered put in the stock market.
In the stock market, a cash-covered put involves selling an out-of-the-money put option while simultaneously setting aside the capital needed to purchase the underlying stock if it hits the option’s strike price. The goal of a cash-covered put strategy is to acquire the stock at a lower price than the market’s offering if the option gets assigned to you. If it does not get assigned to you, you pocket the premium for selling the put. The size of the premium varies and this premium size matters when thinking about the merits of this strategy.
In real estate the mechanics are different from the stock market but the payoff scenarios are similar. Let’s imagine you have a 100 unit apartment building and units are trading for ~$75,000 a door. Though the market value of the building is $7,500,000, to you a fair value is $5,500,000 or $55,000 a door. Rather than roll the dice buying the building for more than you believe it is worth, you provide a bridge loan of $5,250,000 to a borrower at 10% simple interest per year for 2 years. Though your cash is not sitting in your account (where it would have earned almost nothing) as it would be if you were selling cash covered puts in the stock market, you are not selling a naked put either. You have already provided the funds through a mortgage to the borrower that represents your “purchase” cost if the borrower puts the apartments to you. With an option premium of nearly 10% per year, you are getting paid to wait to see if the borrower decides (through default) to put the apartment to you at a price at which you are happy to own the apartment anyway. How so? If as a lender you are selling a put, then your borrower is buying a put, giving her a right to “sell” the apartment complex back to you at your loan amount of $5,250,000 and walk away from her loan. What if asset values truly tumbled over two years and fell to $5,000,000. In the stock market as a put seller you would be out of luck. However, it’s more nuanced in real estate because nine times out of ten you will require the borrower to sign a personal guarantee. In the event that there’s a deficiency between the value that you realize disposing of an asset you have taken back, and your loan amount, a personal guarantee allows you to pursue the borrower’s other assets.
Some of the Risks What if the building burns down? As a condition of making the loan you have the borrower add you as a loss payee on her insurance policy protecting you from typical property losses.
What if she lets her insurance lapse? You can prevent this on the front end by impounding for property taxes and insurance so that a loan servicer collects for both concurrent with monthly loan payments. Though no investment is without risks, making private money loans secured by first mortgages is a solid heads I win tails I win strategy in an uncertain world where real estate values are higher than your estimate of intrinsic values.
Why now? While the localized nature of hard money always makes it less efficient, the level of inefficiency varies depending on the type of asset that acts as collateral for the loan and the timing in the cycle. Today is an interesting time in the hard money space because many hard money lenders lost access to institutional capital sources when the stock and credit markets went into a tailspin in late February and March of this year. In terms of the efficiency of different types of collateral for hard money loans, the market for institutional grade assets is more efficient than “mom and pop” assets because there are far more lenders serving the market for institutional assets. Conversely, if you just make loans secured by small mom and pop mobile home parks or mom and pop self storage facilities, you will encounter inefficient markets where you can lend money at higher interest rates, lower loan to values, or both.
There is also a level of inefficiency that comes with both the primary and secondary whole loan market because they are relational. There’s no centralized exchange where you can just post bids and offers. Though I have purchased whole loans from online platforms before, there’s not a lot of depth of bids in these markets. The fact that 99% of the time you have to build relationships with either borrowers, principals or brokers adds layers of opacity to the market. These loans require that you either develop your own pipeline of borrowers or you develop secondary market sources that can sell you whole loans that your sources have originated. The secondary market for whole loans is even more relationship oriented because escrow is uncommon. A seller provides a prospective buyer with a copy of a collateral file, makes some reps and perhaps some warranties, buyer wires the funds to the seller, and the seller causes the original collateral file to be sent to buyer. Building sources of buyers and sellers requires a squeaky clean reputation for honesty and performance.
You mentioned the need for relationship based lending for this to work. What other hurdles exist for investors?
It sounds like total investable assets could be a hurdle? One of the advantages of stocks is that you can start investing with $1,000 or less. How much capital do you need to begin private lending?
Are third party brokers required to facilitate transactions? Or is that only considered at certain $$ value breakpoints? How often do you have to get a lawyer involved? Either to sign a deal or enforce one?
Whether an investor forms a relationship with hard money lender or directly with a borrower, a lender will need to evaluate the character of that individual. Besides understanding the borrower or the hard money lender that is presenting you the deal, it’s critical you understand the collateral, what it’s worth today and what could adversely affect it’s value. For example, if you made a loan like this secured by a retailer you better be sure their business is solid. That’s why I prefer to make hard money loans to investors that are secured by apartments, mobile home parks or single family houses. I understand the value of these assets best.
Hard money lending or private lending is regulated both federally and at the state level. Whether a broker needs to be involved depends on the state. For example, in California if you want to make a loan secured by a first trust deed above the statutory usury rate a real estate broker will have to arrange the loan (I’m not a lawyer, get your own council do your own homework).
You need real money to get involved in private money lending. Some states like California have net worth requirements which effectively keep all non-accredited investors out of the market. However, if a lender were to act as an issuer through a rule 506(b) fund that pools loans like this they might allow up to 35 non-accredited investors into the fund. (I’m not a lawyer, this is not legal advice, do your own homework).
I’ve arranged and invested in a good number of private money loans in California and have never had a lawyer involved. A good hard money lender should have about a 3-5% default rate across a cycle. Our borrower’s have been professional investors, they have never defaulted. In addition California allows for non-judicial foreclosure. I suspect lawyers are likely to get involved in states like Florida that have judicial foreclosure processes. However, you’d have to hire a lawyer if a borrower filed for bankruptcy. A bankruptcy stays all collections including foreclosures. Typically in these circumstances you would petition the court for “relief from stay” which if granted would allow you to the proceed with a foreclosure.