In the long-term, investing in stocks generates good returns. Over the last 70 to 100 years, long-term investors in the stock market with a 10+ year horizon have been able to generate 8 to 10% average returns but this is by sticking to investing for the long-term.
The unfortunate reality is that for many investors, actually capturing long-term stock market returns can be challenging because not everyone has the patience, time or the stomach to ride out the ups and downs.
As I write this in the summer of 2020, the Corona virus and Covid-19 illness have spread around the world. Markets have been on a roller coaster ride, and after a great year for US markets in 2019, 2020 has been scary enough that many investors have sold out and are sitting on the sidelines in cash even as the market has started to mostly recover from its late March losses.
This year has been a great illustration and test of the challenges that investors can face in their ability to withstand market volatility. Every time the market has a major pullback, it reveals that many investors just cannot handle watching their portfolios drop by 20 to 30% or more, even if the drop is temporary. For these investors as well as those approaching retirement, the ability to generate a steady return would perhaps be more attractive – at least for a portion of their money.
Traditionally, investors looking for safety and steadier income returns have looked to bonds as their main alternative to stocks. Bonds are considered less risky than stocks but also trade and fluctuate in public markets as well.
Unfortunately, right now, interest rates are at historical low levels. As a result, it is very challenging in today’s low interest rate environment for investors to find high quality bonds that generate a worthwhile interest or income rate of return.
Normally, longer maturity bonds have higher interest rates than shorter maturity bonds (and this is still true today). However, interest rates are so low right now that even 30 year treasury bonds yield less than 1.4% per year. This income will probably be lower than inflation over the next 30 years. This means that the actual “real” return from holding long-term treasuries will likely be negative.
Inflation rising should be a worry for many reasons. The federal reserve is printing money to combat economic disruptions caused by Covid which could lead to future inflation. Even without the money printing presses, long-term bonds also fluctuate significantly when interest rates move.
The relationship between the value of bonds and interest rates is an inverse relationship. If interest rates fall, the price of long-term bonds rises creating gains. However, if interest rates rise, the value of the bonds will fall, potentially creating significant losses. Thus, just like stocks bonds are also subject to quotational market fluctuations as they trade.
Due to this exposure to interest rate risk, bonds and especially long-term bonds can also be subject to market volatility and credit risk as well. However, since interest rates are already at all-time lows, the risk of interest rate fluctuations seems more to the upside.
Despite the challenges associated with bonds today, the need for income has not gone away. Ideally investors could find sources of income that are both high enough in the amount of interest earned to live on the income, but also steady and predictable.
What can an investor who wants or needs higher income or returns, like stocks, but with more safety and steadiness like shorter maturity bonds do?
The case is not hopeless if you know where to look. Read on as we discuss how investors today may have the opportunity to earn steady and secure returns of 6% to 8% by participating in investments in private debt.
Steady Income Returns from Investing in Private Debt
The US Stock market is very large and valuable – as of mid 2020, the value of the entire US Stock market was estimated at around $35.5 Trillion. While this is a large market indeed, the US Real Estate Market including commercial and residential real estate is estimated as over $50 Trillion so it an even larger pool of assets.
Within the real estate market, there are quite a few niches. One of the large areas of activity and opportunity is lending against real estate. Much of this lending is done by banks against residential and commercial properties. Typically, banks will lend 60 to 80% of the value of their real estate collateral, but they also verify many other items such as income and credit worthiness before extending loans. Bank loans are usually slower to obtain, involve a multi-step application process, and have their own restrictions, but also feature lower rates. One key is that because banks have many rules to follow they cannot move quickly and say no to many lending opportunities that fall outside their guidelines.
However, there are niches within real estate markets that require faster availability of loans or more flexible lending criteria. One of these areas involves so called fix and flip properties whereby an experienced real estate operator finds homes or other properties seeking to buy them in as-is condition at a discount. These properties typically involve an experienced investor who is planning to rehab property to create value and then resell it or rent it. Most fix-and-flip projects have a 3 to 9 month projected turn around. The margins are high enough for experienced operators to pay higher interest rates in exchange for speed and flexibility. However, in many cases, banks are not comfortable providing financing to these operators or cannot move quick enough.
It is this gap between banks inability to move quickly and the needs of private investors who can find and rehab and sell properties that creates the opportunity for savvy investors, who know what they are doing and can identify the right operators to make higher returns through private money lending secured by real estate.
Investors who want to diversify, earn higher returns than banks and bond markets, and put idle money to work can lend their own capital to other investors if the borrowers have the experience and track record to find good projects and renovate them to create value.
Private investors usually lend when the private loan is secured with a mortgage against real estate, so it’s backed by valuable real estate collateral. To the investor, it offers some of the underlying security of and profit potential as rehabbing or wholesaling, but without acquiring properties and with less risk since the private loan is in a senior position compared to the equity that the sponsors or developers are bringing to the project.
Private money loans generally charge higher rates than banks, but they are used as an alternative when a combination of speed and flexibility is critical to the borrower. The speed of implementation is the key here, because for the fix-and-flip borrowers it can mean the difference between closing on/or losing a deal with a lot of profit at stake.
Private debt opportunities are generally created when the borrower has good collateral, usually valuable real estate and has an urgency to borrow or is dealing with time-limited special situations. Generally, private loans are originated within one to four weeks, as opposed to most banks that require two to three months along with income and credit checks.
The borrowers who are sourcing funds from private lenders are typically doing so for one of the following types of real estate projects:
- Fix/Sell: Loans to investors who are buying real estate at a discount to fix and sell at higher prices. They pay higher rates for short-term loans secured by their real estate projects because they need to move quickly to buy from a discount seller. If you have you ever seen the signs “We buy houses for cash” in and around your area, these are generally posted by real estate investors looking for fix and flip opportunities. In most cases, they will have relationships with private lenders to fund any opportunities they fund to buy the property, improve it and sell it (flip-it).
- Fix/Rent: These investors generally purchase a residential property and complete renovations with the intention of renting the property for cash flow purposes. Once the property is rented and “seasoned” with a few months of rental payments, the investors can generally refinance at a lower interest rate and pay back the private lenders with interest.
- Builders/Developers: Builders and developers will purchase vacant land to permit and develop into residential or commercial use. Borrowers in this sector are interested in private money primarily based on the speed with which the funds can be accessed. Also, many banks will not lend on speculative development. This area usually has more risk and somewhat longer time frames for private lenders than fix and flip of existing properties, so the returns and interest rates can be higher.
- Commercial Investors: This population of real estate investors may seek to use private money as a “bridge loan” for a commercial property when a conventional bank will not lend on an un-stabilized asset. They will invest to stabilize the asset which may require some reconstruction or repositioning and then refinance from a bank at lower rates to pay back the private lender.
- Buying secured loans from banks: The loans may be performing or non-performing and the bank can sell the loan at a discount. Buying existing loans from banks or other investors is a specialized area. These loans are generally collateralized so an understanding of the collateral value is important. Sometimes, the loans are purchased with the idea of foreclosing on the underlying collateral in a so-called “loan to own” scenario.
- Mezzanine loans: These can also be backed by investment real estate where we provide some additional loan amount between the more senior bank loan and the equity owners of an income producing real estate project, effectively allowing a project to reduce its amount of equity needed and increase the leverage (and returns) available to the sponsors.
You may be asking yourself how all this translates to getting 6% – 8% returns. Well, private loans allow lenders to negotiate exactly how much they will charge and the terms of when they will be paid back. As long as the property is being used for investment purposes, it falls outside of the Dodd-Frank Act and allows the investor to determine the interest rate or loan terms that are agreed upon between both parties.
The majority of private loans provide a return to the lender/investor from two sources:
- Interest Payments: The most common set up, you can set an interest rate at the time of the loan approval and wait for the money. Interest rates to private loans backed by real estate are generally much higher than the rates banks charge.
- Points: These are fees paid by borrowers upfront to originate the loan. Generally calculated as a percentage of the overall loan value, with one point referred to as 1% of the loan. Points are often paid at the beginning of the loan term as an incentive for granting the loan.
- In addition to interest and points, some private loans may have other structures that can be sweeteners such as:
- Profit share: Investors can sometimes negotiate to a receive a percentage of the final profits, the amount will vary based on the contract and the investment. Since profit is less certain that interest, most lenders stick with interest payments
- Exit Fees: Requires the borrower to pay a predetermined amount at the end of the loan term, it is often negotiated as a percentage of the overall loan sizet. You can even negotiate an increasing exit fee that changes depending on when the loan is paid in full.
The main pro of private money lending is participating in the real estate market passively while receiving a steady and predictable income funded by the cash flow that comes from the loan payments. The main cons of private money lending are the risk of borrower default, having to taking legal action to recover interest or principle can be a timely and costly hassle, and also the illiquidity of having private loans, you may have to wait until they mature to get your principal back.
Who can be a private money lender?
- Investors with cash or investments looking to generate predictable income.
- People who have a sizable retirement savings account.
- People who can convert a traditional IRA or 401k plan into a self-directed IRA plan.
- People who may be more risk averse and are uncomfortable with stock market fluctuations
If the idea of making 6 to 8% returns from lending against real estate sounds appealing to you, the first step is to figure out how much you are willing to lend and how much would be appropriate to put into private loans given your overall situation.
Obviously, it is rarely a good idea to put your entire portfolio into just one area or one category. Rather, its still important to follow sound principles of investing and diversify your funds across different investment opportunities to mitigate risk.
Private lending is a specialized area with a learning curve just like any other. If you are going to be a private lender, you need the right attorneys and access to borrowers who are worth lending to. You also need the ability to inspect and value the collateral and to monitor the progress of the borrowers project and rehab timelines.
Besides having the money and finding good experienced private debt borrowers with worthwhile projects, you would have to conduct due diligence on each investment and each borrower to determine the loan terms and finalize the loan. After each loan is originated and the money lent, the loan needs to be serviced, i.e. payments tracked and notices sent etc.