I recently got an unexpected lunch invitation. The most successful real estate developer I know made a beeline for me in the church lobby. He requested lunch as soon as possible.
We met for lunch the next day. We hadn’t even ordered when he started pouring out his heart:
“I’ve got a problem. I’ve been doing business with two banks for decades. One of the bankers has become a close personal friend.”
He paused with a pained, pensive stare at nothing.
“But they’re both acting…weird. They seemed nervous last fall. But now it’s more serious than that.”
He went on to describe how his favorite banker changed the terms and then outright canceled an approved loan days before closing a few weeks before. This deal had been in the works for well over a year. My friend had to make a painful phone call to the seller to sheepishly ask for an extension to a now-uncertain closing date.
He was meeting with me because he knew I invest in commercial real estate. But my friend didn’t need equity. He had that. He needed a new source of debt.
“I’m done with banks,” he said. “I’ve got to find a private lender I can trust. We’ve got a series of land acquisitions in the works, and I will not be screwed again!”
“It was the managers who should have been wearing the ski masks.” – Warren Buffett, referring to savings & loan associations in the early 1990s.
I didn’t expect this. As I said, this is no small developer. This three-generation professional operation does large deals with Ryan Homes, D.R. Horton, etc. One of their upcoming developments is platted for 8,000 residential lots, and 1,000 are presold to a national homebuilder.
I would have been surprised…if I hadn’t seen lenders pull back in the last cycle. And the one before.
It was ironic timing because I was planning to sit down to write about our newest operating partner and investment that day.
Investing in a Private Debt Fund
We’re not investing in banks. And we’re not looking to finance loans directly.
We’re partnering with a seasoned operator to invest in a portfolio of commercial real estate loans.
Before I tell you more about them, I want to tell you why.
In the Great Financial Crisis, seasoned investment professionals hedged their portfolios with debt and preferred equity, while most “regular” investors ran for the hills. The pros invested in assets with current cash flow and a safer position in the capital stack. And they created a lot of wealth for their investors.
As investment managers, we made a commitment that our fund would have two top priorities:
- Safety of principal
- Predictable cash flow
These are followed by growth and tax advantages.
Fund managers have struggled for the past 12 to 18 months to find investment opportunities that meet these criteria due to market conditions. I admit we’re in that same boat.
We’re pleased with the investments in the fund so far, and we painstakingly vetted each operating partner for safety.
But a few of those investments have limited cash flow in the first year or two as value is being added. So, we looked to people like Warren Buffett and others to observe their practices about how to hedge our portfolio with fixed income.
We discovered the fixed-income component we were looking for in the form of private debt. And we found the appropriate vehicle through our latest operating partner.
Our Private Debt Operating Partner
The founder, a third-generation real estate developer, has created an organization that we believe is uniquely positioned for this role. Between 1988 and 2009, the founder successfully developed over $350 million in commercial and residential real estate projects.
So, unlike most banks and other private lenders, this firm can intelligently evaluate deals, and, as importantly, we believe they are in a position to step in to take the project to completion in the event of trouble. This was a critical condition for us, and it is vital in times of uncertainty like we’re in now.
This group is not your typical local private lender. The track record in the fund we invested in includes:
- Safety: Zero losses from inception in 2009 to date across 128 paid-off loans.
- Scale: 196 loans totaling over $4 billion.
- Alignment: The two founders invested $20 million of their own cash in their fund.
- Yield: Annualized net yield since inception is 12.9%.
- IRR: Weighted average gross IRR for paid-off loans is 19.9%.
If you are puzzled by the high IRR, realize this: In addition to charging points, private lenders often release cash in draws as needed. But the borrower pays interest on the entire loan amount for the entire loan in many cases. This could allow a 12% loan to create a 19% IRR, as an example.
Our partner employs rigid due diligence criteria, even re-creating the design and the budget from scratch before approving the loan. They do a value analysis, reviewing the location, design, layout, and overall economics, including cost versus potential value.
As a licensed general contractor, they can step in to finish every type of project they lend on, if necessary, potentially increasing profits to investors.
Over 30% of their borrowers are repeat clients. Developers appreciate them because, unlike banks, they can close on a project in four to six weeks.
And private loans may not cost as much as I thought. My developer friend and I did some quick math, and he realized that a loan like this would only cost him about $250,000 extra compared to his nonperforming bank, which seemed to him like a drop in a bucket for a deal projected to profit $7 million to $8 million.
Sample Full Cycle Loan
Here is one of many successful deals our private lending partner completed in the middle of the pandemic. This was a $19.8 million construction loan on a six-unit multitenant retail building in Temecula, California.
For context, this operator’s worst deal generated a 9.7% gross IRR, and the operator’s best deal generated a 113.9% gross IRR. As with all investing, past performance is no guarantee of future returns, and there are other risks of which you need to be aware.
Speaking of cash flow…
By now, most of us have heard about funds and syndication cutting or stopping distributions and doing capital calls. We take no pleasure in this, especially since many investors are being harmed.
Hedging your equity investment with debt is no guarantee of success. Debt and equity holders were harmed during the Great Financial Crisis, as many of us recall.
But I don’t believe this is 2008. And I do believe that a safer position in the capital stack, with returns that rival equity, will be a great move for many of you.
You should note that investing in debt will not provide the tax benefits enjoyed by equity investors. But debt investments often provide liquidity, a good trade-off for some.
Liquidity means investors can theoretically enjoy the cash flow for a while and then exit when they locate suitable equity opportunities. If this downturn goes like others, we may expect to see some distressed opportunities at bargain prices within about one to three years. This is a Warren Buffett strategy, one that works for real estate as well as stocks.
Maybe even better.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.