Real Estate Debt Funds: An Alternative Investment for Your IRA
The boundary between traditional and alternative markets is becoming increasingly blurred as many institutions today expand their product offerings to include alternative-type funding in an effort to generate higher yields. Alternative investment options can include private equity or venture capital, managed futures, art and antiques, crypto, commodities, derivative contracts, hedge funds and more. The proliferation of Self-Directed IRAs has further opened the door to a vast array of alternative investing opportunities, as one can own assets in an IRA account that are not frequently included in a retirement portfolio.
While alternative investments are becoming increasingly popular among private investors, many still consider them to be an exclusive and narrowly defined class of investment opportunities. This could not be further from the truth. Alternative investment solutions are available in a number of formats and include a diverse range of assets and methodologies and are an excellent tool for assisting investors in achieving growth and diversity while reducing volatility.
Real Estate Alternative Investment Types
Amongst investment alternatives, real estate is typically deemed an attractive asset class that appreciates in value over time, serves as a natural inflation hedge, and can generate a consistent stream of cash flow. Yet, real estate is a broad term that comprises a variety of subsectors, each of which offers a unique set of investment options. At a macro-level, commercial real estate is divided into several groups, such as office, lodging, retail, manufacturing, warehouses, and residential properties, amongst others. There are also sub-segments within each of these sectors. For example, in the residential sector alone, sub-segments include single-family, multifamily, mixed-use, best quality, low-end, government-sponsored housing.
During the past two decades, I have had the chance to be an active general partner (GP) investor in several different residential real estate markets. I was a developer in the NYC area, specializing in residential developments; I have acquired and stabilized multifamily buildings; and I have compiled a large portfolio of single-family homes in mid-western states, which were sold as a package a few years back to a Real Estate Investment Trust (REIT.) Prior to that, I gained international development expertise by working in Eastern European countries on the construction of residential projects. In recent years, however, I have steadily switched my focus away from equity funding and toward debt financing alternatives.
On one hand, there are numerous advantages to being a property owner. There is long-term appreciation, investors generally expect to receive a double digit return on their investments, and some assets generate cash flow. However, there are some risks associated with equity investing as well. From my experience, single-family houses are more of an operational business, requiring the owner to be hands-on in order to ensure that the business is running smoothly at all times. Mismanagement can quickly result in significant reductions in cash flow and property value. The same is true if the property is owned in a self-directed IRA. Development brings with it a whole new set of risks and liabilities, such as finding a dependable general contractor, increases in the cost of materials, identifying the right moment to sell, and so on. If investing in this asset class with your IRA, you may need to get a non-recourse loan if you don’t have a large IRA.
Finally, all equity investments in real estate have two inherent drawbacks, the first of which is that use of leverage (non-recourse loan) means that the investor's IRA is always second in line behind the banks' interest in the transaction. Second, real estate investments are made for the long term and are therefore generally illiquid, as compared to equities or bonds. A majority of real estate investments have a lock-in period that is determined by the length of time it will take to execute the project. This can potentially be challenging if you are nearing retirement or have to take RMDs. Finally, even if you own a house outright, selling it can always be a lengthy and complicated procedure.
Real Estate Debt Fund Investments— an Alternative within Real Estate
Investing in real estate debt (e.g., as a limited partner investor (LP) in a debt fund) has its own risk-reward ratios to consider. To understand the risks and rewards of debt investment, one must carefully consider the real estate supporting the loan, how safe or secure the loan is, and whether the fund is leveraged.
An example of this type of investment is a short-term bridge loan. Short-term bridge financing products offer benefits to investors who are more risk averse and seek a solid annual return. While more speculative real estate investments may potentially offer double-digit returns, these real estate debt funds, especially conservative ones, tend to yield high single-digit returns, but consistently with low volatility.
Bridge financing focuses on loans that will be repaid or refinanced within a year. The loans are designed to meet the needs of real estate developers allowing them versatility to better manage cash flow and create new business opportunities. A common need to a bridge loan is quick financing. When a real estate investor comes across an opportunity to acquire a property but need it close quickly, a bridge finance is a good solution, (and cheaper than an equity partner) allowing him close in less than 10 days. In other instances, developers want to rehab or stabilize the property and increase its cashflow allowing them to maximize the value before seeking permanent financing. Also at times, the developer intend to fix and flip the property, so a bridge loan, that typically does not have prepayments penalties, is the optimum solution.
The following are seven points to consider and things you should know when investing in short-term bridge financing funds:
- Asset Backed: Are the loans secured by a real estate asset, i.e., a first position mortgage on the property (not a mezzanine loan)? Is the fund itself is leveraged? The equity lenders require borrowers to put down, (typically at least 20%), provide investors a real cushion in case the market changes and values go down.
- Short term exposure: Bridge financings are typically for a year which mitigates the risks of a longer financial cycle process. Bridge loan funds have the ability to adjust to market cycles and reduce the long-term risk exposure.
- Hedge on Inflation and Interest Rates: In today’s economy where inflation is circling and the Fed has yet to determine how it will deal with interest rates, these short-term exposures provide a hedge against inflation and changes in interest rates.
- High Yield: Bridge financing funds yield a steady high single digit return.
- Liquidity – Open ended funds provide investors with real liquidity options, with the option of redeeming investments with only a few weeks advance notice.
- Cash flow: Debt funds collect monthly interest from its borrowers, which enable the fund to make quarterly and annual distributions to investors.
- Low volatility. Unlike the stock market, the interest collected from loans generated produce a steady income that doesn’t fluctuate much. Looking back at graphs of debt funds that are conservative, they will have a constant steady monthly return.
Amit Stern, Managing Partner
Arion Fund LLC