June 12, 2024
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Alternatives Within the Alternative Market Real Estate Debt Fund

A look at one more alternative investment for your IRA.

The boundary between traditional and alternative markets is becoming increasingly blurred, as many institutions today are expanding their product offerings to include alternative-type funding to generate higher yields. Alternative investment options can include private equity, venture capital, managed futures, art, antiques, crypto, commodities, derivative contracts and hedge funds. 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 include a diverse range of assets and methodologies and are a potent tool for assisting investors in achieving growth and diversity while reducing volatility.

 

Real Estate Alternative Investment

Among investment alternatives, real estate is typically deemed an appealing asset class because of its ability to appreciate in value over time, serve as a natural inflation hedge, and generate a consistent stream of cash flow. Real estate, though, is a broad term that comprises a variety of subsectors, each of which offers a unique set of investment options. On a macro-level, commercial real estate is categorized into several groups, including office, lodging, retail, manufacturing, warehouse and residential properties, among others. These sectors are further categorized into sub-segments based on asset quality, asset use, unit count and government sponsorship. For example, in the residential sector alone, sub-segments include single-family, multifamily, mixed-use, best quality, low-end and government-sponsored housing.

During the past two decades, I have had the opportunity to be an active general partner (GP) investor in several residential real estate markets, including residential development in the metro area, acquisition and management of multifamily properties, and the compilation of single-family portfolios in Midwestern states, which were sold as a package a few years back to real estate investment trust (REIT).

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 (IRR); and some assets generate cash flow. However, equity investing does not come risk-free. For example, investment in Class B multi-family properties or single-family homes are considered to be 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.)

More than once, I was asked to assist individuals who had purchased a single-family home somewhere in the Midwest. They were promised a double-digit annual return, only to realize that they were not making any return at all. Instead, they found themselves needing to inject additional equity to maintain the property in a livable condition and avoid city fines due to the lack of upkeep. Dealing with vacancy, turnover and the costs of repairs and maintenance can quickly erode any profits. As a result, they had reached a point where they were even willing to sell at a loss just to avoid dealing with the ongoing issues of the property.

Development brings with it a whole new set of risks and liabilities, such as finding a dependable general contractor (GC), monitoring the cost of materials, identifying the right moment to sell, and more. (Investment in this asset class via IRA is more complicated.) Through my own experience in development, I’ve learned the significance of working with professionals (GC, project managers, advisers) for the project’s success. However, even then, you can experience unforeseen scenarios (neighbors, building departments, weather) that can affect the project.

Finally, all equity investments in real estate have two inherent drawbacks, the first of which is that use of leverage (bank financing). This means that the investor’s IRA equity is always second to the bank’s interest in the transaction. This becomes an issue especially in the present environment, where investors have floating rate loans and encounter difficulties in refinancing their properties or managing the burden of substantially increased monthly payments. Today, positioned as a lender, we are seeing how some borrowers are finding it difficult to refinance projects with maturing loans, and they are now required to come up with additional equity for each project rather than be able to pull money out, as they had in their original business plan.

Second, real estate is typically a long-haul investment and is therefore generally illiquid as compared to equities or bonds. This can potentially be challenging if you are nearing retirement or must take required minimum distributions (RMD).

 

Debt Investments: An Alternative Within Real Estate

Investing in real estate debt (e.g., as a limited partner investor 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 backing the loan, the duration of the loan (exposure to time), the safety and security of the loan and the leveraging of the fund.

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 and 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 the ability to create new business opportunities.

A common need for a bridge loan is quick financing. When a real estate investor comes across an opportunity to acquire a property but needs it closed quickly, bridge financing is a solution that is cheaper than an equity partner and allows the developer to close in less than 10 days. In other instances, developers want to refurbish or stabilize the property and increase its cash flow, allowing them to maximize the value before seeking permanent financing. Also at times, the developer intends to fix and flip the property, so a bridge loan that typically does not have prepayments penalties is the optimum solution.

How does a short-term bridge loan work or when does it come into play?

The following are seven points to consider, and things you should know when investing in short-term bridge financing funds:

  1. 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 leveraged? The equity lenders require borrowers to put down (typically at least 20%) to provide investors a real cushion in case the market changes and values go down.
  2. 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.
  3. Hedge on inflation and interest rates: In today’s economy, where inflation is still being fought aggressively by the Fed, these short-term exposures provide a hedge against inflation and allow for quick changes in interest rates.
  4. High yield: Bridge financing funds yield a steady high single-digit return.
  5. Liquidity: Open-ended funds provide investors with real liquidity options, with the option of redeeming investments with only a few weeks’ advance notice.
  6. Cash flow: Debt funds collect monthly interest from borrowers, which enable the fund to make quarterly and annual distributions to investors.
  7. Low volatility. Unlike the stock market, the interest collected from loans generated produce a steady income that doesn’t fluctuate much.

In summary, while long-term ownership of high-quality real estate has proven to be a sound investment strategy (with the right manager being a critical factor), diversification into the debt market offers additional benefits to the IRA investor. Graphs of conservative debt funds will tend to have a constant steady monthly return.

Finally, as the saying goes, “Cash is king.” Having a steady flow of cash and a high degree of liquidity is priceless. Real estate debt investments, as an alternative investment for your IRA, provides several advantages, especially in the current economic climate.

Amit Stern is the managing partner of Arion Fund. He has over 15 years of experience in real estate, particularly residential development and management of single/multifamily portfolios. Before Arion Fund, he managed a $150M Eastern European real estate fund. Stern has a BA in biology from Yeshiva University, an LLB from Sha’arei Mishpat Law School, and is a member of the Israel Bar Association. He currently serves on the board of the Van Cortlandt Park Alliance.

 

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