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Warning: Real Estate Debt Funds Are Not All the Same

“Risk comes from not knowing what you are doing.”

— Warren Buffett

There’s a lot of confusion surrounding debt funds.

I used to be confused by them myself!

But as I’ve studied and learned about debt funds, I’ve come to find out a few things.

Some things I really like!

Others are a little alarming.

Many people invest in debt funds thinking they’re safe when they actually have a fair amount of risk.

One of the most important things in investing is understanding what the risks are.

Even venture capitalists take risk into account when investing.

According to this analysis of their investment activity, venture capitalists make many of their decisions based on expected return and perceived risk.1

Sometimes, we assume risks are very low in certain investments when they’re actually much higher.

What I like about debt funds is that they’re typically safer, especially certain types.

First position debt funds provide amazing cash flow.

As the saying goes: It’s only when the tide goes out that you see who’s been swimming naked.

This facet of investment won’t be without struggle.

We’ve had our fair number of struggling deals recently.

But through those experiences, we’ve really grown.

I hope the knowledge I’ve gained will help you today.

Let’s jump into it!

1. Do You Understand the Debt Position?

The first question I want to ask is: Do you understand the debt position?

This chart shows the different types in the capital stack.

If you look at the bottom, you’ll see senior debt.

Above that, you have mezzanine debt.

Then you get up to preferred equity and, finally, common equity.

As you can see, there’s higher risk the higher in the stack you go.

If there is some sort of issue in a deal, like a loss, who actually gets pinched?

It’s typically equity.

Equity usually has a higher potential upside, but debt is considered much safer.

If any losses happen, they usually happen on the equity side.

The second side is that mezzanine debt.

A lot of people think their investments are safe because they’re in a debt fund.

But that’s not the case.

We see people doing debt funds with flipper money (or other types of funds) and accumulating mezzanine debt.

Now, let’s look back at that stack.

It’s actually not all equity at the top.

There could be a lot of mezzanine debt or other types of bridge debt on the top.

Especially in a flipper fund, you are at the highest risk of losing money.

In most cases, the flipper doesn’t bring any capital to you.

You’re providing a secondary amount of money.

It’s semantics whether they qualify that money as debt or equity

But on the stack, you’re typically the highest.

If the value comes down, you could have a loss.

One example of this is multifamily.

We’ve seen national losses in multifamily value recently.

The rates have gone up and the values have come down in almost all markets.

It’s not uncommon to see a 20% to 40% decrease in the property’s value.

As a multifamily investor, that’s tough to see.

One of our Atlanta multifamily properties lost 42% of its value in one year.

The property was in the same condition with no changes.

Looking at the stack, if the equity position was there, that’s the most at-risk position.

No matter what you do, you’ll probably have some loss.

It’s important to remember that risk.

Let’s talk a little bit about first position notes.

If you’re in senior debt, you’re at the lowest risk of loss.

That’s partially because you’re seeing the highest returns.

You’re also at a low loan-to-value.

The loan-to-value is how much of a loan you get.

Being at a 50% loan-to-value means your investment is safe if the value decreases by 50%.

I know there’s some transaction costs involved in certain instances. 

But even so, it’s a much safer investment.

In the investment sphere, venture deals and private equity are on the risker side.

They’re high risk, high return.

On the other end, you’ve got things like money market funds and treasures.

They’re very safe.

Some consider them as good as cash.

It’s important to understand where you are on the stack when you invest.

2. Originators Matter

The second thing you should keep in mind is that originators matter.

Who originated that note?

Was it a group you know?

When did it originate?

It’s not necessarily how the note originated.

But you should keep an eye on certain situations.

This can include doing even the most basic market research.

According to this article in the Journal of Brand Management, market research benefits investments by:

A)   Increasing shareholder value

B)    Improving company performance2

The more aware you are and the more research you do, the better off you’ll be!

I am a big advocate for educating yourself, and this is no exception.

If you’re buying a distressed note, a much higher percentage of those will go bad.

For example, let’s say I’m getting a 15% return on a longer-term senior debt position.

In that scenario, you get a distressed note.

I would think the return has to be substantially higher.

You’ll need to assume some deals will go bad.

Maybe you’ll need a 25% to 30% return.

In order to find that magic percent you need, look at the history of these deals.

See how many go bad.

Maybe the senior notes are only 1%.

But distressed ones might be 10%.

There are people who work in that space that are really good at figuring that out.

Overall, though, there are two ways to come out on top in this regard:

1)     Work with a lending partner that originates the notes

2)     Do your own research to understand the notes

Both of those options provide a lot of safety.

3. Risk vs. Reward

The last thing I want to mention is the risk vs. reward.

When I was a newer investor, I saw a lot of investors claim deals heave up to 20% returns.

At the time, I believed that.

But in reality, you can put whatever you want on a page.

It doesn’t change what the projections are.

It doesn’t change the risk factors.

I have come to learn that there are things we consider very safe and things we consider higher risk.

Deals that have a higher reward often come with a moderate level of risk.

Unfortunately, things can change very quickly.

We’ve seen that happen even now.

Warren Buffett himself says: “The rule number one investing is don’t lose money.”

If you have a loss, it takes a lot of time to recoup that loss.

I’ve been looking at what I can do in the safer space that provides consistent return.

Can I get 10x or higher?

Can I find some exponential upside?

We try to look at those things.

Whatever you invest in, it’s important to look at debt funds and understand the risks.

All debt funds are not created equal.

Now I want to hear from you!

Do you plan to look into debt funds?

Let us know in the comments.

Before you leave, make sure to check out our special report about inflation investing. It shares the best choices to invest during an inflationary environment.

If you are interested in investing with us, we are happy to answer any questions that you may have. Join our investment club today and we will be in touch.

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Disclaimer: I am not your investment advisor. This is for educational purposes only. I am not giving specific advice on what you can do. I am simply giving my opinions.

Works Cited

1.     T. Tyebjee and A. V. Bruno. “A Model of Venture Capitalist Investment Activity.” Management Science, 30 (1984): 1051-1066.

2.     D. Haigh. “Connecting market research with shareholder value.” Journal of Brand Management, 7 (2000): 153-160.

Bronson Hill

Bronson used to work as a consultant for a medical device company but switched to investing in apartment buildings to make his money work for him. He started with a single rental property that made good money and, after some advice from a family member, moved into bigger real estate projects. Now, he's all about helping others get into this kind of investment to earn money without having to work all the time. When he's not dealing with investments, Bronson loves to travel, write songs, stay active, and help fight modern slavery through his work with Dressember. He believes in working smarter, not harder, and wants to share how that's possible with everyone.

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