I had a friend recently ask me about hard money loans. I lend money as “hard money”; this constitutes about 33% of my investment portfolio. It’s hard for me to talk about hard money without backing up a bit and putting it in a broader context. And disclaimer; this post is going to be a very 30,000 ft birds eye view. I’m not fleshing out a lot of important details here.
Gurus like Mr. Money Mustache say all we really need to do is put our money in index funds. Which I would mostly agree with. Over the next 50 years, it’s unlikely any of us can beat index funds by our own “super smart” “active investing.” However, I see things a little bit differently.
First, I am self-employed. My income isn’t guaranteed. And I REALLY want to avoid going out and getting a “real job.”
Second, I am raising my kids NOW, not in 50 years. It’s more important for me to ensure the next 10 years freedom, than to ensure I’m free in 50 years. If I can preserve my freedom for 10 years, even if that means I don’t maximize my long term profit, that’s a trade off I’m happy to take.
So that brings us to what I call “Income investing.” Income investing isn’t just investing so that I get my 7-10% stock market returns over the long run. The stock market could have a crappy next 10 years, for all we know. It may all even out eventually, but the next 10 years could be down. That means I can’t use the income now.
Income investing basically says the following: I’m OK giving up some potential for principal growth, in return for a safe and steady income now. Yes, there is some income to be had even in index funds – around 2-3% in the form of dividends. But if you aren’t super wealthy, 2 or 3% of a nest egg doesn’t amount to much income. Dividend growth stocks work the same way – your Coca Cola’s, or Boeings, or Johnson & Johnson’s don’t pay much more than 3-4%.
So, there are a few strategies I use to gain more income. I generally look in the neighborhood of 6-12% as being ideal. And I’m willing to give up some principal growth to attain that income. Remember, right now I’m mainly focusing on the 10 year horizon. And yes, I do own growth stocks and index funds too. We are just talking about the income portion of my portfolio.
The very best income ivnestment I have is my duplex, which I bought in the market crisis in 2012. This thing is a cash cow. It makes me 10-15% cash-on-cash return, and that’s not even counting the appreciation it’s experienced, the tax depreciation I get to take, and the amortization (paying off) of the loan. In short, this duplex has been badass! Of course, the duplex does have some issues. It takes a lot of time and headache to manage. I do enjoy this time and headache much of the time, it’s a fun project. But I am not sure I’d want to own 10 of these duplexes.
So that brings us to more passive income investing, of which I partake in several types. We’ll look at hard money last.
First, preferred stocks. These are a special type of stock where a really solid company like JP Morgan Chase says to the investors, “we’ll pay you a huge dividend of 6 or 7%, but you never get to grow your principal.” I love preferred stocks and own a lot of them. There are some risks, including interest rate risk. But these stocks are senior to common (regular) stock, so as long as the company stays afloat, they are very safe.
Second, covered calls. This is a fancy stock option trade that basically works the same way. You get an income but give up upside potential. I don’t do much of this anymore because it is very labor intensive. While I’m happy to put labor into the duplex because it is a stellar investment and kind of fun, the covered call plays aren’t that fun for me and they have less return.
Lastly, hard money loans. This is basically where you play the bank to people who can’t get loans from the bank because they have bad credit or they are doing some kind of business / real estate deal that banks don’t like. As such, these can be risky deals. They are, however, safer than owning equity in many types of real estate, because debt is higher in the capital stack (higher seniority) than equity. In layman’s terms, this means that if the market drops 10%, equity holders will take the hit before debt holders.
There are some rules to hard money lending which will prevent many people from participating. First, you aren’t allowed to loan money to people against their primary home; all the deals have to be against investment property. And second, and this is a big one, in order to do most hard money lending, you have to be an “accredited investor,” which means you have to meet certain government guidelines for being rich enough to participate. I think this is a super dumb rule; the government shouldn’t assume that rich people are “smarter” than less rich people, and anyway, the government shouldn’t even have a say in how we invest — way too much big brothering if you ask me. Harkens back to, “don’t tread on me.” But anyway, we have to follow the law. So to become an accreddited investor you have to have an annual income of more than 200,000 / year, OR you have to have assets (not including your primary home) of greater than $1M. Yes, this rule will cancel out many people who would want to do this.
There are two ways to do hard money lending, and I do a little of each. You can lend to individuals, through a broker. I have one loan out that is secured against collateral of two buildings in South lake Tahoe; a house and a commercial building. The loan pays 10%, and they haven’t missed a payment in the 4 years we’ve had the loan out.
There are some disadvantages to doing these individual loans. If they default, you sort of have to handle things yourself and pay for attoreyes, etc, to get your money back. But even worse, if they pay you back and everything goes as planned, you still have to then get your cash back and look for another loan. Between looking, headaching, time involved, etc., let’s say your money is only invested 50% of the time. That means your real annual return is only 5% instead of 10%. So I reserve these kinds of individual loans for only the best situations.
The second way to hard money invest is with a manager. This manager pools investors together, so there is a lot more money to invest, But more importantly, it gives you a lot of diversification. If you put $20,000 into a $100,000,000 pool of 300 loans, you instantly get a slice of ALL the loans. So if they have 300 loans, you own a bit of each. If one defaults, you only lose one of 300. Also, the manager handles all the headaches; it is totally passive to you. I love this structure. Diversification and passivity. Of course, there are downfalls. One of the downfalls is that you have to trust management. They may be crooks, or they may just not care as much as you do, or who knows, a tornado could knock out their headquarters and you could be left with no one to manage the fund. Also, you worry about geographic diversification; what if their 300 loans are all in downtown seattle and a tidal wave takes out the city.
For this reason, I try to spread out my hard money loans into several different managers in several different locations. Right now, I have done this with 3 managers, one in Tahoe, one in Seattle, and one in Colorado (though the Colorado one is under the same parent company as the Seattle one). They all send out monthly updates and keep us investors up to date on what the latest problems and victories are. And they all do pretty wide areas; the Seattle one does WA, OR, ID, and the CO one does CO, WY, AZ, etc. So I have some good management + geographic diversification. These are very illiquid investments, meaning you can’t always get your money out easily. (Note: For the Tahoe company mentioned above, I know the people who run it personally, and they’ve been family friends for years. This is the kind of credibility you might look for when you pick who is allowed to manage your money).
I generally do all of my hard money investing in my IRA’s, which requires that you go beyond simply having a normal IRA brokerage account such as Fidelity or eTrade. Instead, you have to establish an account with a “self-directed IRA,” which is another stupid hoop the government makes you go through. I use Quest IRA, who I like, but who has pretty high fees (though they all have fairly high fees).
You’ll note, if you read my blog, that you should do income investing in an IRA whether or not you want the income NOW or in RETIREMENT. It’s always better to do it in your IRA. In fact, I wrote an interesting article on this a few months ago (I’d link to it but I’m feeling lazy) and may article got picked up by some radio stations and other blogs because it was so important and apparently novel.
What I like about income investing is that if you don’t need the income, you can still reinvest it. You can even use it to buy index funds if you want to. I’m sitting on some cash right now from 2016’s income investing, and I can spend it, reinvest it, or let it sit there. It provides a lot of flexibility.
If you aren’t an accredited investor, you can do a version of hard money lending through the stock market; you can buy stocks that are publically traded that emulate hard money activities to some degree. Just be careful, they can be squirrly. Some of them use “leverage,” where they don’t just lend out your money, they lever up by borrowing more money, so their victories are sweeter but the risks are higher. That’s not my thing. I only do “unleveraged” income investing. You could consider buying into some REITs (real estate investment trusts) which are just like owning real estate, only through the stock market. Some of them, such as LXP which I like a lot, pays a 6 or 7% dividend and has good chances for appreciation. You could also buy LXP’s preferred stock. While I generally recommend staying away from MREITS (mortgage REITs), because they tend to be very risky, lately I’ve been dabbling in CMREITS ( long acronym!! Commercial Mortgage REITS). These are similar to hard money lending where you are providing cash for businesses and against commercial buildings, and you get paid a steady stream of income but there’s not much chance for capital appreciation, similar to hard money loans or preferred stocks.
Also, with new technology and the internet, there is a massive inflow of online based hard money lending operations. These are super promising and interesting. Because they are online, they can cut management costs, increase diversification, increase investor data, and even slice down minimum investment amounts from $20 to $100k down to about $2 to $5k. Some require you to be an accredited investor, some don’t. Some big names I follow in this segment include PeerStreet and RealtyMogul. You can hit up their websites and check out the real estate they lend against. If I do more real estate debt investing, it will likely be through one of these outfits. Right now, my portfolio is pretty heavy into real estate, so I’m not super keen on getting deeper into hard money loans. Don’t confuse these outfits with the consumer lending companies like Lending Club. I’m not a fan of lending club because it gives loans with no collateral. Hard money loans have the real estate as collateral so if the borrower stops paying you have some where to go to get your money back. The world of online lending via PeerStreet, RealtyMogul & many others, is a huge promising area and will likely reward investors handsomely. Similar outfits have popped up for index investing, such as Wealthfront; where certain little hassles are automated like tax loss harvesting.
So there’s my little primer on hard money lending. Feel free to ask any specific questions about this topic. And when you are new to this stuff, never put too many eggs in any one basket. I have my money spread out very thin over many of these kinds of plays, because I don’t have any dilusions that I’m a genius and can’t lose. Instead, I know I’m not a genius, and I can lose. So I want to make sure I’m not too exposed to any one risky area, whether that be geographical risk, interest rate risk, management risk, bear market risk, or bull market risk. And remember what your goals are; those will help steer investing choices. For example, if you are 20 years old and you only care about growing your money for when you are 60, you may just be fine with index investing. But if you are like me and your income is variable and your top goal is maintaining income integrity while you raise your kids so you can go camping and bike riding with your family instead of work your ass off, then maybe income would be more of a goal for you.
Please share any comments, questions, or promising discoveries you make, in the comments section!