Recession Planning Part 2/3 – Private Lending Opportunities & Risks

What we’re going to be talking about is the tightening of credit, because banks are losing deposits. They’re not lending. I liken this back to the recession. We saw similar activity. Before we started, I was talking about how I was doing a loan with Lehman Brothers on a commercial building. I said to them, it’s almost like you don’t want to loan the money.

I took my business elsewhere, when a regional bank closed within 30 days. And lo and behold, Lehman Brothers goes bankrupt a couple of months later. I just remember going, Jiminy Christmas, they just can’t say they’re about to go out of business.

A lot of banks are in that same area. We want to talk about the opportunities that that creates for you. At the same time, what are the risks involved with those opportunities? I’m going to hand it to you. What are the opportunities in this market? And what are you seeing?

Stefan: I think the immediate opportunity is you’re seeing investment funds that are stepping in to fill the borrowing needs of legitimate borrowers today, that like you said, it doesn’t feel like the bank wants my business, or they’re way too slow, and they’ve got a business to run. You’re seeing more and more funds step into that gap and begin to provide those lending needs.

Toby: The lending needs that you’re seeing, is it Joe Public or is it Amazon and other companies? Are we talking corporate bonds? Are we talking everything?

Stefan: The biggest opportunity (I think) are the lending to small- and medium-sized companies, as well as real estate–backed loans. These are funds, for example, that are lending as a first lien collateralized by real estate. They typically will specialize in one type of real estate fund that we invest in that does just real estate loans backed by residential real estate. There’s another fund that does predominantly commercial real estate.

Toby: Be careful with that one. Commercial is going to be a hot potato, hot potato, hot potato.

Stefan: One of the things that’s important is when you’re doing this kind of lending, if you’re lending now, you have the benefit of knowing that things have changed. You need to be smart about the risk that you’re taking.

A lot of these loans are done with relatively short-term tenors. You’re not locked in for 5, 10, 15 years. These might be funds that are investing in one- to two-year loans. That helps reduce the risk as well. A lot of these borrowers, again, they’re not distressed. They’re just stressed by the process of working with banks. They don’t want to wait forever to get the loan.

Toby: It goes like this. A bank, you get a deposit, you put your deposit in with the bank, they take that, they’re able to do fractional banking, they’re able to loan that dollar out. Let’s just say in a perfect world, they didn’t do that, and all they did is loan your dollar out to somebody else.

Deposits are shrinking. Their assets are shrinking as a result because they showed that as a deposit. Unlike the custodial account at a financial institution, where it’s your money and it’s bifurcated, in a bank, their assets are shrinking and they’re not able to loan.

If you are somebody who needs to borrow to grow your business, you’re in, all of a sudden, that weird situation where the bank is talking a good game but they’re not moving, you’re not getting the funds that you need. So you’re going to go to an alternative which is the private market, and that’s what you’re doing.

These funds that somebody would invest in, are they syndications? Is there something that I could do as an individual? How do I get access to these?

Stefan: They come in different flavors. They’re syndications, they’re partnerships, different structures of funds. That’s where it’s helpful to have a team to be able to come to, help you source them, and do due diligence on them. The theme is really where banks are struggling, there are new opportunities that are arising for investors like you and me.

The interest rates now are high enough that the rates of return now are attractive. If you’re making 8%, 9%, 10% with either monthly or quarterly distributions on assets that are not levered and where you have collateral, for a lot of people, they say, hey, this serves a good medium risk, medium return, I’m not looking to bet the farm, I just want to stay ahead of inflation, and I want to get some cash flow along the way. This can be very helpful.

Toby: We’re seeing this with folks that had, for example, real estate loans that were 2%–3%. They don’t want to pay them back, and they have the cash. Basically, they could be paying off that loan. Or they could put it out there to go generate some income.

Then they’re sitting there going, should I put it in that CD that’s paying me 4½%–5%? Should I put it in the money market that’s paying me 4½%–5%. Or should I do this? You’re getting 7%–8% returns. Is that the target in these?

Stefan: I think 7%–8% is very doable. If you have access to firms that specialize in this area, there are also ones that are making a little bit more than that.

Toby: Higher risk, obviously.

Stefan: Let’s talk about risk in one second. I want to first talk about the tax side of it. When you are making these returns, it’s also even more attractive if you can locate this asset inside your self-directed IRA, your self-directed Roth, or even inside your company. It could be a defined benefit plan or cash balance plan. That’s the other way that people have been benefiting from using this kind of strategy, because then you’re not paying tax on it.

Toby: Let’s say that you’re invested in a fund and you’re making interest, it’s ordinary income. If you could put that into an IRA, 401(k), defined benefit plan, or whatever, then it’s exempted. It’s not going to be taxed. Or it’s going to be deferred. It’s not going to be taxed. Or an HSA, let’s just throw that out. That’s the triple threat out there. If you don’t know what that is, health savings accounts are awesome, too. Only accredited investors, or can other people participate?

Stefan: Other people can participate, but I would say there’s still well over half. You still have minimum requirements.

Toby: That’s fair. You mentioned there were two opportunities.

Stefan: Actually, I’m going to go back to your comment about risks. I’m glad you asked about that. Any type of investment strategy has risk, and this is no exception. It’s important that you be smart about it.

Let me give you three different things to pay attention to. One is leverage. I see a lot of people out there who are adding a lot of leverage to the strategy because they’re trying to make 16%, 17%, 18%, 20% returns, but it’s because they’re adding a lot of debt inside that investment vehicle. I would be careful about that.

Toby: Don’t do that.

Stefan: Don’t do that.

Toby: You’re not a big debt fan.

Stefan: I think you need to be very, very careful with that.

Toby: They’re levering up because the cash on cash return looks better that way. You’re like, oh, this is even […].

Stefan: It makes it easy for them to raise money. People are like, oh, wow, this is great, I’m making a higher return.

Toby: But it’s higher risk.

Stefan: It works until it doesn’t, and then it gets really ugly fast. Personally, in terms of our practice, I don’t want to lose sleep at night worrying about that. I’m sure you’re the same, but most people don’t want to give up sleep for a few extra points.

Toby: What about the other opportunities? We’re sitting in a building here. I don’t know if it’s financed or not. It’s not my building. But let’s just say this building here has a loan on it. It’s 30% vacant now because businesses are not making employees come into the office. I think that’s probably pretty close to the vacancy rate. There are millions and millions and millions of square feet.

Stefan: It’s more than that, actually, Toby. I just looked at the most recent statistics. If you look at the top 10 US metro areas and look at the office buildings, their physical occupancy, which is reality, the leases can lag, but the physical occupants today, 50% still.

Toby: 50%? All right, all of a sudden you have a note that might not be performing, or it’s going to reset. I think we have over $1.5 trillion of resets coming in the next three years, which means all of a sudden, that debt is going to be much, much higher. The cost of that debt is going to be much, much higher. What’s the opportunity there? Are they going to be selling off these notes? Is there going to be an opportunity to come in and buy distressed notes?

Stefan: Yeah. There are two flavors of the opportunity. One, you’re going to have professional investors that are just upside down and walk away from it. That property will be taken over by a servicer, and that’ll then be sold at a significant discount. We’ve already seen some examples this year of that happening quite a bit. It’s happened with a couple of large scale malls. It’s happened with some big office towers in San Francisco most recently and including a couple large hotels, where the professional investors have just…

Toby: They’re walking away and they’re saying, we’re done. Here in Vegas, for example, I used examples of stuff that I dealt with. You had banks that took back a lot of properties. They foreclosed on those properties, but they weren’t in the business of being a landlord. They would just sit there with what we call it shadow inventory, all these vacant houses. We would work with the banks to maintain them.

A lot of investors just like myself said, hey, you know what? Let’s go out there, we’ll mow their lawn, we’ll make sure it stays clean, we’ll make sure that it doesn’t look like it’s a vacant property so you don’t get squatters. But they weren’t in the business of being a landlord, they were in the business of being a bank.

They’re going to dump those properties eventually. We were buying them up like crazy. Blackrock was buying them up like crazy. That was an investor who was salivating, saying, give me a bank tape. That was always the thing. Is that going to happen? Are there going to be these types of assets?

Stefan: That’s already starting to happen. If you think about it, those assets are failed assets. Think about how hard it would be to take that asset, go to your local bank, and be like, hey, I’d like to get a loan on this failed asset. Your local bankers are going to cringe and pull away from you immediately. Those often are sold all cash, which means there are fewer buyers, and those buyers have even more leverage in terms of negotiating lower prices.

Toby: How do we participate in that? How do I participate in that? If I don’t have a banking relationship, I don’t know. I’m not going to buy a building that’s in distress or whatever, but how do I participate if you’re like me?

Stefan: You just mentioned the magic word, that’s distressed. There are distressed investment funds that do exactly that. They either buy the hard asset, or as we were talking about earlier, they’ll buy that paper, the note from the bank at a huge discount. Because that bank has already taken a write off against that, so the bank will sell that paper for a significant discount. The funds will buy that paper, foreclose on the asset, and then either sell it or operate it for a little while.

Toby: And you can find these funds. You have access to these funds, I take it.

Stefan: There are a number of funds out there. We work with a number of them. It requires a little bit of sophistication because it’s a different process than normal. But it’s a very, very common strategy that’s been around. Every 10-15 years, we have a crisis.

Toby: Close with the cycle. It seems like it’s cyclical, and you keep dealing with it over and over again. Last time, the government screwed it all up by bailing out the banks. Instead of letting us just buy the notes and deal with the borrowers, the banks pretended to do the modifications, and they took the government money, and they hosed all their borrowers.

I know it because before the big bailout and after the bank bailout, we were doing modifications, and it was so much easier before the bailout. After the bailout, the banks lied to you through their teeth. They wouldn’t mediate.

Stefan: They wouldn’t work with you. No.

Toby: There was no incentive for it. The government got involved. Hopefully, the government stays on the sidelines and lets the market do what the market should be doing, which is, hey, there’ll be folks like you or funds that come in put together monies to go out and take over these distressed assets in profit as a result.

Stefan: It’s funny because the word distressed is scary. But don’t let it scare you, because if you’re on the right side of that transaction, it can be, in my opinion, less risky than going out there and paying a market price for some asset. You’re buying things at significant discounts in complicated situations, and that’s why you’re getting paid very, very well in those funds.

You have to understand, these funds do not pay out money every quarter or on a regular basis. The way these funds work is you make an upfront investment. You should count on having to hold that fund for three to four, maybe five years. It’s towards the end of that, where a lot of these realizations, the profit, then comes back to you, your principal comes back to you. It’s just a different style, but those higher return distressed investment-type funds, don’t expect cash flow along the way, but they’re significant opportunities.

Toby: You’re doing a long term play, because the market at this point in time is tight on the credit. Banks are suffering, banks are losing deposits. There’ll be more bank failures. They’re holding a ton of this paper anyway.

You’re going to see the credit markets tighten, and private individuals going to have to step in there. You’re going to see funds looking to take over the asset, and you’re going to see funds putting together lending opportunities where you can participate and you can become the lender. Hopefully, the government stays on the sidelines with these things. It would have been much better off for everybody, had they not done that. That’s my personal opinion.

Stefan: What happens is a lot of these deals start getting marketed, and you start seeing people trying to sell you an investment in a property that…

Toby: We’re already seeing it. You see like, oh, here’s an office tower. You could own a high rise and all this stuff. I’m like, it’s empty, isn’t it?

Stefan: There’s an old phrase, don’t catch a falling knife. It’s hard because the initial discounts look really good. It’s 30% off, but I just would encourage you to be, as hard as it is, say no more than you say yes. Just be patient. Wait for it.

This is going to be a slow-moving train wreck, not an overnight, oh, I missed it kind of deal. Don’t be afraid of saying no. Get an extra opinion if you need to, but don’t fall for the hype. The people that are patient and really wait for those opportunities tend to do better.

Toby: That’s good advice. Obviously, we’re just bringing up something that’s going to be an opportunity, and it’s making you aware so that you can take advantage of it and benefit as a result.

It just comes down to this. The market needs these products, and they need these funds, and they’re willing to pay for it. Normally, they go to source A which might be the banks that’s drying up, so they’re going to go to source B, which is you and me, as part of these funds. You’re going to get introduced to those funds through somebody like Stefan.

Find a fiduciary who is a money manager and get access to these things the right way. Don’t go out there and look on the internet and see a soup du jour. Be very, very careful about this and make sure that you have somebody that’s guiding you along the way. Thanks, Stefan, for coming in. It’s pretty enlightening.

Stefan: Fun to be here.