by Dennis H . Doss
This discussion is educational material, not legal advice. Consult a knowledgeable lawyer before implementing any of the ideas in this article.
Is it time to think outside of the box when structuring private money mortgage funds? In the traditional mortgage fund we have created hundreds of times to house private money mortgages, the pool manager collects payments on the mortgages in the fund and from that cash flow first pays the manager an asset management fee. Second in the waterfall is the payment of a preferred return to the fund members (private investors), say 7%, and to the extent that there are profits in excess of the preferred return, splits those profits with the members, say 50/50. The manager does not guaranty any return; the return to the investor is wholly dependent upon collection of the mortgages the fund owns.
Some private money mortgage funds go to a bank to obtain a credit facility, pledging the pool’s mortgages to secure a line of credit. The cost to the fund is typically in the 5% to 6.5% range, which is below the pool’s preferred return. This cheaper source of capital increases the yield to the members.
A show of hands in is order: who thinks banks are reliable? Who feels confident their bank will not undergo a “change of policy” while the credit facility is outstanding and demand repayment? Typically you can negotiate a one year wind-down period. But is that enough time? And how do you replace the lower cost of funds to keep the members interested in your fund? If they lose interest, your fund will be inundated with redemption requests—you will have to cope with a “run on the bank.”
There is a simple solution—a private money senior debt class at a low coupon, say 4.5%, collateralized with $2 of mortgages for every 1$ borrowed. This solves the fickle bank risk. It reduces your risks for reasons I will explain. The debt class gets paid out of loan collections before anyone else gets paid. If the average loan-to-value in your pool is 70% the effective loan-to-value of the senior debt class is only 35%. In other words, real estate would have to decline 65% before the debt class suffered a loss! Possible, but not very likely.
“Winter is coming,” the actors in Game of Thrones frequently say—it’s just a matter of time. What kind of investor would take a 4.5% investment that is super secure? Simple–those that are risk averse and can’t survive a financial winter like the one that began in 2008. They are the investors that never want to get a phone call from you telling them there is no check coming to them this month. Some investors depend on the cash flow of their investments to pay their bills. They can’t afford to wait out a down market while you liquidate real estate. They need the money to live and it’s your job to respect that and plan for it.
What benefit is there to YOU to sell 4.5% debt to private investors? First, it is probably the most suitable investment for the investor who depends on cash flow to live. So you can pat yourself on the back for doing the right thing. That’s worth something including a better night’s sleep knowing your weakest investors are the most protected. Think twice before selling a normal fund membership to a weaker investor, even one that is accredited. If you do sell them a normal fund membership and financial winter sets in, how will you cope? Will you want to answer the phone? What about the attorney letters and eventual lawsuits? Will Cabo San Lucas start looking like the place to relocate?
Think too about your stronger, normal fund members. They get to enjoy the enhanced yields from the lower cost of funds that leverage provides. They can ride out the storm just fine. In addition, if they whine when a downturn sets in, which is only a matter of time, you can turn to them and say: “I offered you the senior debt piece but you passed.”
Doss Law, LLP has created hundreds of mortgage funds over the past 20 years and has always been on the leading edge of the private money market. If you need help to creating a new mortgage fund or to modify an existing one, please give us a call—and sleep better at night.