I learned this lesson the hard way beginning back in 2007. Actually, I didn’t really grasp it in its entirety until much later, but it was eventually learned and it was painful.
Back in 2007, times were a little nuts. This was when real estate was flying and there were hard money lending deals that seemed safe as could be. One of those deals was a 21.5-acre site of vacant land near the base of the famous Squaw Valley Olympic Ski Resort.
Very long story short, Steve and I were part of 65 investors who lent $11 million on this piece of land that was appraised for $37 million. Then, the economy melted down. The $37 million turned into $4.5 million. Yuck. This is how Steve and I got to know each other. We ended up taking over the management for this investment, trying to produce the best outcome for everyone involved.
Fast forward 6 years later and we’ve foreclosed and sold the property through a very painful and frustrating process. So what does this have to do with income producing property? Everything.
Everything we do today stems from this lesson and other similarly painful experiences of owning vacant land. Despite how much it is worth on paper, vacant land produces nothing but expenses. You are always at a financial loss speculating on what that land may sell for in the future as it is extremely unknown, unpredictable, and at the whims of economic cycles that can take decades to come full circle.
It is not just the expenses you encounter either, it is the opportunity cost of your money. What could your money have been doing for you, if it was not tied up in a real estate deal like this? Having $11 million tied up for 8 years, using an 8% return per year, cost us and the other investors $4 million in opportunity cost on our money.
As Steve and I built our first fund, ROI Strategies, we built it with all of these painful lessons in mind. There isn’t a time we don’t ask about what this investment would look like if we were to have another economic downturn, or worse yet, another meltdown. We now know the way to protect our investment funds is to build them around income producing properties – more specifically, those such as single family homes in the lower price ranges. These properties can and will be able to produce income through any real estate cycle, even if it is less than you might wish for. Our newest fund, Guardian, was created with this criteria in mind.
It is great to make nice returns on your money, but it is even better to always protect your principal. As we have talked about before, protecting your principal must be your number one goal. An opportunity to make larger returns in exchange for less safety is a fool’s game. Trust me, I have played it and lost. I’m sure I’m not telling our readers anything you don’t already know.
However, it is not always black and white. A couple weeks ago, I was meeting with a family who was interested in investing in Guardian, and they asked a lot of good questions. As part of our time together, I like to get know what people are already investing in. In this case, they were investing in a few projects as hard money lenders.
I know many people really like this type of investment, but I have come to the conclusion that they like it because of the familiarity of it, and not so much the experience. Most of the projects involved in those investments don’t include income producing real estate. It’s usually real estate that needs to be rehabbed, built and sold, or leased before it becomes income producing. That is a fine business model until… the economy cycles into a downturn.
The borrower will immediately be placed into a situation of having an unviable project that is not completed. The lender is now in the same position. If the borrower walks, the lender can take it back, but it is almost guaranteed that the loan-to-value will evaporate overnight. We are back to where so many investors were starting in 2009, including Steve and I, owning property with no income and only having expenses. This is a huge pain to manage and leads to years of opportunity cost losses.
There is so much more to talk about on this subject. I know everyone that is acting as a hard money lender on non-income producing properties has discounted my story here in their mind, but maybe it has gotten a few people to think a little more about what their true risk is with their principal and investment. If you would like to discuss this further, get in touch with me. I would be glad to share more of what I have learned with you.