The story of how I learned this lesson the hard way starts all the way back in 2007. In reality, I didn’t really grasp it entirely until much later, but once I did, it was very painful (but also very useful). Funny enough, it’s in this same story that I met Steve Sixberry, who later became Hughes Private Capital’s COO. Because of that, and the lessons it taught me, the experience wasn’t a complete loss, but it sure wasn’t fun at the time. We had to endure a long and awful process that left us with hundreds of thousands of dollars lost. However much I hated the steps that got me there, I like to tell this story so people can learn the same lesson without going through the stress and massive loss that Steve and I had to push ourselves through.
It begins back in 2007 when things were a little nuts. This was when real estate was soaring and there were handfuls of hard money-lending deals that seemed smart and safe as could be. I came across one of those deals: a 21.5-acre site of vacant land near the base of the famous Squaw Valley Olympic Ski Resort. Steve and I were 2 of 65 investors who lent $11 million on this piece of land that was appraised for $37 million. With that type of value backing up the loan, “What could go wrong?”
It would take too long to map out everything that went wrong in one post, so I’ll make a very long story short. The economy melted down. The $37 million turned into $4.5 million. Yuck. It was after the shock of this incredible loss that Steve and I got to know each other. We ended up taking over the management for this investment, doing everything we could to produce the best outcome for everyone involved.
Fast forward 6 years later and we had foreclosed and sold the property for $8.3 million through a very painful and frustrating process. While this story might be interesting, what does this massive loss have to do with income producing property? Everything.
Everything we do for our investors 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 ― which, in realty is unknown, unpredictable, and at the whims of economic cycles that can take decades to come full circle.
And, it is not just the expenses you encounter, it is the opportunity cost of your money. In other words, what could your money have been doing for you if it was not tied up in a long and unpredictable real estate deal like this?
When 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 ourselves 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 the return is less than you might wish for at some points. Every one of our investment options are 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 I have pointed out 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 you anything you don’t already know, but sometimes we need a reminder. This story works as a reminder for Steve and I every time we look at the investments we offer, and I use it as a tool to teach anyone who is looking to invest, not just in real estate.
However, it is not always black and white. Years ago, I met with a family who was interested in investing in our fund, and they asked a lot of good questions about their current investments and the benefits of our fund. As part of our time together, I like to get to 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 hard money lending investments, but after talking with so many on the topic, I find that most people feel this way because of the familiarity of it ― even if their experience with hard money lending does not support this positive attitude. The problem is that 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. Plus, you have no idea how or when the property will become income producing. Now you are stuck with an unpredictable investment that is not liquid — which means your money might be tied up when you may need it most.
Just think of it this way: the borrower will immediately be placed into a situation of having an nonviable 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.
Those who are acting as a hard money lender on non-income producing properties have probably already discounted my story 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.