{"id":181218,"date":"2025-02-24T13:11:56","date_gmt":"2025-02-24T20:11:56","guid":{"rendered":"https:\/\/www.biggerpockets.com\/blog\/?p=181218"},"modified":"2025-02-24T17:19:37","modified_gmt":"2025-02-25T00:19:37","slug":"debt-fund-investing-101","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/debt-fund-investing-101","title":{"rendered":"Debt Fund Investing 101"},"content":{"rendered":"\n

There is a rising interest (pun intended) among investors about the returns offered by debt funds, so I thought I\u2019d write an introduction to approaching investment in a private credit or debt fund. <\/span><\/p>\n\n\n\n

Why Invest in Debt Funds? <\/span><\/h2>\n\n\n\n

Debt funds often offer high yields, in the 8% preferred return range, with a profit share after the pref. They pay out regularly, are backed by debt that is often senior in the capital stack and is, on paper, a great potential way to turn a few hundred thousand dollars into a few thousand dollars per month in income. They are usually more liquid than many other types of private or syndicated real estate-related investments, with lockup periods of two years or less in most cases.\u00a0<\/span><\/p>\n\n\n\n

Debt funds typically pay out simple interest, so they are <\/span>particularly attractive<\/span> for investors who have, or plan to have, little in the way of realized income, who have or plan to have <\/span>large<\/span> losses that they can use to offset simple interest income, or who choose to invest in debt funds via tax-advantaged accounts like self-directed IRAs. <\/span><\/p>\n\n\n\n

I <\/span>personally<\/span> would be<\/span> greatly interested in using debt funds <\/span>as a tool<\/span> to meaningfully subsidize my healthcare costs<\/span>.<\/span> Imagine putting $50,000 to $100,000 of HSA funds into a \u201cself-directed HSA\u201d (yes, this is a thing), investing in debt funds yielding 9% to 11% simple interest, and then using any interest to reimburse healthcare-related expenses in early or traditional retirement. Any excess interest could, of course, <\/span>be reinvested<\/span> in the funds. <\/span><\/p>\n\n\n\n

Debt funds are likely a poor choice; however, they are for investors using after-tax dollars and earning a high taxable income. In most cases, effectively, all returns will be paid out as simple interest, and you will pay taxes at your marginal tax rate.\u00a0<\/span><\/p>\n\n\n\n

If you are reading this and earn $250,000+ as an airline pilot, for example, and expect to continue flying planes for five more years, then taking money out of the S&P 500 to pay ~40% marginal taxes on the interest makes little sense in most cases.<\/span><\/p>\n\n\n\n

Hopefully, this guide helps you think about the merits of investing in one of these vehicles and appropriately scares you about the risks\u2014even if you can invest in debt funds tax-efficiently, there is no free lunch in terms of high returns with little risk, and debt funds are no exception. <\/span><\/p>\n\n\n\n

Please note that the title of this article\u2014\u201cDebt Fund Investing 101\u201d\u2014is a bit of a misnomer. <\/span><\/p>\n\n\n\n

If you are reading this, you are considering investing in a private equity debt fund or syndicated offering. You are entering the Wild West, where the rules that govern publicly traded funds do not apply. You are in a world where there are, and will be, bad actors and where even the good actors can lose. If you don’t understand the basic terminology and language I use in this article, you should not be investing in a private credit fund.\u00a0<\/span><\/p>\n\n\n\n

I will not dumb down the language or pretend like this is something that should be accessible to novice investors.<\/span> Debt fund investing is inherently a 202- or 303-level real estate investing technique that, in my view, is even riskier than direct-to-borrower private lending.\u00a0<\/span><\/p>\n\n\n\n

You have <\/span>been warned<\/span>. <\/span><\/p>\n\n\n\n

Defining a \u201cDebt Fund\u201d for <\/span>the Purpose of<\/span> This Article<\/span><\/h2>\n\n\n\n

While a debt fund can technically invest in any <\/span>kind of<\/span> debt, from U.S. Treasuries to junk bonds, BiggerPockets, and <\/span>PassivePockets<\/span><\/a> investors typically are referring to the world of investing in funds that own or originate <\/span>hard money loans<\/span><\/a> or similar types of bridge or construction financing.<\/span> <\/span><\/p>\n\n\n\n

This<\/span> is distinct from<\/span>, say,<\/span> what our friends at PPR Capital do: purchasing both performing and non-performing notes of various types, including mortgages on single-family homes.<\/span> <\/span><\/p>\n\n\n\n

That\u2019s a topic for another day. I have not done extensive research on other types of debt funds, and this discussion is limited narrowly to debt funds backed by <\/span>hard<\/span> money or bridge loans. <\/span><\/p>\n\n\n\n

A hard money loan (HML) is short-term financing typically used to finance <\/span>fix-and-flip<\/span><\/a>, ground-up construction, or redevelopment. The term \u201cbridge loan\u201d can also apply to this type of financing and can be used interchangeably with \u201chard money loan,\u201d but \u201cbridge loan\u201d or \u201cbridge financing\u201d are terms more typically used to describe a <\/span>larger<\/span> project than the typical fix-and-flip. <\/span><\/p>\n\n\n\n

The recipient of the hard money loan is typically an aspiring or professional flipper who desires high leverage and has few other realistic or reliable options for capital (can\u2019t get a 30-year fixed-rate mortgage on a property that needs to be completely gutted, demolished, or needs hundreds of thousands of dollars in repairs, for instance). <\/span><\/p>\n\n\n\n

These loans are attractive to private credit funds and private lenders because they can charge extremely high interest\u2014like 2-3 points for origination and 10%-14% interest, on average. <\/span><\/p>\n\n\n\n

Debt funds will pool <\/span>a number<\/span> of these loans together, either by buying them from originators or originating the loans themselves. A common approach is for a hard money lender to have a business that originates loans and a second company that operates as a fund to hold or \u201cservice\u201d the notes, collect interest, and ensure repayment.<\/span><\/p>\n\n\n\n

An Example of a Hard Money Loan<\/span><\/h2>\n\n\n\n

A Denver flipper finds a property for sale for $600,000. They believe that a high-end flip that requires $250,000 and nine months of rehab can turn this property into a $1.1 million home. Our flipper has $200,000 available in cash. <\/span><\/p>\n\n\n\n

A hard money lender offers to finance the project for the flipper. The flipper brings $200,000 as a down payment, and the hard money lender agrees to lend the remaining $600,000 for the project. In the meantime, $450,000 of this $600,000 loan is made available for closing and permitting, and the remaining $150,000 is released in a handful of stages as the rehab work <\/span>is completed<\/span>. <\/span><\/p>\n\n\n\n

Our flipper pays 12% interest and two \u201cpoints\u201d ($12,000). At the end of the project, the flipper sells the property, collects a profit, and <\/span>the loan <\/span>is repaid<\/span>. <\/span><\/p>\n\n\n\n

This is how things go in the hard money lending world in recent years, a very high percentage of the time.\u00a0<\/span><\/p>\n\n\n\n

While the flippers don\u2019t always win and profit\u2014especially recently\u2014the lenders typically collect their interest and points and reportedly foreclose less than 1% of the time on these <\/span>types of<\/span> loans.<\/span><\/p>\n\n\n\n

The Risks of a Hard Money Loan<\/span><\/h2>\n\n\n\n

This<\/span> is <\/span>pretty<\/span> good business for a hard money lender!<\/span> Earning a 15%-16% annualized return on capital (including points and interest) is not too shabby, especially if you have a less than 1% default rate. <\/span>When I talk to debt funds, they all assure me that their default rate is less than 1%, yet somehow, I <\/span>just<\/span> don\u2019t believe this is true and\/or believe that when and if prices come crashing down, this rate of foreclosure will be much higher on a vast scale\u2014we will cover risks later.<\/span><\/p>\n\n\n\n

However, there is a reason for the high returns offered by hard money loans. <\/span><\/p>\n\n\n\n

Folks just beginning to explore the world of hard money lending and debt funds often come in with the na\u00efve idea that they are lending to a professional flipper with a neat, buttoned-up business plan, three full-time crews doing construction round the clock, and a thriving business model and unlimited quality deal flow. <\/span><\/p>\n\n\n\n

This<\/span> is not reality. I\u2019d estimate that there are less than 10,000 of these so-called \u201cprofessional\u201d flippers in the United States (if we define this mythical professional as a business doing five or more flips per year for the last three years <\/span>in a row<\/span>). My friend <\/span>James Dainard<\/span><\/a>, for example, is the exception, not the rule, in the world of home flipping. <\/span><\/p>\n\n\n\n

These flipping professionals are few and far between, and they are also the best possible clients for hard money lenders (and they often get better terms than those used in our example). A seasoned flipper is likely reasonably high net worth and relationship-driven <\/span>and would<\/span> likely take a massive loss on a project rather than default and kill the relationship with their sources of capital. <\/span><\/p>\n\n\n\n

These folks can lose a hard money lender\u2019s money every once in a blue moon, <\/span>yes,<\/span> but they are extremely low risk and likely get better terms than <\/span>what<\/span> the example used to describe our Denver-based flip example.<\/span> <\/span><\/p>\n\n\n\n

Many, if not most, of the borrowers of hard money loans, do not have the profile of a professional flipper. They are amateurs or journeymen in the flipping game, going all-in on the next flip. These borrowers are potentially worth lending to, but not without high interest rates, a wide margin of safety on the underlying asset, and an eyes-wide-open view that these folks can lose money (and a lot of it). <\/span><\/p>\n\n\n\n

These borrowers are also out of options. A hard money borrower has no other options <\/span>readily available<\/span> to finance the project. No cash, no HELOC, no traditional financing options, etc. An aspiring flipper should tap essentially every other source of capital, including borrowing against their 401(k), taking a HELOC, or <\/span>otherwise<\/span> looking at lower-interest personal loans before resorting to a hard money loan. <\/span><\/p>\n\n\n\n

It’s because they are out of other options, at least for reliable capital, that they are using hard money and borrowing at 2+ points and 12%+ interest.<\/span><\/p>\n\n\n\n

Hard money borrowers are typically not \u201cwealthy\u201d (though they are also typically not \u201cbroke\u201d). They are usually not \u201cprofessionals,\u201d although they may have at least one to two flips under their belt\u2014many hard money lenders do not lend to first-time flippers unless they get excellent protections, like larger down payments or tons of equity in the property. They <\/span>are usually using<\/span> high leverage to execute a high-risk, complicated business plan involving the trade-offs that real estate investors know well when working with contractors\u2014you can pick two out of three: reliability, speed, and cost. <\/span><\/p>\n\n\n\n

Despite growing caution in general from flippers, they <\/span>are often caught<\/span> with unexpected delays and costs inherent to the business of <\/span>large<\/span> remodeling or development projects. <\/span><\/p>\n\n\n\n

Hard Money Lenders Mitigate These Risks With a Couple of Common Tactics <\/span><\/h2>\n\n\n\n

First, hard money lenders are often themselves or employ former or current flippers. They are in tune with the local market, have a great handle on what a \u201cgood deal\u201d looks like, what the \u201cafter repair value\u201d on a potential flip is within a tight range, and at least when they get started in the <\/span>hard<\/span> money lending business, typically understand what local contractors will charge for remodeling costs and\/or have relationships with contractors. In some cases, the hard money lender is still an active flipper and has no problem foreclosing on a borrower and finishing the flip themselves as part of their pipeline if things go south.<\/span><\/p>\n\n\n\n

They can review business plans and feel comfortable about the margin of safety on most projects, and in many cases, get to know their borrowers well, with <\/span>good<\/span> amounts of repeat business. <\/span><\/p>\n\n\n\n

Second, hard money lenders will cap their loan amounts against the ARV (often 70% of the projected finished sale price) that they feel confident in and have controls in place to release funds as the project generally progresses against the rehab plan provided by the borrower.<\/span><\/p>\n\n\n\n

Third, hard money lenders will typically require personal guarantees\u2014these loans are often\/usually full-recourse loans and borrowers need to have reasonable credit scores and some net worth that they don\u2019t want to lose in the event of foreclosure. These protections may be less strict if the borrower has a very high LTV \u2013 for example, I once lent to a person with a poor credit score but with <\/span>a completely<\/span> paid-off asset at a ~50% LTV. <\/span><\/p>\n\n\n\n

Fourth, hard money lenders are usually the senior lender\u2014they have a first-position lien and no one else to deal with in the event of a foreclosure. <\/span><\/p>\n\n\n\n

Not all hard money lenders have these rules <\/span>in place<\/span>, but most do. <\/span>Some have more, and some take far more risk<\/span>, in my view<\/span>.<\/span> This<\/span> is a private marketplace, and the loans are private. Almost anything that the hard money lender and borrower want to agree to can and does happen, but as a rule, these controls are the most common. <\/span><\/p>\n\n\n\n

A quick tip: <\/span><\/strong><\/p>\n\n\n\n

I <\/span>simply<\/span> do not believe that a debt fund <\/span>that operates<\/span> nationwide or in many separate geographies can bring deep competence in analyzing the risk of the underlying <\/span>hard<\/span> money notes.<\/span> I would not invest with a credit fund that did not have geographic concentration on this type of lending process<\/span>, and I<\/span> would not invest in a credit fund that was massively complex in this specific type of lending ($500 million+ in AUM on notes averaging less than $1 million in size), as I believe that the risk of management buying garbage notes where they don\u2019t <\/span>really<\/span> know what they are doing is too high. <\/span><\/p>\n\n\n\n

If a fund gets <\/span>huge<\/span>, with multiple hundreds or thousands of notes, then the only way for me to believe that they are credibly keeping risks low is if they get so conservative in underwriting that the returns won\u2019t be worthwhile. If they have conservative underwriting and vast scale but the returns are high, then I\u2019d worry that they are playing games with the debt fund\u2019s capitalization structure (we\u2019ll get to this later) that I don\u2019t like. <\/span><\/p>\n\n\n\n

And if a fund is on the verge of convincing you that they have <\/span>extremely<\/span> conservative underwriting, national scale with hundreds or thousands of portfolio loans spread across the country, offer <\/span>extremely<\/span> high returns (12%+), and have no fund leverage<\/span>, then you<\/span> are likely getting ripped off or scammed. There\u2019s no free lunch.<\/span><\/p>\n\n\n\n

Over the past 10 years, I have seen several of these national funds <\/span>seemingly<\/span> grow rapidly and then <\/span>appear to<\/span> evaporate.<\/span> <\/span><\/p>\n\n\n\n

To mitigate the risks of geographic concentration (e.g., the recent fires in Los Angeles or the hurricanes on the East Coast), I\u2019d also never put all the money intended for credit funds with a single regional sponsor, even if they checked every single box I could ask for in a debt fund. I want each individual debt fund to be an expert in their market and to geographically diversify myself by placing money with funds in different regions, for example.<\/span><\/p>\n\n\n\n

Let\u2019s get back to it.<\/span><\/p>\n\n\n\n

Let\u2019s Zoom Out to a Hard Money Lending Business<\/span><\/h2>\n\n\n\n

A successful hard money lender will quickly <\/span>run into<\/span> a problem with a business model like this. <\/span><\/p>\n\n\n\n

Remember that loan of $600,000 to the flipper in Denver? <\/span>Well,<\/span> after we do that 10 times, we <\/span>now<\/span> have lent out $6 million.<\/span> After we do it 100 times (not <\/span>really<\/span> a ton of loans for a lender), we have $60 million in capital deployed. Many respectable hard money lenders have deployed $60 million or more in capital<\/span>, but few<\/span> of the owners of these <\/span>hard<\/span> money lending businesses have a net worth of $60 million or more to lend.<\/span><\/p>\n\n\n\n

For hard money lenders able to find reasonable borrowers, capital constraints become a problem quickly. <\/span><\/p>\n\n\n\n

The hard money lender has two options to scale their business and meet borrower demand. First, they can sell the loans. The buyers of high-yield hard money loans could be anyone, but they are often institutional buyers with specific requirements. <\/span><\/p>\n\n\n\n

These institutions are also fickle, <\/span>or<\/span> so hard <\/span>money<\/span> lenders report to me.<\/span> They may buy a ton of notes with a seemingly endless pool of capital into <\/span>the<\/span> tens or hundreds of millions of dollars that meet specific requirements for a year or three <\/span>and then<\/span> dry up overnight and stop buying.<\/span><\/p>\n\n\n\n

If<\/span> an institution buys the notes from a hard money lender<\/span>, the good times roll<\/span>.<\/span> The hard money lender makes as many loans as <\/span>they can<\/span> that meet their buyer\u2019s criteria and charges points the whole way. <\/span>Every time they originate a $600,000 loan<\/span>, for example<\/span>, our Denver-based hard money lender makes $12,000 in pure profit.<\/span> If they can sell that loan the next day and get $600,000 back into the corporate bank account, they can do it <\/span>again and again and again<\/span>.<\/span> <\/span><\/p>\n\n\n\n

Selling these notes is a business that ebbs and flows for many hard money lenders. <\/span>Firms will skyrocket to massive sizes and <\/span>then<\/span> disappear overnight in the 10 years I\u2019ve <\/span>been watching<\/span> this industry.<\/span> <\/span><\/p>\n\n\n\n

Quick tip: <\/span><\/strong><\/p>\n\n\n\n

As an aside, few hard money lenders make a business of it, but they are often small enough that if you have $300,000-$1 million, perhaps in your 401(k), and want to generate some simple interest, you can give them a call and ask to buy notes from them directly.  <\/span><\/p>\n\n\n\n

They will often be willing to sell you many, if not any, of the loans they currently own so that they can free up capital to do the next deal. If they could, they would love to sell more loans to investors like those on BiggerPockets or PassivePockets. It\u2019s just that few investors are willing or able to stroke a $300,000-$1 million check to purchase these notes whole. <\/span>The appetite for a market for these private loans <\/span>just isn\u2019t there currently<\/span>.<\/span><\/p>\n\n\n\n

I <\/span>personally<\/span> have done this with \u201csmaller\u201d loans in the Denver area. It\u2019s work and a big chunk of your wealth tied up in a single property\u2019s loan for six to nine months if you are a \u201csmaller\u201d accredited investor with $1 million-$5 million in net worth. But it\u2019s also high yield, and I figured that in the worst-case scenario, with the proper paperwork in place, I could foreclose on the property and own a free-and-clear single-family rental for 70%-80% of its market value in most likely downside scenarios.<\/span><\/p>\n\n\n\n

The problems with this approach, however, are the following: <\/span><\/p>\n\n\n\n

1. The income is all simple interest and highly tax-inefficient outside a retirement account. <\/span><\/p>\n\n\n\n

2. I had to keep <\/span>doing analysis on<\/span> new projects repeatedly every six to nine months as the loans matured. <\/span><\/p>\n\n\n\n

3. I worry that my position as CEO of BiggerPockets gave me a warped sense of the risk profile of buying these sorts of notes\u2014was I getting <\/span>particularly good<\/span> deals and service from lenders who, in some cases, were partners with BiggerPockets? <\/span>Is it reasonable for me to assume that my experience would be mirrored by members?<\/span>  <\/span><\/p>\n\n\n\n

While this experiment was successful, I let all my loans mature and put the cash into good old-fashioned real estate (equity) instead. <\/span><\/p>\n\n\n\n

If you\u2019d like to learn more about private lending \u2013 either originate loans directly to local flippers or <\/span>buying<\/span> notes from hard money lenders, the BiggerPockets book <\/span>Lend to Live<\/span><\/a> is a great primer and could be very valuable to you as you explore debt funds to invest in.**<\/span><\/p>\n\n\n\n

OK, back on topic. <\/span><\/p>\n\n\n\n

The second way <\/span>that a<\/span> hard money lender can scale their business is to raise capital. Raising capital can take two primary forms, like any other fund:<\/span><\/p>\n\n\n\n

    \n
  1. Equity:<\/span><\/strong> The simplest structure to comprehend.<\/span> Imagine that our Denver lender has $60 million in capital raised from investors and lends this out in 100 loans at a blended 12% interest rate. The <\/span>returns of the fund<\/span>, before fees, are 12%, everyone is happy, and the structure is simple. <\/span><\/li>\n\n\n\n
  2. Debt: <\/span><\/strong>A debt fund, just like a property, can be levered. Our Denver hard money lender could <\/span>very well<\/span> get a loan or line of credit from a big bank for somewhere approaching or surpassing 50% of the fund\u2019s outstanding loans. <\/span><\/li>\n<\/ol>\n\n\n\n

    Equity is the simplest structure to comprehend. <\/span>In our example for this hard money lender, <\/span>the<\/span> $60 million in loans <\/span>they have made<\/span> generate $7.2 million in interest if fully deployed at 12% for a calendar year.<\/span> This<\/span> is a 12% yield in a 100% equity debt fund. <\/span><\/p>\n\n\n\n

    In a \u201clevered debt fund\u201d example, our Denver hard money lender might lend out 100 $600,000 hard money <\/span>loans,<\/span> or $60 million in capital at 12%. They might borrow $30 million at ~7% to 7.5% (SOFR + ~3%) from a large institutional bank and use $30 million of investor\/equity capital for the rest.  <\/span><\/p>\n\n\n\n

    Leverage has the advantage of <\/span>both<\/span> increasing the amount of loans a hard money lender can make by <\/span>increasing<\/span> the pool of capital and the returns of the fund on the loans it holds on its balance sheet by arbitraging the rate.<\/span><\/p>\n\n\n\n

    If the fund has $30 million in senior debt at 7.5% interest, that\u2019s $2.25 million in interest that goes to the bank. The remaining $4.95 million in interest from the hard money loans can be distributed against $30 million in equity, bumping the yield on this debt fund for equity investors to 16.5% <\/span>annualized<\/span>, assuming all goes well. <\/span><\/p>\n\n\n\n

    Summarizing the \u201cTypical\u201d Business of a Debt Fund and Hard Money Lender<\/span><\/h2>\n\n\n\n

    A \u201ctypical\u201d hard money lender and debt fund does not exist. But if I had to average it out, it looks something like this: <\/span><\/p>\n\n\n\n