Private Lending vs Buy & Hold

19 Replies

For the past few years I have been lending my money on SFR fix and flips and getting a 12% cash on cash return. Recently I've been looking at the tax benefits, potential appreciation, and CAP rates on a multi family or commercial property and wanted to see if anyone has a compelling argument either way on whether private lending at a 12% return or buying and building a portfolio of rentals/multifamily/commercial property is a better path for building long term wealth?

Currently I am only able to find cap rates at 6-8% on either NNN commercial or multifamily properties and the market is flooded with retail buyers fighting for the bigger deals.

My cash on cash return is higher doing the private lending but I am not able to realize any appreciation or tax benefits at the end of the year on my private lending.

My individual goals are similar to most I would assume -- Building my net worth and increasing cash flows while avoiding as much taxes as possible. Any insight, experience or actual numbers using leverage(financing) to build wealth would be much appreciated.

I'm not willing to share my financial situation online for the world to see, but for example let's assume $500K of cash at 12% private lending vs leveraging financing and buying properties over a 10 year period.

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@David Sims You asked "which is better for building long term wealth?" The answer to that is with out a doubt building a portfolio of rental property. 

When it comes to real estate investment the two most powerful things are debt (leverage) and taxes. You receive neither of those benefits when doing hard money lending. 

You mentioned an example so lets run with that:

Hardmoney lending:

$500k lent out for 1 year at 12% interest will give you a gain of $60k. Lets assume you are in a 35% tax bracket. You will cut a check to the IRS for $21k, leaving you with $39k or a after tax cash on cash of 7.8%

Apartment building investment:

$500k down payment on a $2.5MM building. At an 8% capitalization rate that you quoted (very achievable) you are left with $200k net operating income. lets assume when you borrowed the $2MM from the bank they lent it to you at 4% interest over a 25 year term. This means your mortgage payment is $127k (rounded up) leaving you with $73k in cash flow or a pre tax cash on cash return of 14.6%. This beats your 12% from above and we haven't even started on all the other benefits of investing in real estate.      

So you cash flowed $73k do you pay tax on $73k?? NO! another beauty of real estate and leverage is the depreciation tax benefit. Even though you only put 20% of the $2.5MM in to the property you get ALL of the depreciation. Apartment buildings are depreciated over 27.5 years which means you get to depreciate $2.5MM/27.5=$91,909. What does this mean? It means you don't pay any tax on that $73k you made on the building. You actually have a paper loss of $17,909. This loss can off set other income. Again assuming a 35% tax bracket the paper loss of $17,909 would result in an additional $6,268 in tax savings.  This means your after tax return is 15.85% almost DOUBLE your after tax return from hard money lending. 

Thats all great and will make you a lot of money, but where wealth is built is in the amortization of the debt you put on the property. The 2MM in debt you put on the building will have an army of tenants paying down your mortgage month after month. In our example after 10 years you will only owe $1.4MM on the building IF the property never appreciated one cent and it was still worth 2.5MM in  10 years you would have $1.1MM in equity. You could then sell it or refinance it (again tax free). 

Now lets wrap the amortization into our example. using the loan terms I mentioned the first years of the loan will result in a $52k reduction in principle or if the value stays the same that would be seen as a $52K increase in equity. If we add that $52k into the cashflow and tax benefits we are left with a all inclusive after tax return of 26.3%. How much tax do you pay on that??? NONE.

This is just the basics. You can accelerate depreciation benefits through cost segregation, Structure loans for quicker amortization depending on your goals and many other tricks. 

if you're thinking this sounds great but those are just made up numbers and assumptions. These numbers are real in my own investing. I close on a 42 unit 8 cap apartment in 2 weeks. The loan is what I stated above and the price tag is very similar. On top of all the benefits I listed I will also be able to add $600k in value over a two year period even further boosting returns. 

I obviously enjoy talking about this stuff. Feel free to reach out to me whenever and we can talk more. 

Disclaimer: I am not an attorney or CPA. This is just examples and my own experiences. 

As a former multifamily owner, I am selling my 2nd to last complex now, I would recommend lending over multifamily investing. I bought all of complexes during the last downturn at a per unit price since there was NOI of zero at the time and I am selling now because I can get a higher rate of return lending the profit I realized even after paying taxes. Apartments are a business which require a lot of supervision and the risk is high. Liquidity is low so your exits are limited. If you want to invest in apartments and be patient it is a cyclical business so wait until everyone is fleeing and then buy.

Keep in mind there is very little that you can do to protect your income from lending from taxation. The marginal benefit of a dollar increases with the more you make, meaning tax planning will take precedence. If you are tied up with note investing, while certainly a great way to invest, you will toast from a tax perspective.

I know a few note investors who pay more in taxes than your mid-range CEO makes in compensation and can't protect themselves. It's painful in the upper echelons. 

If you can fund a Solo 401K or a self directed IRA and do your lending through those accounts you will be able to defer (of if your IRA is a Roth) avoid taxes entirely. Depreciation must be paid back eventually unless you plan on gifting the building or passing it onto your heirs.

@Jered Sturm thank you for the thorough response. Over the last few months I have been analyzing several potential multi family and industrial properties through local brokers/loopnet/costar in an attempt to find a property that would yield somewhere near a 10% Cash on Cash return and a 15%+ internal rate of return (including NOI, depreciation, and a 2% assumed appreciation).

Using your numbers: $2.5M purchase price with $500K down and $127K debt service - 4% interest over a 25 year term; the property yields a $73K gross operating income which would equate to14.6% of the 500K down. However I don't think I can use that number to compare to a 12% private lending fee as I would also be required to figure in the operating costs of owning the property in order to calculate the real cash flow and my Cash on Cash return. 

$200K gross rents (8 CAP) and $127K debt service leaves 73K before operating expenses. After I account for taxes, insurance, management fees (which I am finding cost between 5-10% of the gross income), maintenance, leave room for vacancy assumptions, and HOA fees in some cases, I have found these operating costs average about 25% of the gross income. In this example that would equate to $48K per year operating costs leaving only $25K cash flow per year after debt service. (200K - $127K - $48K = $25K)

I've read on BP that you should figure 50% gross rent operating costs when analyzing a property? If that's the case I would need to raise the rents, get a cheaper interest rate, lengthen the loan, or put more money down. 

$500K down payment plus closing costs of 1.5% = $507.5K cash out of pocket

$25K net cash flow per year after all operating expenses and debt service only yields a 5% Cash on Cash return.

The 27.5 year deprecation helps with the internal rate of return and the potential appreciation is appealing for building equity. My numbers may be off, but the risk of vacancies, unforeseen maintenance and market fluctuations have me leaning toward a NNN (triple net lease) commercial deal where a 8 CAP gets you closer to that 8-10% cash on cash return as you have no operating costs. The down side I am finding in NNN industrial is that lenders require a 30% down payment, the appreciation is limited, and the vacancy can be a killer if you go 2-3 months without a tenant. (3 months out of 12 = 25% vacancy rate vs owning an apartment building where you have multiple units)

Maybe I haven't found the right property yet and I have been looking into lending with a MF syndication group with the goal of becoming an eventual property lead. Reading through several posts on BP has given me a lot of confidence that owning is that right way to go.  Maybe I haven't found the right deal yet. 

@Jered Sturm - if you get time I'd like to talk further maybe over the phone. Thanks again for the response.

ered Sturm

@Jered Sturm Fantastic information to this post, would you mind if I PM you with further questions in the future. I've found great information on the site and do my very best to network and learn from anyone I can. I'd love to speak with you more if you don't mind helping to educate, of course I'd love to return the favor if possible!

Thanks for your consideration.

@David Sims Great question, awesome post! I am only a year into my ventures but these are the things that get my blood flowing!

David,

To me, if you could lend inside your qualified accounts and take advantage of commercial real estate in taxable accounts that would be ideal. If you have your own business, I'd be maxing our my solo 401K and putting notes in there. For your taxable portfolio, if I look at my simple SFR properties and include cash flow, appreciation (leveraged), depreciation and debt pay down the all in returns (ROI) is in the 25% range. Even w/passive buy n hold MF (apt) strategies you get the tax advantages of the apartment ownership with a very tax efficient cash flow in the +10% range and LTCG on the sale at the end. Experienced syndicators are consistently getting high teens and low 20% on all in ROI over 5 yr holds. I like hybrid strategies, using different investment plays that can take advantage of the tax laws based on their unique characteristics.....going either in my taxable or qualified accounts. But comparing the two to me is like apples and oranges. Solid MF properties give you more bang in taxable accounts and short term notes / lending are best for qualified accounts IMO.

@David Sims  Thanks for the response. I am traveling today so I have plenty of time to respond but unfortunately have to do it from my phone, so forgive me on structure or typos.

First it's great to hear you are out analyzing properties. That is the best way to get comfortable.

You are always welcome to reach out to me directly on here and we can set up a time to chat on the phone/skype. Nonetheless I'd like to clarify the math and dig in a little more to help all other readers of this forum.

A large variation I found between my math and yours is the calculation of gross rents, and NOI.

For clarity: NOI (net operating income)= gross income - operating expenses. For this industry NOI does not factor in debt service.

I think the most important disconnect between our math was gross income and how it plays into valuation. So let me explain how I figured my original message to hopefully clarify:

If the property was purchased for $2.5M at a capitalization rate of 8% then the property must produce a $200k NOI because $200k / .08 = $2.5M. In my experience a Apartment complexes operating expenses will be roughly 50% of the gross income. If we apply that 50% to our example that means gross income for our example property is $400k.

I believe you may have been confusing the gross income to be $200k and then subtracting out operating expenses where really the $200k is the NOI which already has the operating expenses subtracted out.

Of course our 50% of gross income as operating expenses is an average. Depending on the property that could be 40% it could be 60%. For example our recent apartment purchase was bought for $2.15M with gross income at $360k with an NOI of $178k. Which means operating expenses were 50.5% of gross rents.

I believe you may have misunderstood the $200k to be gross income.

Two other things I want to dig into are depreciation and deducting principle expense of a mortgage payment. In my example above I intentionally over simplified to make it easier to understand, but I feel I should clarify now. The depreciation expense is not for 100% of the purchase price because land is not depreciable. After consulting your tax preparer to help determine the value of the land your building sits on you will then depreciate that amount. Industry standard is 80% building 20% land.

In my example above for simplicity I also reduced the taxable income by the full mortgage payment. Where in reality it will reduce only by the interest portion of the payment because the principle portion is not deductible.

I hope these last two points didn't jumble the example. I left them out to simply and get the key points across. RE is an awesome investment that has so many pluses. Like I said in my first post this is just the basics you can get far more creative to boost returns.

I hope this has helped clarify some things for you. Because our recent purchase is so similar to our example here. I would be happy to share over the phone or private message the full details and strategies involved in our recent purchase of a 42 unit building.

We were fortunate enough to purchase all of our properties up until now with our own capital. However in the next 6 months we plan to begin syndicating deals to enter into larger complexes in the SW Ohio and NW Georgia markets. I'd be happy to talk to you more about that opportunity on the phone if you do decide syndications are a route you want to go. 

One final note to my very long response. You mentioned underwriting to an IRR I think it's great to take in the time value of money when analyzing. One thing to remember to factor In your analysis of your IRR is your exit (sale) or the refinance. These major actions will greatly play into the IRR calculations.

If you would like to discuss this over the phone or Skype. Please feel free to reach out to me via personal message so we can coordinate times. 

Best of luck on your next ventures!

Jered

A lot of great information here! Thanks to all who have contributed.

@David Thompson , a lot of investors share your preference to hold passive assets such as notes within the self directed retirement accounts while pursuing the actual ownership of real property outside of the retirement account and I think this can be a good strategy.

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@Jered Sturm you are correct I was assuming the $200K was gross rents, not NOI after expenses. I'm having a hard time locating a property that advertises anywhere close to that percentage of rents compared to the total sales price with multifamily in the Texas marketplace. Again, I think my issue is finding/locating the right deals which will probably require off-market sellers rather than over inflated Loop net listings. Your analysis makes much more sense especially with the 50% operating costs. Congrats BTW on the $2.1M deal. I'll send you a PM to schedule a call at your convenience.

@David Thompson I'm going to research more about the solo 401K as well as IRA lending. Look forward to meeting with you Friday to discuss your deals!

@Justin Windham would you mind sharing a high level overview for myself and other readers of this form on how investors are structuring their purchases with their retirement accounts? You mentioned "while pursuing the actual ownership of real property outside of their retirement account."  With this structure, are investors creating an entity inside their retirement accounts, lending out of that retirement account against the property with the borrower being the individual investor? Could you provide a specific example and structure?

@David Sims

With the proper investment vehicle (such as a Solo 401k or IRA LLC with checkbook control), the investor has a lot of flexibility with regard to how they may want to structure these investments. It is typical for Solo 401k plans to be setup with a trust that holds the plan assets. In this case, the 401k participant is the trustee, which gives that person checkbook control. Assets can be acquired directly by the trust, however some investors will indeed create an additional entity within the trust such as an LLC, so either way is possible.

With an IRA LLC, the IRA accountholder is typically the manager of the LLC that is owned by the IRA. This is how the IRA accountholder has checkbook control. The investments are typically held by that IRA-owned LLC, though additional LLCs can be introduced if desired, just as they could be with the Solo 401k.

Yes, oftentimes when the self-directed investor is lending funds for another's real estate investment, it is a loan directly from the IRA LLC or Solo 401k trust to the individual who is doing the real estate investing. This loan can be secured by the property. The terms of the loan are decided upon between the lender (for instance the Solo 401k) and the borrower.

All of the above is with regard to making an investment inside the retirement account. That same person with a self-directed IRA or 401k could also make the same investments with their own funds or with business funds and that would be an example of an investment outside of the retirement account. I hope this next point doesn't confuse the issue of inside vs outside the retirement account: Some 401k participants will borrow money from their 401k to use those funds to invest in real estate. That is an example of an investment outside of the retirement account since those funds, once borrowed, become the participant's funds until they are paid back to the plan.

In general, investing into any asset with a retirement account is much like investing into the same asset outside of the retirement account except that prohibited transactions rules apply and there are special tax benefits in the case of the retirement account investment. Some of these tax benefits can be replicated, at least temporarily, with deductions commonly associated with ownership of real estate. This is why some will choose to own investment real estate outside of the retirement account (with taxable money, but taking deductions) while keeping other assets such as notes inside the retirement account where it is fully sheltered by the tax benefits of the IRA or 401k.

@David Sims

(I see that Justin & I posted simultaneously, so he apparently addressed the question)

I'm sure that what Justin was meaning to say was that folks who have resources both inside and outside of a retirement plan may choose to put the plan funds to work in notes and separately invest in rentals with non-plan funds. There can be no intersection between the two, however. An IRA or 401k could not lend to you or an entity you own.

Notes are a nice asset for self-directed retirement plans, because they are simple and clean, and can provide solid, predictable returns.

The ownership of income property can also be very beneficial for a self-directed IRA or Solo 401k, but can introduce a greater degree of complexity depending on the strategy. There is the potential for both cash flow and appreciation, and one can use leverage when purchasing properties, so the income potential may be higher than one might find with notes, depending on the deal.

Both types of assets provide a solid underlying asset and the potential for consistent income to the plan.  Which is best for a particular investor will come down to factors of their market & opportunities, level of expertise and temperament.

Originally posted by @David Sims :

For the past few years I have been lending my money on SFR fix and flips and getting a 12% cash on cash return. Recently I've been looking at the tax benefits, potential appreciation, and CAP rates on a multi family or commercial property and wanted to see if anyone has a compelling argument either way on whether private lending at a 12% return or buying and building a portfolio of rentals/multifamily/commercial property is a better path for building long term wealth?

Currently I am only able to find cap rates at 6-8% on either NNN commercial or multifamily properties and the market is flooded with retail buyers fighting for the bigger deals.

My cash on cash return is higher doing the private lending but I am not able to realize any appreciation or tax benefits at the end of the year on my private lending.

My individual goals are similar to most I would assume -- Building my net worth and increasing cash flows while avoiding as much taxes as possible. Any insight, experience or actual numbers using leverage(financing) to build wealth would be much appreciated.

I'm not willing to share my financial situation online for the world to see, but for example let's assume $500K of cash at 12% private lending vs leveraging financing and buying properties over a 10 year period.

David, why not have BOTH - lending and investing in properties?

I do BOTH.

Why?

Investing in real estate (MFs and SFRs) is good for cashflow, depreciation, appreciation and loan paydown. Downside with real estate is you have to actively manage it, you need to get a loan on it (hence more liability) and there are more hassles (you have to deal with contractors, tenants, etc). 

Private lending on the other hand is more passive and the YIELD is (generally) higher than real estate investing. Taxes can be reduced to zero if you have a Self Directed Roth IRA but you can only get the money when you're retirement age.

You can invest passively in real estate by having an active partner or you can invest in turnkey but the returns will be even less than private lending.

If you can do both - do both. You get higher income as a result of lending and you get appreciation and equity build up over time through buying & renting properties.

At the end of the day, only YOU can decide for yourself. You need to answer questions like:

- how much time can you devote?
- do you want to actively participate or just be passive?
- what's your investing horizon?
- what's your risk tolerance?
- is your credit, income and debt to income good enough to get loans/mortgages?

@David Sims I agree with Account Closed why not do both and be opportunistic? Also, as you noted this may simply not be the right time as rates on multi can be low right now. True taxes suck (and as others mentioned you use a retirement account for that at least somewhat) and true you don't get any application so you prob look at how much money ou are losing compared to those who jumped in. The problem is that turns on a dime. At some point, you will prob look really smart for waiting. Of course trouble is, how long will that be and where will prices be that time? No one knows nor will they ever know until its too late.  As such, its really a matter of just waiting for the right deal regardless and it seems you have not found that deal. Don't lose discipline, its better to lend than be stuck for 10 years in a bad deal. 

With that being said private lending has advantages in that its typically short-term, it typically has a lot more protection, it requires a lot less knowhow and there are a lot less issues to deal with than ownership.  So there is a lot of optionality and a lot lower risk in what you are doing and I would say many people don't put as high a value on that as they should. 

Here is what I would do if I were you:

1) If you are lending use it as a learning experience not just money. I hope you are lending to great operators if you are use it to learn something so you can move from debt to equity. Maybe it won't be in multi right away maybe it will be smaller but you will learn as you go and either move to larger unit sizes or just keep doing well with smaller units. Get enough of them and you can do very well.

2) Use the activity you are doing now to be in the game and wait. Its hard to wait when you want to act. By doing deals lending or smaller equity you will be doing RE but won't be as likely to feel the NEED to buy deals. This should decrease the odds of being a bad deal. Also, by being in the game you are meeting people and building a reputation which will help you find deals and close them. 

3) Do equity transactions with those you are comfortable with. This could get you better deals as well as show you how those who are more experienced look at the properties you want to buy. Group deals can be good for this.