Leveraging Your investments – Pros and Cons
Wendy Sweet (00:04):
Hi, I’m Wendy Sweet and I’m Bill Fairman and we are welcoming you to our show today. We wanted to do a quick little covering of the benefits and the dangers of leverage in a fund. Yes, that’s really important, right? Yes. Why don’t you talk to us a little bit about that brother Bill. Okay. Is it was my turn. It’s your turn and then I’m just kidding. I always have to talk about the boring stuff. Okay. Because you know it all. Yes, I do. Once again, I’m not a tax professional or an attorney. This is purely for educational purposes. Okay. But I’ve been in the mortgage business for 30 plus years. I’ve had some really good mentors in the fund business as well. People who have been there, done that. I have gone to the bottom and come right back up because they were at the top in the first place. Markets change, things change.
Bill Fairman (01:07):
And these are, things I like to talk about. So you have them in the back of your mind when you are investing in a fund. There’s a couple of things about leverage that you need to be aware of. And what do I mean by leverage? So in a fund structure, a fund, let’s say for example, you have a $10 million fund, which means you’re kind of limited to what you can do with $10 million. If you were doing, you know, $40 million a year in loans and if they’re all four month loans and you might be able to use $10 million a year cause you’re turning it over for time, right? But in reality, most loans are going to last longer than four months. At the same time, if you want to buy properties as part of your ownership of properties in your fund and you have a $10 million fund, you’re going to have a limited amount of properties you can buy with a $10 million fund. Unless of course you’re buying double-wide mobile homes, then you probably have, you probably have more money than you need.
Bill Fairman (02:13):
That said what you can do with leverage and there are credit facilities and typically they’re banks and hedge funds that will look at your assets and they will loan against their current assets in the fund. And they will leverage them two to one or, or three to one even. So what does that mean? And if I have $10 million in assets, they’ll give me a $10 million credit line, right? So now you have the power of $20 million, right? But now you as the investor, basically we’re in first position on the 10 million. Right. Now, the credit facility is in first position and you’re now in second. Now, there’s nothing wrong with that. If you had twice the earning potential being in leverage, then your yield or your return, it should be a lot higher including what you pay them as being in first position, right? No, that has no, It’s right..
Bill Fairman (03:27):
Your same amount of money will have a higher yield because it has much more buying power, earning power there. Basically doubling your, your money, but your money hasn’t really doubled. Just your earning power. The downside to this is if you’re using an IRA to invest in this, IRS, as I said in an earlier episode, does not like leverage. So they’re going to, or you are going to be subject to, unrelated business taxes. So you may have to pay 45% of your profit based on the amount of leverage. It doesn’t mean this 45% of your earnings, it’s 45% of whatever you would have earned based on the additional leverage. Okay. So it’s real fun to try and figure out that I don’t have to do it once again, not a tax person or an account.
Bill Fairman (04:29):
Now, as I was saying, the benefit of that is you have twice the buying power, and twice the earning a potential. The downside comes is that, let’s say for example, the, most of these credit facilities are there. They’re like a line of credit. They’re only available for a finite amount of time, right? And then you have to refinance that or you have to get an extended, and there are no commercial banks out there. If you ever got an a commercial loan, you can’t get a loan that is a 30 year fixed, you know, any kind of commercial product. It’s usually a, yeah, five years or seven years. They may give you payments based on 15 or 20 or 30 but the loan is only for a finite period of time. Why? Because markets change and they don’t want to be locked into a longterm contract. Right. Okay. So I’ll give you an example of a fund that I know of that had leverage through a large bank. We all know who they are. I’m not going to say who, but there. They’re one of the big three and they love America. Everything.
Bill Fairman (05:41):
Anyway, everything was fine. They were going to extend it and this was in 2008 as things were going down, right? They were, they were going to extend, extend, extend, and then when they got right down to it, they said, yet, Nope, we’re not extending. Now you owe me the other 10 you know, the $10 million we loaned you already out in debt. It’s already out in loans. What do you do? Well, at the same time, we’re going through a big crash, right? And the assets that were currently under management, the assets that we’re loan against, those people were having trouble, right. And they were doing it and they were having to do a lot of foreclosures. And the ones that weren’t being foreclosed on, they couldn’t sell them anyway. Even if they were paying, they couldn’t sell them because the values keep going now. Right. So what happens is you as the investor or getting paid nothing because all the money it goes to the credit facility first and waterfall, we were talking about that, that waterfall agreement means that, leverage, yes. First income. And then when payouts come, they get the first part of that. So you’re getting nothing. So as an investor, you’re not making any money and you can’t get your money out. So how’s that? Not too good. So there’s dangers.
Bill Fairman (07:10):
All right. So the, the reason that we bring this up is because when you’re reading those PPMS, almost all of them and ours included says that we can get leverage if we want, as the management, we can choose to do leverage. And now we choose not to do leverage because of that, that same interest, same thing that happened. So our friends in 2008 now, we’re at a point now or everything is really good and you know, you could utilize leverage, but you never know what happened. So it’s a tough decision. It works out for some, you don’t have to get three, two, one, you can, you don’t have to get two to one. You can just get a little bit more and make sure you still do the leverage, but make sure that it’s small enough where it’s not going to hurt you terribly.
Bill Fairman (08:00):
If they call it due we’re late, they can’t get it refinanced or extended. Right? So aren’t you all cheered up looking forward to signing up for that? But what we want to do is we want to make sure that you’re looking at your PPMS in the right way and asking the right questions and understanding the ramifications both on the positive and negative and, you know, make up your own mind because it’s a risk going into anything. Yeah, there’s risks with any type of an investment, but you have to look at all the possibilities and understand what’s going on. If you’re with the good manager, they’re going to explain it to you. And by the way, this same fund that we were talking about, they went through some tough changes with this because they hadn’t, like I said, they had investors that weren’t earning anything and they had to wait through this and eventually they, as a matter of fact, I was just recently told that they just, and it’s selling their last asset and they retained almost all their investors and almost all their investors that didn’t, you know, get out early or try to get out early or get their money back.
Bill Fairman (09:12):
Plus they made money even though this was the worst catastrophic thing that could have happened.
Wendy Sweet (09:18):
Right. But it’s all about relationship communication, making sure that you’re transparent with the investors that are in your fund. Yup. And just being all out honest, whether they like what you’re saying or not, you’ve got to be able to really be honest and carry that relationship with, with strong, thorough communication on what’s going on. Really making sure that the folks in your fund understand every side, everything that you’re dealing with. And if you gain that kind of trust and relationship with people, you can go a long way cause you do much better in a group then everyone out there buying for themselves. Right?
Bill Fairman (10:02):
Absolutely. So thank you so much for watching. Don’t forget to subscribe and like us, we do have some more episodes in other places. If you want to find them somewhere. Yeah, you click on them. Our website is CarolinaHardMoney.com. You click on the investor tab or if you’re looking to borrow money, there’s a apply now, but because we do give loans as well, don’t we, yeah, well we need the money in order to make loans. That’s right. That’s right. Have a wonderful, you know what, we’re Oh, I can talk about next time?
Wendy Sweet (10:36):
I don’t know. Let’s figure that one out. We were talking about it earlier. The next episode will be a surprise for you. That’s right. That’s right. You have a great day. Thank you very much for joining us. Hope you had a good time. Got a little knowledge as well. Don’t forget to subscribe and like us, and if you like to see some more episodes, right? You can go over here or perhaps up here or perhaps down here, but there’s a place to press to get to the other episodes. Enjoy