Deep-dive Into My 7 Figure Alternative Investments / Real-estate Portfolio: 2019 Q4 Update
Updated: Oct 25, 2020
My boring-by-design portfolio cranked out a nice 8%+ in income (not counting price appreciation). And I've added 3 difficult-to-find uncorrelated asset classes that should not only harden the portfolio against the next downturn but also boost returns.
Note: this is an older version of this article series and there is another, newer update now available. Click here to view the master index which contains a link to the latest and greatest update (as well as all of the older updates). (Usual disclaimer: I'm just an investor expressing my personal opinion and not a registered financial advisor, attorney or accountant. Consult your own financial professionals before making any financial decisions. Code of Ethics: We do not accept any money from any sponsor or platform for anything, including postings, reviews, referring investors, affiliate leads or advertising. Nor do we negotiate special terms for ourselves in the club above what we negotiate for the benefit of members.). Many people ask me, "What's in your portfolio, and how's it doing"?
So since 2017, I've been regularly sharing a deep-dive review of my portfolio. And here's the latest update on all the things I'm invested in, how they're doing and my detailed thoughts on each one.
First, it's important to understand where I come from so you can put my portfolio choices into perspective. I'm a retired serial-entrepreneur and rely on my investments to support myself and my family. So I'm an extremely conservative investor. And preservation of capital is #1 for me, while return is second. So what I do may not be appropriate for someone who's more aggressive, speculative or coming from a different financial situation. My strategies for 2019/2020:
Here are things that I like right now:
Thinking defensively: I believe we are late in the cycle and don't want a nasty surprise. So I pound every potential investment with difficult recession-level stress tests. If I can't live with the results I walk away. I also generally require a sponsor who has at least a full economic cycle track record through the recession and has lost no or very little money. These aren't easy to find, and if someone isn't a match, I pass. More about my method is in "The Conservative Investor's Guide to Picking Real Estate Investments".
Uncorrelated: I also like investments that are uncorrelated to the business cycle and can continue to crank out attractive returns even in a downturn. These are very hard to find but can provide great diversification and protection for a portfolio. Examples include litigation finance and life settlements (more below).
Quick and slow: For investments that are susceptible to downturns (which is 99% of what's out there), I prefer quick and slow. "Quick" means short-term investments like hard money loan funds with short lockups of one year or less. And "slow" means long-term equity investments (7+ years) with low leverage, long-term fixed rate debt and conservative underwriting that I intend ride through and beyond the next downturn.
Cash is king: I also hold lots of cash to perhaps take advantage of distressed situations when the downturn comes.
I also have a public market portfolio. It's mostly index funds since statistics show that the odds of an active manager outperforming the index over time is ridiculously low. Since public markets aren't the focus of this article (nor the website) I'm not discussing this part further.
I also completely avoid the typical value-added, highly leveraged investments with 2-5 year floating rate debt which makes up 99% of the offerings on crowd funding platforms. They're a better match for someone who's more aggressive than me. (see "My Real Estate Investment Strategy: Part 1").
My wife and I share financial decisions and have 7 figures invested in "alternative finance". This is mostly (88%) in real estate and a smaller amount (11%) in hard-to-find asset classes that aren't directly tied to the business cycle like litigation finance and life settlements .
As of Q4 of 2019, we had an 8%+ annualized return for the trailing 12 months. This is down from the 8.76%+ I reported in Q1 of 2019 because:
I intentionally reduced half of one of my highest returning assets (Broadmark returning 11.2%) to be more defensive. This is the main reason.
To a smaller extent because I intentionally took a small reduction when I sold a couple of higher-yielding residential rental properties (returning 9%+ from distributions alone not counting price appreciation). Again this was to be more defensive because the areas they were in were becoming a little bit iffy.
Also, Broadstone Net Lease reduced the return a little, because its price appreciation moved sideways this year (versus an extra 3 to 4% of return last time).
In general, I'm quite happy with a slightly lower return in exchange for significantly lower risk. Also I was able to further liquidate even more of my poorly performing Lending Club and Funding Circle portfolios. I can't wait until they're 100% gone and can give them both a huge, "Good riddance!" And I'm very excited about the new non-correlated asset additions to the portfolio since last time. Not only will they harden my portfolio in a recession, but should also boost returns as well.
My Portfolio: Low-level details
Here's how it's invested by category:
...and by sponsor/investment:
And here are the individual 12 month returns of each investment.
What's behind the scenes on this? Here's the details on each one...
1) Residential rental properties (36.54% of portfolio). Return: 8.3% (income only)
This is by far the biggest part of my real estate portfolio. I follow the core-satellite approach to risk. A huge, conservative core lets me feel comfortable taking more risk on smaller, satellite portions. Residential renters tend to be more stable and longer term than multifamily/apartment renters, which I like. I target working class neighborhoods with affordable rents (to maximize the renter pool, and align myself with the long-term trend of a growing lack of affordable housing). I also pick neighborhoods that are low in crime and properties that meet my yield and other minimums. These were purchased with no debt, which I believe hardens them extremely-well against a severe downturn. More aggressive investors will prefer higher projected returns by taking on leverage instead. The 8.3% return only includes what it made in income. And as an extra bonus, due to a hot property market, the price has appreciated over 10%. Since I intend to buy-and-hold and it's ownly theoretical I didn't include this in my returns. If If I did, I really got a 18.3%+ return here and my overall portfolio was alot higher too.
My allocation to this dropped from 50.5% last time to 41.28% now. This is because I sold two of the properties. Both of them were very high earners, but the neighborhoods were starting to deteriorate due to crime creeping in. Since they no longer met my above criteria, they were sold. The market in Tampa is very strong and they each made 20%+ in extra profit from price appreciation (after all expenses including broker commissions). However, since this was a one time event, I didn't count this in my overall returns (since they are being compared to previous periods). But in reality it boosted my returns here and my overall portfolio return significantly.
My goal is to redeploy that cash into this asset class. But as mentioned in previous writeups, the price rises in Tampa have compressed the yield a lot. So it's hard to find something that looks good versus other options. But I'm continuing to look. Also I'm not willing to do this in a remote city via a turnkey operator, because I feel there are too many financial incentives and ways for them to hide significant problems that I'll never even realize. So if I can't redeploy here I'll keep it in cash or find some other place for it. 2) Short-term 1st position debt (28% of portfolio): Return: About 9.5%. This is my 2nd biggest strategy. First position debt is the safest part of the capital stack, and short-term allows me to possibly liquidate quickly if conditions change. (Here's a three-part article on how I do due diligence on hard money loans.) About 58% is in a hyper-local acquisition/rehab hard money loan funds called Arixa Capital Secured Income Fund. (It averaged 7.35% return over the last year). They target 60 to 65% loan-to-value maximum, a very good < 1% uncured default rate, non-judicial states and no leverage. Doing this meant accepting a lower overall yield than Broadmark (below). But I feel the diversification protection is well worth it. Recently the sponsor has started to move outside of their traditional area of expertise into multifamily. Additionally I have been disappointed when they have occasionally made higher risk loans that are way above 65% LTV or loaned in judicial only states. These violate my personal criteria and make me feel very uncomfortable. Thankfully, we have not had a recession and so far these loans have been okay and a very small part of the portfolio. So I am okay with continuing with the risks for now. It's a shame that this is not a set-it-and-forget-it investment for me and I will need to monitor them regularly. If I start to become uncomfortable with things, I'll either reduce my allocation or liquidate entirely. About 42% is in BroadMark Capital Fund 1 and 2 (averaged 11.4% return over the last year). It has a 65% loan-to-value maximum, a good uncured default rate (less than 2%), no leverage, and only loans in non-judicial states. It does do construction loans, which have added execution risk over other types. So I balance that out with a second fund that doesn't do any construction (Arixa). (If you'd like more details on all the things I look for in evaluating a hard money loan investment, check out this three-part article series.) Over the last year or so, I've had some increasing concerns about this sponsor. While they continued to produce solid profit, I felt there were some concerning cracks showing up in the foundation. Fund 2 experienced increased defaults. Fund 1 also had increased defaults and even lost money on a loan or two. And it felt to me like pulling teeth to extract useful information on what had happened on these from investor relations (as it typically took two or three follow-up questions to get a reasonably thorough response). I personally didn't feel very comfortable with the ultimate answers and have been more concerned about what might happen to this fund in a severe recession. So I was continuing to monitor the track record very closely to see if it would firm up to be more like the "old-days" or further deteriorate. Then the news came out that they were going to go public. I already have plenty of REITs in my public market allocation and prefer to invest via diversified index fund rather than riskier heavy-concentration individual investments. And the whole reason I invested in Broadmark in the first place was because it's private market. I wanted the extra profit from pocketing the liquidity premium for myself (rather than having it sucked away by "Mr. Market"). And I also didn't want the extra drama and correlation to public market volatility. So I was very disappointed by this. At that point I took the opportunity to sell 50% of my Broadmark holdings and held the remaining 50%. My idea was to take advantage of any pop in price when it went public, and then to reevaluate. This did indeed go public recently as the New York Stock Exchange treatment stock BRMK. It has gone up modestly (I believe about 5% if a person can sell at just the right time) but basically has moved sideways. There has not yet been a huge pop like some were expecting. It may be early still as there may be many who are exiting at this point. So I am continuing to monitor this one to see what I will do going forward.
Of course, since it's a public security now: if we have a severe bear market tomorrow, BRMK could go down in price and not recover to the original price for many years. So one thing that I did was vote "no" to it going public, which gave me something called "dissenters rights". So if everything goes downhill quickly, I can choose to exercise these as late as December 20. And if I do I am entitled to get the shares back at the original price. So this is a nice little bit of additional insurance. 3) BroadStone Net Lease (NNN leases) (11.8% of portfolio): Return: 6.6% total (6.6% income, 0% price appreciation). The next largest part of my portfolio is invested in a triple net lease (NNN) fund called Broadstone Net Lease Fund. A triple net lease is a lease in which the tenant is responsible for almost all expenses (maintenance, taxes, etc.) and the landlord's responsibilities are very minimal. The leases lock the tenant in long-term for 15 to 20 years with built-in escalations. So it makes for a much more predictable income stream than a typical real estate investment that has much shorter leases. The Broadstone fund specializes in recession resistant and Amazon resistant industries like medical, fast casual restaurants, industryal etc. It has full-real estate cycle experience, low leverage at 40% LTV, has an investment grade rating and generates healthy income and price appreciation. This year, the real estate has continued to perform very well and distributions are the same as last year. But, the more volatile and difficult to predict price appreciation hasn't happened like last year and the NAV has moved side-ways. However recently they put out news that they intend to go public via an IPO. When I heard the news I was very surprised because investor relations has said many times this was not their intention. But I also understand they are not always privy to management decisions. Again I already have public stock market exposure to triple net lease and not looking to change it. And as a private investment, BNL allows me to pocket the extra profit of the "illiquidity premium" for myself, reduces price volatility and is mostly uncorrelated with the public stock market which helps to diversify and protect my portfolio. If it does go public it will lose all of these advantages. On the other hand, if it produces a price pop (say of a couple years of profit at once) than it would be hard for me to be upset with this. Right now this is a very recent development and its unknown what the terms of the IPO might be or if it will even happen. If the stock market tanks I would expect this idea to be shelved for at least a cycle. So we'll see what happens here. 4) MG Properties Group (11.6% of portfolio): Return: 6.45% income = 6.45% total. I added money to this over the year and am in 8 properties with this sponsor (in multiple different funds). MG Properties is one of those very rare sponsors that appears to have gone multiple cycles without losing any investor money. They do multi family value-added, using moderate leverage, and high skin in the game (10 to 33%). They also are one of the few to implement a full-featured TIC 2.0 1031 exchange pipeline, which allows taxpayers to defer all taxes indefinitely. This is a long-term 7 to 10 year hold, and on exit I intend to 1031 exchange into a follow-up investment with MG (to defer capital gains). Ideally, I would like to hold a position with them forever, and when my wife and I pass away, pass it on to our son (who would inherit it on a stepped-up basis, and also not pay any capital gains). See this article on "How to Invest in Passive Real Estate Without Paying a Penny of Tax (Legally): Part 2: "Defer, Defer and Die"".
5) Litigation Finance (4.13% of portfolio). Return: Too soon to tell yet.
Litigation finance is providing financing to law firms that need money to pursue cases with a higher than normal probability of success. It's not directly correlated to the business cycle/recessions which can be great protection and diversification to a portfolio during a downturn/recession.
The asset class is becoming a favorite for institutional endowments and large family offices but very difficult for most investors to access. Projected returns can be 18 to 20% IRR net.
The sponsor I invested in, has the longest track record in the industry. It created the asset class back in 2007 and has won numerous industry awards. This asset class does have a "J curve" meaning that it's expected to take a couple of years to break even and eventually produces a profit. It's also not expected to produce distributions in the first year. So it is really for medium-term money (5 year +). The sponsor has requested its identity to be kept confidential in this article. Club members can get full info including their name, as well as detailed due-diligence, etc. here. (Membership is free but requires verifying that the applicant is truly an investor and has no business connections to sponsors).
6) Non-Real Estate Loans (4.13% of portfolio). Return: Too soon to tell yet. This is a non-real estate related debt fund that has one of the most exceptional recession track records I have seen. Employees and family have almost half a billion dollars of skin in the game, and it has won many industry awards. It's also the #1 investment for members of Tiger 21 (investment club that requires $10 million in investments minimum and $30,000/ year membership fee). It is expected to be creating distributions immediately so I will have an details on performance in my next update. The sponsor has requested its identity to be kept confidential in this article. Club members can get full info including their name, as well as detailed due-diligence, etc. here. (Membership is free but requires verifying that the applicant is truly an investor and has no business connections to sponsors). 7) Life Settlements (2.75% of portfolio). Return: Too soon to tell yet.
Life settlement funds purchase life insurance policies from people who decide they don't want to pay for them (price gets too high, don't needed, need immediate money etc.). The fund continues making payments until the person passes away and collects the life settlement.
The asset class is uncorrelated to public market/the business cycle and can be great diversification to a portfolio in a recession/downturn. Returns can be 7.2% to 10% net.
The sponsor has requested its identity to be kept confidential in this article. Club members can get full info including their name, as well as detailed due-diligence, etc. here. (Membership is free but requires verifying that the applicant is truly an investor and has no business connections to sponsors).
8) Front Street Capital (<1% of portfolio). Return: Too soon to tell yet. Front Street is a rare company that has over 30 years of experience, with $100 million in capital and has lost zero investor money across multiple cycles. They develop and acquireoffice, healthcare mixed-use and industrial with conservative 65% LTV target leverage. Normally, I avoid ground up construction at this stage of the cycle. However, Front Street eliminates the normally substantial refinance and interest rate risks by lining up the permanent loan advance. And they also eliminate most or all of the tentatingrisk by placing the tenant in advance. So I feel comfortable making an exception for them on this (especially with the track record). This one is expected to be returning about 7% quarterly right away. And like most real estate syndications it also will realize significantly higher if it can sell properties at a profit at the end.
9) Peer to peer (<0.1% of portfolio). Return:4%. I made progress liquidating my least favorite part of my portfolio, and it's almost history. I used to be a huge cheerleader for both Lending Club and Funding Circle. But over the years, I've grown increasingly unhappy with the quality of the underwriting and the annoyance of the "tax inefficiencies". My returns have dropped from the high 9% in early years, to under 5% last year and 4% now. I'm concerned with what will happen if we have a downturn and not hanging around to see what happens. So as I described in this article, I've been liquidating this portion.
So what will I be doing next? Since I'm concerned about a potential downturn, I'm going to be adding investments in alternative asset classes that aren't directly tied to the business cycle. Also, I'll continue to look at MG Properties deals in the new year and continue the hunt for similar sponsors. I'm also hunting for more conservative short-term debt funds to diversify into. As the cycle ages, I may re-balance my current hard money loan portfolio and put more in lower execution risk rehab/acquisition loans and less in higher execution risk construction loans. I'll continue to watch the local single-family house and multifamily market and if prices fall and get more reasonable then I will add to my position there. Also, I'll continue to liquidate my peer to peer holdings.
Cash is King
I also have an almost-embarrasingly large amount of cash waiting for new opportunities that may arise after we go through the next downturn. Contrary to popular belief there's no guarantee that real estate prices will fall. So I'm not counting on it. But I feel that most likely there will be some sort of bargains to be had someplace. Ultimately, we'll see. I don't actually hold my cash in a savings account, because the returns are ridiculously low (many times less than 1%). Instead, I invest it in five year CDs with a low penalty for breaking them, and which currently are around 2.8%-3%. To minimize the penalty fees, I break up the money into a bunch of little CDs and only liquidate what I need (so I only get penalized for that amount). For example, if I wanted to do this with $100,000 of cash, I would break it up into five CDs of $20,000 each. Then if I need $20,000 in cash I would break just one of them, pay a modest couple months interest penalty on that alone, and continue to draw full interest on the others.
I've been asked to talk about the tax treatment of the different items in my portfolio. This can sometimes get complicated, so many people skip thinking about it. However, doing that can lead to expensive mistakes. So I think a smart investor should always think about the after-tax return of an investment when looking at it. At the same time, minimizing taxes isn't my first goal. Yes, I put a lot of time and thought into making sure that I minimize my tax burden as much as possible. But if forced to choose between minimizing taxes and preservation of capital/reduction of risk, I'll choose the latter every time. Someone coming from a different risk tolerance and financial situation might feel very differently. Or to put it another way: I'm usually fine with losing a few percentage points of projected after-tax return if gives me extra safety and protection of principal. So you won't see me loading up 100% my portfolio in the most tax efficient investments possible.
I live in Tampa, Florida and am lucky in that I have no state income tax. (We do have a sales tax but it applies to purchases and not to income). I also have a relatively small percent of my portfolio in a tax-sheltered self-directed IRA. So, I've saved it for other investments that have much worse tax treatment than real estate. But if you're in a different situation, your self directed IRA or solo 401(k) can be a good way to save on taxes. (See "How to Liberate Your IRA / 401k to Invest in Real Estate") My portfolio tax breakdown:
Residential rental properties: This is taxed at passive income rates. Due to depreciation, distributions were 35% shielded from taxes last year. I expect to get even more shielding this year with the new tax laws going into effect which give an additional 20% deduction for certain real estate investments (Qualified Business Income or QBI).
Short-term position debt: This is the 2nd least tax efficient portion of my alternative investments portfolio (and the worst of my real estate investments) because there is no depreciation. So there is no shielding from taxes. However, both funds can take advantage of the new 20% QBI deduction in the tax law this year. So that will help.
Broadstone net lease: Distributions are 1099-DIV dividends and taxed as such. This was 42% shielded from taxes last year, due to the depreciation. Again, the new tax law also gives me an additional 20% QBI in shielding this year.
MG properties group: Distributions are 100% shielded from taxes. Additionally they have traditionally given their investors the option at the end of the holding period to do a 1031 exchange into a new property. This defers paying back depreciation and paying capital gains. An investor can repeat this over and over and effectively delay paying taxes forever. Even when the investor dies their heirs inherit it on a stepped-up basis and don't have to pay the taxes either. (See "How to Invest in Passive Real Estate Without Paying a Penny of Tax (Legally): Part 2: "Defer, Defer and Die".
Front Street: Distributions are 50% shielded from taxes. Again, the new tax law should also give me an additional 20% in QBI tax shielding this year.
Litigation finance: I've seen different funds structured and categorized differently. The one I invested in happens to be pretty typical and capital gains (which can be very tax beneficial when it is long-term) and ordinary gains (which is taxed at ordinary income rates, and thus not any tax benefit).
Life settlements: I've also seen these structured and categorized differently. This particular fund happens to be set up very well with preferential tax treatment. All gains are projected to be qualified dividends (taxed at just 20%).
Non-real estate business loans: Like most of the funds in this asset class, this one has no special tax benefits and is simply tax-deductible ordinary income rates.
Peer-to-peer: This is the worst of all my alternative investments. First, there is no depreciation like in real estate to shield anything from taxes. Second, I actually end up paying extra taxes on phantom gains that I never really realized, because of the tax and efficiency associated with the loans that have losses. Theoretically, I'm supposed to get those back, but it can be years before it happens. All in all, this is a huge mess and yet another reason that I have deliberately exited from all of these.