Deep-dive Into My Seven Figure Alternative Investment (and Real Estate) Portfolio: 2020 Q3 Update
Updated: May 17
Despite the surprise of a global pandemic and the sharpest downturn in U.S. recorded history, my defensive, boring-by-design portfolio returned about 11.58% (including a decent 6.77% in income). Here's an in-depth look at my portfolio strategy, allocations, deal by deal performance, tax considerations and future strategy.
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 alternative investing portfolio, and how's it doing?" So I've been regularly sharing a deep-dive review of it since 2017. This includes what I'm invested in, how it's doing and my detailed thoughts on each one. So here's the latest update. This article covers:
1) About me (so you can put my portfolio choices into perspective)
2) Current portfolio overview and strategy (and changes from last time)
3) Comparison with other alternatives (stocks, bonds, real estate indices as well as the performance of my last update)
4) Portfolio allocation
5) Investment-by-investment deep-dives
6) My strategy for the future
Plus bonus features:
7) How I manage cash
8) Investment by investment deep-dives on taxes
So let's start off with a little bit about me and my personal situation, so you can understand my portfolio choices.
I'm a retired serial tech-entrepreneur and rely on my investments to support myself and my family. So my risk tolerance for loss is low (especially compared to someone who's working and not depending on their investments to live). And I'm much more concerned about preserving my capital (not losing money) and generally am un-interested in going for the highest projected returns. So this makes me a conservative investor. Alternatively, a person with a different risk tolerance, who comes from a different financial situation and/or has different financial goals, will probably disagree with many of my choices. And that's fine, because (in my opinion) everyone is different and there's no such thing as a single sponsor or investment that's good for everyone.
My Portfolio Overview
My wife and I share financial decisions and have a broad portfolio. And this includes seven figures invested in "alternative investments": investments that fall outside the traditional box (of public equities, bonds and cash investments) that most investors recognize and usually get through a retail broker. Many alternatives are only available to higher net-worth investors and/or institutions. And they're typically only found through word-of-mouth, crowdfunding, and/or through an investment club. My alternative investment portfolio follows the core-satellite approach to portfolio design to manage risk. This means that the majority of it is placed in a huge, conservative core. And that lets me feel comfortable taking more risk on smaller satellite portions. The portfolio is mostly invested in real estate with additional investments in a variety of hard-to-find asset classes that are not directly tied to the business cycle (like litigation finance, music royalties and life settlements). More details on this are in a later section, below.
As of Q3 2020, the portfolio returned about 11.58% (for the trailing 12 months). The income portion was 6.77%. I'll dive into the investment level returns in a following section.
Current Strategy: "Defense, defense, defense!"
My last update was back in the fourth quarter of 2019, which almost feels like a lifetime ago. So it's no surprise that so much has changed in my portfolio since then.
At the time, I was concerned about being late in the cycle, and increasingly worried about what a potential downturn would do to my principal. So back then, I positioned myself very defensively with this strategy:
Invest in assets uncorrelated to the business cycle that could still crank out attractive returns even in a downturn.
Invest "quick and slow": Invest in "quick" short-term investments with sharp lockups (like hard money loan funds) in case trouble hit. And also in "slow" long-term investments of 7+ years (with low leverage and conservative underwriting) that could ride out any short to medium-term trouble. I avoided investments in the middle that might get clobbered if economic conditions deteriorated.
Hold lots of cash to potentially take advantage of distressed situations in a potential downturn.
I also battened down the hatches by reducing holdings in some of my best-returning assets. That slightly reduced my overall returns (from 8.76% in Q1 of 2019 to about 8% in Q4 of 2018). But it let me sleep at night. Then in January 2020, the Coronavirus pandemic hit. Never in a million years would I have imagined this was going to happen. Nor did I imagine that entire portions of the economy would be shut down, millions would lose jobs and we would get the most severe GDP contraction on record. But, my defensive posture paid off by minimizing the damage. Some who invested in more aggressive investments (especially in hotels, retail etc.), aren't feeling as happy right now. So far, the damage has been minimal, but I also know that isn't guaranteed to continue. So, every week I've been closely monitoring the evolving situation, and updating my investment strategy according to the latest info. At the end of this article, I'll talk more about what I think will be happening in the future.
Comparison with other alternatives (stocks, bonds, and real estate indices) and the performance of my last update
First, how was this return compared to other options? Here were the total returns (both dividends and stock price appreciation) for the following public stock market indexes for the trailing 12 months:
Russell 2000 index for small companies: 4.10%
Dow Jones industrial average index for 30 large blue-chip companies (DJIA): 5.10%
Standard & Poor's 500 index for large companies (S&P 500): 13.98%
The volatility in public markets was unusually high, due to the mayhem caused by the pandemic:
And here were the total returns for the following public bond market indices for the trailing 12 months:
S&P 500 municipal bond index: 3.41%
S&P 500 bond index for large corporate grade bonds: 8.92%
The pandemic also caused high volatility here as well:
Meanwhile, the Greenstreet Real Estate "All Sector" CPPI index was down at -9%. This index is composed of number of sectors which had varying up and down performance in the last 12 months, including retail (20%), office (17.5%), apartment (15%), health care (15%), industrial (10%), lodging (7.5%), net lease (5%), self-storage (5%), manufactured home park (2.5%) and student housing (2.5%).
Comparison with Last Update (in Q4 of 2019)
How did my portfolio do this time, compared to my last update in the fourth quarter of 2019? Back then, I only reported income and didn't report total return (because some of it was more difficult to calculate).
So looking only at that: the income-only portion of the return this time was 6.77%. That was down from the approximately 8% last time. And this was mostly due to the dismal performance of Broadmark after it went public. There were also smaller drops by Broadstone Net Lease, Arixa and MG Properties. On the other hand, the no-debt residential properties stayed strong and actually increased to 8.73% from 8.3%.
I'm also very excited about the new non-correlated asset additions to the portfolio since last time. Not only will they harden my portfolio from this recession (and after-effects), but should also boost returns as well. And I also added a pandemic "insurance policy": an investment in a PPE manufacturing startup. I'll go into more detail on every investment mentioned above, in a minute.
Here's the low-level breakdown of my portfolio allocation.
As I mentioned above, I follow the core-satellite approach to manage risk. And so, the conservative core is made up of boring no-debt residential properties, which make up 49% of the portfolio. (More on this below).
The rest is the satellite portion. I allocated additional money to the following investments. (And note, the added money isn't always easy to see from just the raw numbers: more money is being put into other areas as well, and that lowers the percentage.)
Litigation finance (non-correlated asset): now 3.5% versus 4.1% last time
Life settlements (non-correlated asset): now 2.3% versus 2.8% last time.
"Non-real estate" loans: now 3.5% versus 4.1% last time.
And I made brand new investments in:
Music royalties: 1.6% (non-correlated asset)
PPE manufacturing startup: 1.3% (pandemic "insurance")
Dislocated "non-real estate" loans: 1.2% (covid-19 related investment)
I'll go into a deep-dive on each one of these in a minute.
My Portfolio: Real-estate Portfolio Allocation
But first, for all the real-estate buffs: here's how the portfolio is split out between real estate and non-real estate investments.
Real estate remained the largest portion of my portfolio at 83.2%. This is a little less than the 88% in Q4 of 2019. Non-real estate was boosted to 16.8% from 11% last time. How is that 83.2% of real estate allocation broken up? Here's what it looks like (with all of them adding up to 100%):
Again, you can see my core-satellite approach, with the majority of it in very boring no-debt residential properties.
Note that I deliberately haven't included my primary personal residence in any of these graphs and calculations. Technically, it is a real estate investment. And for many people, it's the largest investment they'll ever make (which isn't the case for us). On the other hand, my home also provides shelter, an additional value that's difficult to calculate. And more importantly, my family treats our home like more than an investment. We love it and spend money on it way above and beyond what would be done with a pure investment. So that's why I'm not including it here.
So going back to the graph... here's what changed since last time:
I significantly decreased my exposure to hard money loans. This is because I liquidated most of Broadmark and am in the process of liquidating out of Arixa. The latter is currently 10% of my real estate, which corresponds to 6.24% of the entire alternatives portfolio (versus 28.3% of the whole portfolio last time).
Triple Net Lease (NNN) exposure was reduced from 11.8% of the entire portfolio to 7.488%. I didn't actually liquidate any of my Broadstone Net Lease holdings, but the percentage shrunk simply due to the brand new allocations in other asset classes mentioned above.
Multifamily equity stayed about the same (11.9% versus 11.6% last time). I didn't sell anything here and actually made some additional investments in MG and FrontStreet. But, the percentage held about the same due to adding even more money to the non real-estate asset classes mentioned above.
No-debt residential properties also stayed approximately the same at 36.7% now versus 36.5% last time.
And for those are are curious, here's how my real-estate portfolio currently breaks out, by real estate investment:
A deep-dive on each one of the above is coming up in the following sections.
Trailing 12 Month Returns
How did each individual investment do? Here are the trailing 12 month returns:
And here's how these were calculated:
Many alternative investments have an initial investment period (typically a year or two) during which they are deploying funds and are not making distributions. So I didn't include these in my calculations.
Price appreciation of real estate can be tricky to determine without an expensive appraisal (which isn't practical). And the other way they are valued is when properties are sold. But typically, that sale doesn't happen for 5-7 years after initial investment (to maximize the return). So, as a proxy, I used Zillow's home pricer, the Zestimate, for residential property appreciation. Many feel this underestimates prices. For commercial real estate, I used the GreenStreet CPPI commercial real estate index. Note that both MG and FrontStreet appear to be doing much better than average sponsors, so arguably the are being shortchanged here. So my actual appreciation and total return are probably a little better than the numbers I'm reporting. Still, I feel it's "good enough" for an estimate at this point.
As mentioned earlier, income was down from last update. This was caused by:
Broadmark was our biggest disappointment. It was previously a privately held investment, returning 11.22%. Then it converted into a public stock via IPO (which was against my personal wishes) and the dividend fell to 7.25% (currently based on my entry price). Meanwhile, the volatile stock price gyrated and is currently at about -7.25%. So the net result was about zero gain. To avoid skewing the income returns too high, I reported this as 0% income and 0% price appreciation in the return calculations (which is the same net result).
Broadstone Net Lease dropped from 6.6% to 4.2% (based on my initial investment price).
Arixa dropped from 7.36% to 6.82%
MG properties dropped from 6.45% to 5.29%
The one exception to income drops were the no-debt residential properties. These increased from 8.3% to 8.73%.
Here's a deep dive look at what's happening on each investment (from the largest to the smallest holdings):
1) Residential rental properties: (same as last time at #1)
This is by far the biggest part of my alternatives portfolio. Again, I follow the core-satellite approach to risk. And this large 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 (avoiding class-C) 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. The vast majority of real estate investors would probably consider this to be an outrageously conservative strategy that leaves too much money on the table. And they would would prefer higher projected returns by taking on leverage instead. On the other hand, the strategy works for my purposes. This returned 18.78%. That's obviously very good and not what would usually be expected from a conservative investment. So I don't expect this to happen every year. 8.73% was in income and the price appreciated 10.05% due to a hot property market. I don't expect this kind of price appreciation to happen every year. But when it does it's like getting extra gravy at a meal: a nice bonus. I regularly cull this portfolio when a property falls out of my minimum criteria. And last time, I talked about how I sold two of them. These were high earners but in neighborhoods that were starting to deteriorate due to crime creeping in. And if the neighborhood takes a turn for the worse, turnover and other items can go up a lot. This can kill performance, and I'm glad I sold them.
This time around, I'm now preparing to sell another one. This one has also been a very high earner and the neighborhood is relatively stable. But it's still suffered higher turnover than other properties. I've had four different tenants in about the last four years (versus other properties which saw only one or two). And this kind of turnover kills the return.
Most of my former tenants went on to purchase homes of their own. And I'm happy for them personally, but as a landlord, this tells me that something is a little bit off. This particular house commands a higher rent than most of the others, and is so high that people who can afford it can also afford to buy. I would rather be invested in a property that commands a little bit lower rent, in exchange for cutting down the cost of turnover. So that's why this one is being prepared for sale.
Last time, the two sold properties earned an additional 21%+ in price appreciation, which I didn't include in my portfolio return totals. This time, I suspect it will be similar (and will probably not include it in the return either).
My goal is to redeploy that cash into this asset class. And as I'll talk about later, in the section on my view on the future, I personally believe there is a decent chance that a lot of the worst effects of the current recession have been hidden by massive one-time stimulus and unemployment benefits. And if these aren't renewed, I believe there will be a chance to purchase distressed homes at a lower price than today. But, there's no guarantee that will happen, so we'll see. Also, I'm not willing to buy rentals 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) MG Properties Group (versus #4 last time)
Last time, I was in eight different properties with this sponsor across multiple funds. Since then I've added additional money and am now in ten.
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. See this article on: "How to Invest in Passive Real Estate Without Paying a Penny of Tax (Legally): Part 2: "Defer, Defer and Die". 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). This is all part of the "defer, defer and die" tax minimization strategy mentioned above. When Covid-19 hit, MG suspended the Q1 distributions to get a better idea of the pandemic's impacts. As a conservative investor, I appreciated them doing this (versus some of the more aggressive sponsors who continued to pay out as if nothing was happening and potentially increased future investor risk).
They worked proactively to minimize losses (including in many areas that are less favorable to landlords due to local regulations). And I was very happily surprised when, a few months later, they confirmed that the final rental losses were minimal and significantly lower than many had feared going into the pandemic. As a result, they then made the Q1 (and later Q2) distributions at a slightly lower amount than pre-pandemic.
So, income dropped slightly to 5.29% versus 6.45% last time, which I found perfectly fine and thought was a good result. And I also appreciated the steady hand that MG demonstrated during the pandemic. Additionally, I very much like how the company is remaining fiscally conservative and has plans in place should further disruptions in the economy occur.
3) BroadStone Net Lease (NNN leases): #3 largest (versus #3 last time, so no change)
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 assets that have been Amazon resistant and recession resistant in past recessions. These are mainly industrial, medical and fast casual restaurants. It has full-real estate cycle experience, low leverage around 40% LTV, has an investment grade rating and in the past has generated healthy income and price appreciation for me. Last update, BNL's real estate was continuing to perform very well, along with distributions. But the price appreciation was very disappointing. Unlike other investments, their net asset value (NAV) moved sideways. So I was hoping this might change in 2020.
Then the pandemic hit, which threw all plans out the window, and the company suspended distributions. As I said above, I appreciated that as an investor, because I prefer caution over the more aggressive response of a sponsor that would continue to pay (and potentially run into problems later).
As I've talked about in my weekly series on Covid 19's affect on alternative investments, this recession has been different than most and has hit many sectors in surprising ways. While industrial has mostly held up, restaurants and retail have been hammered. And these are both in this portfolio. And right at the beginning of the pandemic, the parent company of one of BNL's larger holdings went bankrupt. So initially, I was very concerned about it.
After the pandemic's arrival, BNL management put their noses to the grindstone and worked hard to minimize concessions and losses. They also ultimately sued and won a judgment against the bankrupt company that was trying to withhold rent. The result was that after a couple of months they were able to resume distributions. And currently, rent deferrals and concessions have gone down dramatically, and rental collections are surprisingly strong (95.5%). Counting that distribution outage, my current 12-month income (based on my initial investment price) is 4.27%. That's down from the 6.6% last time, which is a little bit disappointing. However, given the big picture and what could have happened, I thought management did a good job, and produced overall a very good result. This result should continue to improve, and once that outage moves out of the 12-month window, the stat should show a big jump.
And as I'll talk about below, I do not think we are out of the woods yet with the pandemic. So I appreciate that BNL management seems to be continuing to take a conservative approach in regards to managing the real estate.
On the other hand, I was not as happy with something else that BNL did. As I mentioned last time, the company had previously announced they intended to do an initial public offering (IPO) and convert from a private offering into a publicly traded stock. I didn't appreciate being forced into this kind of holding, for a few reasons:
When I invest in public stock markets, I prefer to be in a large, diversified fund that is protected from the risks of heavy concentration in one individual stock. Now, after this conversion, I would instead have a significant overweighting in a single stock (exactly what I didn't want).
Since I already have the percentage of triple net exposure that I want in my public stock market allocation, this conversion would also throw my portfolio allocation completely out of whack. And to keep it balanced, I would have to sell BNL and find something to replace it. But, I had spent several years just to find BNL's fund in the first place. So I was not looking forward to having to repeat this process all over again.
Public stocks are typically much more volatile than private offerings, as prices swing up and down with emotional investor sentiment. And I've experienced firsthand how the IPO process can sometimes benefit insiders handsomely, while investors are left with scraps and/or a dismal return. (See Broadmark below). I hoped that BNL would behave responsibly, but was still unhappy with being exposed to general public market risk without my consent.
Ultimately, the stock did IPO on September 16. And the initial price was significantly below what I paid in (about $17 after a four way split = about $68 vs. about $80 per share purchase price). And since then, the stock has pretty much gone nowhere (traded sideways):
However, it's still not yet certain whether I will actually take a loss, break even, or make a gain.
First, as is common with IPOs, my shares are locked in for 180 days until after the IPO conversion is completed. So I won't know at what price I am able to liquidate, until the middle of March 2021. Things could be very different by then.
And second, investments that follow the traditional IPO process, through an investment bank, typically take a couple of months or quarters before they burn off the discount (caused by the investment bank fees, etc.) and reach their full distributed value. Along the way, there are milestones: the release of investment bank coverage, inclusion in an index, etc., tend to push up the price. The hope is that the discount will be fully burned off, and I will break even or make a gain. For example, JP Morgan and Morgan Stanley have a price target for BNL of $20. And Goldman Sachs is targeting $24/share in twelve months. But there is no way to know for sure what will actually happen.
So the bottom line is that I won't know for sure until March of 2021. And then at that time, I'll decide what I want to do with this (either continue to hold, or liquidate and redeploy).
Also, there is a counter-argument to my way of thinking, that says I'm being way too harsh on BNL by judging it's price-performance based on the price after the 180 day lockup. After all, before the IPO, the private fund had a five year lockup before it could be liquidated. So really, the fact that the public stock allows me to liquidate earlier, is just an extra option. And I can't truly judge if the IPO was good or bad for my original investment, until the whole five years have expired. (And this IPO has given the fund a ton of new capital to deploy, which should theoretically increase the ultimate long-term return).
If I go with that longer timeline of thinking, then it's hard for me to imagine that the stock will not have hit at least $80 sometime by then (and presumably would be much higher). If it does, and it also makes up for the drop through 2020, and it also resumes growing at a good yearly rate (i.e. like the pre 2019 years)... then I would have a very different view of the IPO than I do now. On the other hand: that's a lot of "if's". So we'll see what happens.
4) Broadmark Capital short-term hard money loans: (versus #3 last time)
Hard money loans are debt investments that sit in the safest part of the capital stack. And for many years, I've loved the Broadmark hard money loan funds (BroadMark Capital Fund 1 and 2). As a conservative investor, I'm very picky about the type of loans I invest in. And they have been one of the few types able to meet my criteria. (See The Comprehensive Guide to Hard Money Loan Investing):
First position only, which is the safest part of the capital stack.
Short-term (1 year), which allows me to possibly liquidate quickly if conditions change.
Conservative LTVs (65% loan to value maximum).
Good uncured default rate (less than 2%).
Only operate in nonjudicial states.
They do construction loans, which have added execution risk over other types. So, I previously balanced this fund out with a non-construction hard money loan fund (Arixa, which I'll talk about next).
And for a long time, this fund was an all-star performer in my portfolio. In the late cycle period of the last expansion, when bonds were yielding low single digits and CDs much less, this fund consistently kicked out double-digit yields. And in the last update, it was averaging 11.4%. And I privately and publicly raved about Broadmark to many people (such as when I was interviewed by the Wall Street Journal and they were quoted by name).
However, as I mentioned in my last update, I started to get concerned about late-cycle cracks in the underwriting. Both funds experienced more defaults, and Fund 1 even lost money on a loan or two. With proper underwriting, losses generally should not happen during an economic expansion. But it felt like pulling teeth to extract any useful information on what had happened from investor relations (taking multiple follow-ups to get a reasonably thorough response). And ultimately, I didn't feel comfortable with the answers.
And then the news came out: they were planning to offer the fund on the public stock market via an initial public offering (IPO). I was unhappy with this for a few reasons:
When I invest in public markets, I prefer a large, diversified fund to reduce risk versus taking a heavily concentrated risk on an individual stock. So I didn't appreciate being forced into increasing my risk with this holding.
I already had achieved the amount of allocation I wanted, for public REITs in my stock market portfolio, before this IPO. And this would throw everything out of whack and require me to sell and replace. And it's difficult to find a good, privately-held hard-money loan fund that meets all of my conservative criteria. So this was a huge hassle and extra risk.
I didn't like the fact that I would no longer be able to redeem out at my cost. Instead, redemption would be at whatever price the volatile stock market was willing to give me at that time, which was an additional risk.
Still, management claimed they felt the IPO would be the best thing for investors. Ultimately, I sold 50% of my formerly beloved investment before the IPO, and watched what happened.
The stock went public on the New York Stock Exchange (under the ticker BRMK) on November 15, 2019 at $11.08 per share. And here's what's happened since:
It rose a bit for the first few months, then traded sideways for the next couple of months (going nowhere) and peaked at $12.73 in late February. Then it plunged with the rest of the stock market down to a very unhappy $5.82 in late March. It recovered somewhat, but for the last several months, has been stuck and gone sideways again. Currently, it's at $10.02, which is a loss, and underwater from the initial IPO. So, an investor who previously could have liquidated the private fund at purchase value must now take a loss in order to exit.
I personally liquidated another 50% of my remaining holdings in March, before the huge drop (at about the same price it is now).
When I add up all of the distributions I've received (about 7.25%), it almost exactly offsets the loss in share price. So essentially, I broke even.
This is an extremely poor result compared to the 11.4% this investment earned me previously.
Broadmark is now trying to start up yet another privately-held hard money loan fund (with -- presumably --the same ultimate goal of flipping it via an IPO, as well). So Broadmark is again hitting up investors for money. But so far, they do not appear to be getting much traction, as the amount raised is tiny compared to last time.
I can't guess what others are thinking. But for me, personally, the company has left such a bad taste in my mouth, that it's hard to imagine giving them another dollar. Maybe over time, I'll feel differently. But right now, I intend to put my hard money allocation elsewhere.
5) Non-Real Estate Loans (versus #6 last time)
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 a $30,000/ year membership fee). I can say that I was impressed with the sponsor's diligence and competence during the Covid-19 crisis. And I also like how they are remaining conservative and taking precautions in case the worst is not over. I feel glad I chose to put my money with a sponsor that has been through a deep recession before. The sponsor has requested its identity and additional info to be kept confidential in this article. Club members can get full info including the sponsor's 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 conflicts of interest.)
6) Litigation Finance: (versus #5 last time)
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. Additionally, many litigation finance funds have not been negatively affected by the current virus crisis. (And many are reporting increased opportunities due to the pandemic, and so are raising more money).
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 in which I invested 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 produce a profit. It's also not expected to produce distributions in the first year. So it is really for medium-term money (5 years +). The sponsor has requested its identity 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 conflicts of interest).
7) De novo (new) bank startup: (not listed last time)
This was an investment in creation of a de novo (new/startup) community bank. Community banks are local, smaller banks that fill a niche of lending to local businesses. Typically, the big banks don't do these loans, because they don't know the local businesses well enough to underwrite them, and the amounts involved are too small to appeal to the larger banks. So the small banks perform a crucial role in local economies. But so many of them have been bought out by the bigger banks over the last couple of decades, that there aren't a lot of them left. And only a handful have been created since the Great Recession.
I liked this investment because the principals had 28% skin in the game, and the CEO had an exceptional underwriting record through the Great Recession, when he was with another Community Bank (which eventually was bought out). The charge-off/default rate for that bank was 4x-9.6x lower than the average community bank (which itself was much lower than the average big bank).
Prior to Covid-19, this had been performing well. Each quarter, they announced they were hitting or ahead of projections concerning expenses and asset growth, which was good to see.
Then Covid-19 hit, which caused the Federal Reserve to drop rates to rock bottom. And generally, this puts a squeeze on the profitability of banks. So, when that happened, I got worried for this investment.
However, what I didn't anticipate was that there would be a new opportunity for them in writing Paycheck Protection Program (PPP) loans. These were part of the U.S. Federal Government stimulus package to keep businesses afloat. Also, they appear to have an unexpected advantage over other older banks, which is that they have not made very many pre-Covid-19 loans that could unexpectedly go bad. As a result, they actually beat the original projections on net profit in their last quarterly report. This was a very pleasant surprise, and hopefully, they will keep it up.
8) Arixa Secured Income Fund (hard money loan fund): (versus #2 last time)
I talked about the hard money loan asset class in detail above (see Broadmark). And for a long while, this fund was also a favorite of mine in its asset class and produced many years of solid returns.
Arixa Capital Secured Income Fund is (mostly) a hyper-local acquisition/rehab hard money fund. 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 (Arixa averaged 7.35% return in the last update). But I felt, and still feel, the diversification protection was well worth it. However, as the year started, I began to grow unhappy with some things. I didn't like how the number of higher risk loans above 65% LTV had slowly increased since I initially signed up (as well as the number of even higher-risk loans above 70% LTV). As I described in the Comprehensive Guide to Hard Money Loans, high LTV loans have a smaller equity cushion and can increase the risk of loss if things go wrong. I had put up with this when I first entered the fund, because I liked its other strengths. But as the high LTV loans slowly increased and the cycle aged, I started to get more and more uncomfortable.
As I mentioned in my last update, Arixa had moved outside of their area of traditional expertise (residential properties in a small area of California) and into multifamily and across multiple regions. On one hand, this would presumably increase volume, and help them endeavor to maintain the fund's yield in an industry where margins were shrinking as the cycle aged. On the other hand, with so many other competitors doing the same thing, I would've preferred that they stuck to their realm of competence to make it easier for portfolio allocation. More importantly, a small number of loans ended up occurring in judicial-only states. These can end up chewing through the equity cushion if they have to go to foreclosure, and are generally a red flag for me.
On the other hand, the fund had done very well for me for a number of years and provided a very reliable and solid return. So I had a difficult decision to make. But ultimately, I decided to withdraw my money early in 2020.
But then, Covid-19 threw all these plans out the window. Like some other hard money loan funds, Arixa gated withdrawals (including mine) and didn't release full payment to me. Slowly, over the following quarters, they did release more and more of my money. And I believe the next upcoming payment will pay out the remaining amount and I will be fully out. What about going forward? Once I feel this asset class has struck rock bottom and is assuredly moving back upwards towards recovery, I will take a look again at it. Often, after a downturn, many things reset, including getting lower/better pricing and enjoying thicker margins. And theoretically, this would allow hard money loan operators to underwrite fewer of the higher LTV loans and still maintain strong returns. So, if that happens, then I will be revisiting Arixa.
9) Life Settlements: (versus #8 last time)
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 feel they need it, prefer immediate money, etc.). The fund continues making payments until the person passes away, and then the fund 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 conflicts of interest).
10) Music Royalties: (versus not in portfolio last time)
Music royalties have historically been very recession-resistant and not correlated with traditional and/or real estate asset classes. So this non-correlation can provide protection diversification to a portfolio during a downturn. It's also one of the few industries that's projected to grow in 2020 and 2021 despite Covid-19 (according to both Billboard and Goldman Sachs). Target IRRs in the industry can be very healthy 14-15% net IRR. 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 conflicts of interest).
11) Startups-PPE (Covid-19 "insurance"): (versus not in portfolio last time)
The Covid-19 crisis has caused a significant shortage of critically needed PPE (personal protective equipment, such as n95 masks) for healthcare professionals in the United States. Part of the problem is that supply chains were based on manufacturing in China, and during the pandemic, China has diverted these to its own needs and away from the U.S. And the Chinese manufacturers who do ship to the U.S. are often inadequate due to fake certifications and quality control problems. Companies like 3M and others have ramped up supply, but they say that it will not be enough to meet the increased need and demand.
So I invested in a PPE manufacturing firm. I look at this as a form of Covid-19 insurance. If the pandemic runs longer rather than shorter, and many other investments suffer, this one will actually do better. And if the pandemic is gone tomorrow, I would be happy to take a loss on this, because all my other investments would be skyrocketing (although I personally am doubtful of a speedy resolution). It is a startup, so it has more risk than an established business. But I have a portion of my alternative portfolio set aside for this, and it was a good fit.
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 conflicts of interest).
12) Dislocated non-real estate loans (versus not in portfolio last time)
As I mentioned in my previous update, I have set aside a considerable amount of cash. The idea is to be able to take advantage of dislocated and distressed opportunities caused by this recession. There's no guarantee there will be an opportunity to do this, or that it will be profitable. But this is how many small fortunes were built after the Great Recession.
This particular fund was designed to take advantage of dislocated, non-real estate debt caused by the Covid-19 crisis. It's not a distressed fund, so they're not looking for deals that are in trouble. Instead, they're looking for healthy, cash flowing loans that can be purchased at a significant discount due to market dislocations and distressed sellers. So this takes on less risk than a distressed fund strategy.
The sponsor has an exceptional recession track record and has run multiple funds similar to this one successfully in the past.
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).
13) Front Street Capital. Return: (versus #8 before) 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 acquire office, 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 in advance. And they also eliminate most or all of the tenant lease-up risk by placing the tenant in advance. So I felt comfortable making an exception for them on this (especially with their track record). This one was expected to return about 7% quarterly right away and did indeed deliver. And like most real estate syndications, it also will realize significantly higher returns if it can sell properties at a profit at the end.
What's next? (My strategy for the future)
So what will I be doing next? There's so much uncertainty now, caused by unknowns with the virus crisis and the virus-induced economic fallout. And the dynamics -- the shape and speed -- of the recovery will dictate how different investments do and the best strategy to pursue. So, every week, I take a look at the latest developments in data and then reevaluate my personal outlook on the possible economic scenarios, and update my personal investment strategy accordingly. You can see the latest and greatest information here.
As of today, here's my forecast and strategy:
Treatment: I believe chances are good that we'll have an effective medicine for Covid-19 (i.e. antibody treatment, vaccine, etc.) by fall or winter of this year. And with some luck, we could even have more than one. Unfortunately, it's also unlikely it will be 85%+ effective and that it can be manufactured and distributed in large enough quantities to immediately treat everyone in the U.S. who wants and needs it, until well into 2021. If either happens, then it will not be enough to super-charge the economy right away. And, there may potentially be a huge quality-of-life difference between the treatment-haves and treatment have-nots. This will be divisive and will exacerbate existing tensions and conflicts between rich and poor countries. And it's likely to cause considerable instability in "have-not" countries that could easily cause unexpected global consequences, not just for themselves but also for the U.S. and the world.
Recession? When the U.S. was first hit by the virus, many pundits claimed the U.S. economy was so strong, the virus would have little to no effect (or if it did, then it would rebound quickly and things would be back to normal in a jiffy). But, after looking at all of the micro data week after week, I said I couldn't see any way the country could avoid plunging into a technical recession (two consecutive quarters of negative GDP growth). Ultimately that happened (-5% in Q1 and -32.9% in Q2). Going forward, I believe Q3 will show strong double digit growth. But this will be only because it's measured relative to the chasm of Q2 (i.e. an almost 40% plunge from 2019). And it will come up disappointingly well-short of the amount needed to "break even" to where things were back in January (and thus well short of a true V- shaped recovery).
Shape of the recovery: In part 14 of the weekly series, we talked about how the shape of the recovery (V-shaped, U-shaped, swoosh-shaped, W-shaped, L-shaped, combo-shaped etc.) will have a huge effect on the ultimate outcome of many different investments. So far, pretty much everything that's happened has been much worse than the consensus expected. Pretty much no one saw the virus spreading in the U.S. in any meaningful way. Virtually no one came close to imagining that lock-downs would occur in May. Hundreds of thousands more people have been killed than originally projected. And now, even the later, May projections, which maxed out at 200,000 dead, have proven to be too optimistic. Tens of millions more people than expected have lost jobs. The stimulus and unemployment aid was enormous, but had too many unexpected holes and didn't get into the hands of millions who needed it the most. States reopened, but were forced to backtrack. Many businesses have reopened, but customers are staying away. So unfortunately, I don't think a quick, V-shaped recovery is going to happen. I would love to be wrong. I'm getting more and more concerned about a very damaging "W", which could come from the second and/or third waves of the virus. Unfortunately, this is looking more and more likely. My slim hope is that the 3rd wave (from school openings, Labor Day and cooler weather) can be controlled and kept small. If this happens... and if the U.S. government also passes a generous stimulus law... then the worst effects of the additional waves could be mitigated. That's a lot of "if's"... so we'll see. And I'll continue to monitor the data very closely. Currently, I still believe we will have a three-stage combo-shaped recovery that starts off (1) quickly as the first "easy" industries and companies come back online (i.e. v-shaped). But (2) this will peter out as the more difficult ones are unable to return, and a slow swoosh will become apparent. If we get a second (or third) lockdown, then this step (2) will become W-shaped and more painful. Then in fall/winter, (3) I believe we will probably see a treatment and/or vaccine. And if we do, then that would be the trigger for the third stage and an accelerated recovery. But this most likely won't be a straight-V recovery, because it will most likely take time to ramp up production and delivery to enough Americans to push towards herd immunity (not until well into 2021). So the boost will be slower and smaller at first. Also, if the first generation medicines are significantly less effective than 100% (which many health experts believe will be the case), the boost will be even smaller. And all of this will depend on which treatment makes it that far... which we don't know at this point. But, we also could get a little lucky (for example, if the successful vaccine treatment is a newer type that can be scaled up more quickly or is more effective). If so, then the third-stage boost would be faster. If I'm wrong, and we don't get a treatment or vaccine this year, then the economic damage caused by long-term job loss and wage cuts will most likely be very severe, and will further exacerbate (and slow down) whatever type of recovery we do get. That would probably be ugly for the majority of all investments. So let's hope we don't have to find out how that scenario would play out.
Investments: If the above is roughly correct, then it will unfortunately be painful for many individuals and some investors. And some sub-sectors of alternative investing (like certain real estate classes) will come under heavy stress. Many may fold in the coming months. At the same time, I think there will also be an opportunity to purchase dislocated and distressed assets at very favorable pricing and significant discounts. And I believe that patient, discerning investors may be able to take advantage of once-in-a-decade or once-in-a-generation opportunities.
No new investments in real estate or any asset classes that are correlated with the unemployment or the business cycle until there is more clarity about the unknowns concerning the virus and the upcoming financial cliff.
Invest in assets that are coronavirus resistant (and uncorrelated with the business cycle). That includes:
Music royalties (which can actually do better in lockdowns due to increased streaming).
Life settlements (which actually perform better when people are dying faster and in any event aren't directly tied to the business cycle).
Litigation finance (which performs based on winning or losing cases, and also isn't directly tied to the business cycle).
Invest in coronavirus "portfolio insurance" (i.e. an investment that would be expected to do better the longer coronavirus continues or if it gets worse). As an example, an N95 Mask Manufacturing Company. If the pandemic should disappear tomorrow (which I personally am not counting on), I would be happy to take a small loss here given that the rest of my portfolio would be doing extremely well. On other hand, if Covid-19 doesn't disappear and things go as I expect (or worse), then this investment could provide a welcome profit boost and improve my diversification.
Continue to hold cash and be patient for dislocated and distressed opportunities. The worse the economic damage, the more chance there will be for those once-in-a-generation or once-in-a-lifetime opportunities.
My opinions and strategy will change if we get some better or worse news on the science side or in some of the other X factors. For example, a new stimulus law could shift things in a more positive direction. And, as I mentioned above, the virus getting out of control again in large areas and forcing large lock-downs a second or third time, could easily make things worse.
Bonus: How I Manage Cash
I don't actually hold my cash in a savings account or money market, because the returns are usually ridiculously low (much less than 1%). Instead, I invest it in five year CDs with a low penalty for breaking them, and which currently are around 1%-1.3%. 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.
Bonus: Investment by Investment Deep Dive on Taxes
Another thing people ask me a lot about is 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. On top of that, new tax laws went into effect last year which gave me an additional 20% deduction (for 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 newer 20% QBI deduction in the tax law this year. So that helps.
Broadstone net lease: Distributions are 1099-DIV dividends and taxed as such. This was 42% shielded from taxes last update, due to the depreciation. Again, the newer 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. A common setup is income that is considered 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. The particular fund I'm in 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.