Alternative Accesss - February 2020

Private Lending: What Your Collateral Says About You

In an era when interest rates have gotten lower and negative in certain parts of the world, the hunt for yield is as real as it is fierce. Enter debt funds. Debt funds provide income. Your investment is a loan to a borrower, and as a lender, you have a capped upside; the most you can make is the interest and fees you charge. You are collateralized, usually with rental income or real estate. If anything goes wrong, you’re going to get your money back before anyone else. We call this being senior in the capital structure. Equity funds, however, offer unlimited upside, but it comes with the explicit risk of total loss — think venture funds or real estate syndications. If the values go down because the rents aren’t there, then you’re getting an equity impairment, This article will discuss what debt funds are and how you should think of them through the eyes of a professional investor. I’m going to use two different examples of collateral: single-family fixer-uppers versus fine art. My experience, you ask? Well, I wrote the book on private hard money lending called “Making The Yield: Real Estate Hard Money Lending Uncovered.” It’s the handbook for making loans and starting funds around private lending against single-family home rehabs for interest income. Written several years ago, it once was the single most expensive book on real estate lending on Amazon. For the past few years, we’ve been involved in a segment of the industry called fine art-secured lending, a much smaller market where the collateral is more precious than it is prestigious — think Christie’s or Sotheby’s quality art. This is the collateral you post on Instagram to show your friends. which is a polite way to say your entire investment is at risk for a total loss.

It is insured for more than you lent on it by the world’s top insurers.

liquid. This means that loans on an average seven-month term are just as liquid. I mean, what’s the first thing historically stolen in times of war and political strife? The fine art. The gold bars are too heavy.

What’s your execution risk?

If your rehabber can’t finish the job, for whatever reason you’ve heard contractors tell you before, what is the plan?

What will your friends think?

The easier an investment opportunity is made available to the masses, the less valuable it becomes. In the era of crowdfunding, Bitcoin, and other conspicuously entry-level investments, what you invest in is the new form of legitimacy. There’s a big difference between the entry-level speculative investments popularized on “Shark Tank” and owning, say, a loan backed by a priceless piece of collateral. Showcasing a deal toy from a successful IPO or a video of a Class A office building offers the real legitimacy found today increasingly in asset classes that keep the Michael Kors crowd out and allow access only to those with strong and powerful social networks. “Statement asset classes are not only managed by world-class operators into world-class assets and brands but are also perceived to exhibit power and legitimacy and be ‘well-connected.’” It has to answer the question for the very wealthy investor with a low profile who will want to immediately know: “What will my friends think of me when I tell them I invested in this?!” Will they be proud to show off their prized, implicitly priceless Picasso painting in a hidden vault beneath Manhattan out of a “Mission Impossible” movie? Or is it a junker home in Kansas City? You tell me, slumlord. Remember, in an era of people trying to define their legitimacy through Instagram, the difference between the middle class and the 0.001% is the collateral.

You are the plan.

Fine art has no execution risk. You can’t fix fine art. The older it gets, the more valuable it becomes.

What’s your borrower’s credit quality?

Now, there’s lending, and then there’s lending. What you lend on and who you lend to determines everything you need to know about how or when a loan will be paid back. The difference between the middle class and the 0.001% is the collateral. For example, is your borrower a fine-art gallery with a 100-year family reputation and image to maintain? Or is it a rehabber who may have questionable credit and cash to begin with? What happens in the event of default? In a debt fund, you are the lender, and you take possession. In the era of increasingly expanding squatters’ rights, the landlord or private lender will have to work to get your money back. Dealing with judges and lawyers and today’s activists ... It’s messy stuff. Lend on a piece of fine art, and after the UCC-1 foreclosure has been quietly effected, your collateral has been foreclosed on before lunch. With single-family homes, if your borrower or tenant defaults, then you now have to fix it yourself or sell it for a commission, probably. Museum-quality art pieces and priceless works of art are not only perpetually status-enhancing and quite transportable but also surprisingly What are your rights and remedies? What’s your liquidity?

What’s your collateral?

If it’s a single-family home, that’s what it is. You don’t live in it, but we hope it’s close to where you live. It’s not pretty, but it will be, just like on television.

If it’s fine art, it’s securely locked away in a temperature-controlled, bonded warehouse.

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