As I write this newsletter, the media is hawking the slow down in the real estate market. Most of the historically “hot” areas of the country are experiencing a 10% slow down in resales and new construction permits, with the Midwest being the positive exception. If new construction real estate speculation, based on rapid appreciation, was your game plan, you may now be rethinking your strategy. Perhaps it’s time for not just a new strategy but a new game plan. Here’s a thought for you. Instead of buying and selling real estate, what about being the Lender? A new light is being cast on the role of being the Lender instead of the owner of the property. Let’s take a look at some of the options being the Lender and holding notes in your IRA or self-directed retirement plan.
Case Study 1
John B., a top producing agent with Coldwell Banker, has had a long relationship with a small custom builder that constructs 3 homes a year. The builder has already purchased the land and has his crew on payroll. While it is not an ideal time to be building another “spec” home, he will “trade dollars” if that’s what was required to keep his company viable. He is looking for “cash partner” to complete a home on one of the lots.
John has been offered an opportunity to buy the home, but doesn’t want to purchase the “spec” home directly because he believes the marketing time for the custom home may exceed 6 months. John agrees to partner with the builder but not own the property directly. He will act as the construction or “mezzanine financing” in the transaction. Current construction financing rates are 9.75% from most traditional banks and lenders.
John and the builder negotiate and agree to a rate of 8.25. This is substantially more than he could receive from a money market or CD. They come to an agreement on the interest rate but now needed to iron out the terms of payment.
John could be paid:
oin a lump sum when the property sold.
Not surprisingly, the builder opts for the latter and John agrees to be paid at closing for all of the accumulated interest and repayment of the original principle balance. John’s attorney drew up the note that indicated the note holder as your “Trust Administrator”, FBO John B. IRA. His attorney asks if he wants to collateralize his note by placing a lien on the land with a mortgage. Wanting to maintain compliance with IRS guidelines, John contacts our office and asks what his options are. The answer is that either way, with or without a mortgage, he will still be in compliance with the IRS.
Being a prudent investor, John opts to have a mortgage prepared and recorded with the County. One year later, the property sold after being on the market for 8 months. John’s attorney prepared the payoff letter and proceeds were sent to the IRA custodian directly from the title company at closing.
John was satisfied with receiving a short term return of 8.25% on his IRA funds instead of the riskier proposition of carrying the property of its operating expenses for 8 months. The 8.25% return represented a 4.00% higher return than a bank certificate of deposit would have given him. Was John’s option to act as a lender worth the additional risk? Well that is for each individual investor to answer. Each investor must apply their own criteria to the evaluation of risk in each investment made.
Case Study 2
Jackie O., a commercial real estate broker and CCIM with Equity Partners, has a client that owns 22 acres along State Highway 47. The client inherited the land several years earlier and wants to develop the land, with the necessary site improvements, to make the parcel of land more marketable.
Jackie has $225,000 in her individual 401k. She and her client, Ari, decide to partner on this project. Jackie has two issues to consider when structuring the transaction. First, her company has strict limitations with regard to agents/brokers partnering with clients in real estate transactions. Simply put, partnering with clients is discouraged because of the implied liability to the company. Second, Jackie’s prior experience with partners has not been pleasant. Her previous partners did not understand the risks inherent in real estate investment and very often their expectations often exceeded performance of the investment.
Ari wants Jackie as his partner on this deal. Ari trusts Jackie and knows her reputation in the real estate community. He also knows that Jackie’s contacts with the municipality and local contractors are invaluable.
Here is the “deal” Ari and Jackie work out:
oAri will retain ownership and control of the land.
oJackie’s 401k will lend Ari the amount needed for development and the site improvement costs.
oAn outside, unrelated party, will complete the site improvements and handle the necessary municipality permits.
Two separate companies, a REIT and big box retailer – BlueMart, have approached Jackie about purchasing the improved parcel of land. Since Ari has no capital to repay the note, Jackie’s 401k will write the note as a “participation note”. In other words, Jackie’s 401k will lend the money in exchange for a percentage of the profit when the improved parcel is sold and Jackie’s initial 401k loan is repaid. They agree to a 15% participation fee.
Jackie’s attorney prepares the 401k note in the name of your “Trust Administrator”, FBO Jackie 401k. The note is secured with a lien/mortgage on the land. Ari’s attorney reviews the documents along with the participation clause in the note and approves the transaction.
Eight months later, the site improvements are completed and BlueMart purchases the parcel from Ari for $2,500,000. Net profit after closing expenses, commissions and repayment of Jackie’s 401k note of $225,000.00 is $2,000.000. Jackie’s 401k also receives $300,000.00 from the title company as repayment of the participation agreement in the note. Remember, “taking notes” can be profitable.