When a debt fund beats a duplex on every line that can be calculated

Two columns side by side, and the second one keeps winning, which usually means it was built wrong. Column one, a duplex at $340,000. Gross rent $2,850 a month, so $34,200 a year. Taxes, insurance, water, management at 8 percent, and $2,400 a year set aside for repairs gets to about $19,700 of NOI. That is 5.8 percent unlevered on purchase price, before a mortgage, and before any appreciation or the depreciation deduction. Column two, an open-end real estate debt fund. Distribution 8.25 percent, paid monthly, minimum $50,000, one-year lock. No tenants or roof, and no phone calls. The published debt fund index returned 5.5 percent year to date gross of fees against 4 percent for the equity index, so the direction of travel is broader than one sponsor's pitch. So the debt fund pays 245 basis points more per year for doing nothing, and the other half of the cash stays liquid instead of tied up in a down payment. Somewhere in that comparison is a cost that has not been written down. Part of it is tax treatment, and part is that the duplex return is not really 5.8 percent once it is financed. The more interesting question is what the fund column is missing on its own terms, before anyone goes to an accountant about the tax side. What line should be in column two that is not?

hannah_west29 SS2APRO 16

Answer

marcus_hale41CapitalPRO

The line missing from column two is credit loss. An 8.25 percent distribution is the coupon on the loan book minus fees minus whatever the borrowers don't pay back, and the third term is zero until it isn't. Ask the sponsor for realized losses by vintage, in dollars, not as a percentage of a growing NAV, because a fund that doubled in size last year can bury a real loss in a bigger denominator. Ask what they did in 2009 if the firm existed then, and if it didn't, ask who on the team was underwriting real estate credit at the time.

Second line, liquidity. A one-year lock plus whatever the redemption gate says means your money comes out on the manager's schedule during exactly the quarter you'd want it out. Read the gate language, not the summary.

Third, your 5.8 percent duplex has an inflation adjustment built into rent and the fund's 8.25 does not. A fixed coupon looks great now and looks like a bond in five years.

On the tax point, interest income and rental income are treated differently and depreciation doesn't exist on the fund side. That difference can be large enough to reorder your two columns, and it depends on your own situation, so put it to a CPA before you compare the two headline numbers again.

marcus_hale41CapitalPRO

2 replies

tonyv88 PU4APRO 10

That $19,700 NOI assumes nobody moves out. Add a vacancy month and one turnover per unit every three years, then rerun it.

tonyv88 PU4APRO 10

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