A debt fund beats my duplex on every line I can calculate, which bothers me

I've got two columns open and the second one keeps winning, which usually means I built it wrong.

Column one, a duplex I can buy 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 me to about $19,700 of NOI. That's 5.8 percent unlevered on purchase price, before I put a mortgage on it, 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, no roof, 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 isn't just this one sponsor's pitch.

So the debt fund pays me 245 basis points more per year for doing nothing, and I keep the other half of my cash liquid instead of tied up in a down payment. Somewhere in that comparison is a cost I haven't written down. I think it's tax treatment and the fact that my duplex return isn't really 5.8 percent once I finance it. But I want to know what the fund column is missing on its own terms, before I go asking my accountant about the tax side. What line should be in column two that isn't?

Answer

1marcus_hale41CG4A

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.

2 replies

1tonyv88SO4CPRO6

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