My last (not ever, but for a while) Reader Poll showed that most of you thought that my hypothetical real-estate transaction was a good deal, provided that it didn’t tie up your money for too long.

Thomas, who has all the hallmarks of becoming a great real-estate investor, liked the strong returns on cash invested:

I don’t have to invest the full 100k. I can finance most of it, secured by the real estate. So, let’s say I can finance 80% of it, which means I “only” need to come up with 20k myself. If I can finance it at 5%, the interest on the 80k would be $4k a year, which would leave me with $3500 left over each year. $3.5k annually for an investment of 20k is a return of 17.5% per year. In addition, any appreciation is also yours, so unless you need to average a very high annual compound rate, this sounds like a great deal.

I, too, think it’s a pretty tempting deal, but NOT for the reasons that many of you gave for liking it in the first place …

… to summarize; here’s what I like about the deal:

– very well-established commercial strip-mall in a great area

– fully rented, with long leases

– currently returning 9%, less contingencies … so, estimated yearly distribution is $7,500

So, on an investment of $100k, I get a 7.5% – 9% return each year … presumably, there’s some sort of ‘ratchet clause’ in the lease to ensure that rents at least keep pace with CPI and/or market. I would NOT invest until I knew the answer to this question, but it’s a reasonable assumption to give an ‘in principle’ OK to the deal … with the cost of funds at sub-6% these days (and, I can lock in for 5 to 10 years on a commercial loan), this is beginning to look quite good. The capital appreciation almost becomes a ‘bonus’ …

So, here’s what I don’t like about the deal:

– It’s a general partnership … luckily I am the general Partner and get to control the property, but the rest of you don’t 🙂

– There is a rental/return guarantee

Whoa … I DON’T like a guarantee??!! … what’s up with that?!

To me, the guarantee is  a risk – not an opportunity – because the real returns should meet or exceed the guarantee at all stages, anyway, except in two cases:

1. The value of market-place rents decline (a recession can cause deflation; tenants may leave or go broke and we may need to cut rents to retain new tenants),

2. Costs can go over budget (vacancies could cause protracted loss of income; hidden structural issues could cause major repair costs; etc.)

3. Both could happen at the same time

Rick agrees, sounding the following warning:

It really sounds too good to be true- if a lot of these businesses go out of business can the $9K/year really be guaranteed? Could you really find another buyer in the current economic environment?

If only one of these things happen, we may be able to dig into our contingency fund to ‘ride it out’ (remember, we retain roughly 1.5% on net income each year as a ‘contingency’), but if a number of things happen at once, such as in the current economic and real-estate ‘perfect storm’, then the fund may run ‘dry’ …

… if this were our only investment, we would simply not take much/any rent out of the deal until we covered these costs and rebuilt our fund (if the situation becomes dire, we may need to put more money in or even sell out … but, this should be extreme).

However, because this is a partnership with a guarantee, the General Partner (me) has to maintain a minimum 7.5% return to the partners (you); which only leaves me a few choices:

1. Dig even further into the contingency fund, or

2. Ask you ALL to agree to vary the contract and take less money this year OR sell the project (are you ALL going to agree?), or

3. Borrow more money to pay the guarantee and/or cover the costs (increasing the expenses on the project even more), or

4. Wait for the bank, a supplier, or an investor to foreclose (because we pay you and slow down the bank and/or suppliers, or we pay the bank and one of you initiates proceedings because we fail to pay you as ‘guaranteed’).

In all of these cases, the flaw is that the ‘guarantee’ is funded by the project itself and forces the General Partner to make decisions that he would NOT make if ‘the project’ didn’t have to pay the guarantee …

I like to think that the ‘managers’ on any project or business that I am involved in are always making the best commercial decisions, not acting artificially to enforce some sort of ‘forced distribution’ …

…. kind of like the board of directors of a business focusing on maintaining a certain level of dividend for investors, rather than growing the business’ long-term earnings (a.k.a. profits).

Can you now see that dividends and profits (businesses) or guarantees and net income (real-estate) are NOT the same thing?

So, for this project, if I were an outside investor, I would make a decision on the project and insist that there were NO guarantees … simple. Unfortunately, most investors don’t think past their noses (“what’s my return?”), hence the ‘guarantee’.

As to me, unless I was the General Partner and there was no guarantee, I would NOT invest …

What do you think?

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