Author Topic: Guaranteed 4% return to replace bonds. Good investment?  (Read 14940 times)

webguy

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Guaranteed 4% return to replace bonds. Good investment?
« on: May 03, 2016, 09:39:33 PM »
A close family member of mine is in the medical field and is building a new building for their practice. Instead of utilizing a bank for a commercial loan they have asked whether I might be interested in helping to fund the build.  The building costs about $900,000, they are putting down 1/3 and then looking for two investors to put down the other 1/3 each - an investment of $300,000.  Here are the details of the loan:

- 10 year term (but could potentially be paid back in 5)
- Fixed 4% interest rate for the first 2 years, then adjusts with inflation annually (no more than 1% change per year and no more than 7% maximum)
- There's zero risk of default due to disability/life insurance and other factors

My own personal situation is that I currently have a very high income (approx $70k/month before taxes) and a portfolio of about $680k ($560k stocks/reits, $120k cash/bonds), along with about $120k home equity. I also have about $150k in cash in the business account which I can take a withdrawal from as needed. My high income isn't guaranteed long term but I'm not expecting it to go down significantly until at least a few more years (or maybe longer if I'm lucky). They wouldn't need the money until the end of the year so if I decided to do it then the plan would be to save $180k and sell my current bond funds of $120k. The $300k would then replace the bonds part of my portfolio, plus some.  As the loan repayments are made (just over $3000/month) then I could use that money to re-purchase bonds or other investments.

My investment philosophy lately has been to hold off on investing in stocks for a while as I feel like I have a good chunk of change invested in them and I'm more focused now on capital preservation and diversifying into some other investment areas with less risk. Due to my high income I don't necessarily need high growth in my investments at the moment (this may change in the future) and so feel like a 4% return isn't bad as a guaranteed return, especially with bond interest rates so low and savings account giving 1%.

Questions:

- Is this a good investment in place of bonds in my portfolio?
- Does it seem like a good deal, or should I try to negotiate better terms?

hodor

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #1 on: May 03, 2016, 10:42:59 PM »
I wouldn't do it simply because it is a family member and it can be unwise to mix family and investing.

A ratchet clause would probably be a good idea. i.e the interest rate can't go down, only up, or a floor at 4% at the least.

One of the advantages of bonds is you can use them to re-balance your portfolio, you will be missing out on this flexibility and the ability to take advantage of any potential market crashes by doing so.

At the end of the day your income allows you more flexibility. You have stated income returns aren't your top priority and unlike me helping your family get the building they want might outweigh the risk of doing business with family.

MustacheAndaHalf

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #2 on: May 03, 2016, 11:44:56 PM »
If you believe there's no way to lose, you're missing something.  You're saying when intermediate term bonds pay 2%, you've found a "zero risk of default" way to earn double that.  You need to ask yourself why this sounds too good to be true.  If you're fortunate, maybe the real risk of default never shows up.

For example, why do you consider life and disability insurance as the only risks?
If there's zero risk, why isn't a bank extending them a $600k loan at 4%?

Papa bear

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #3 on: May 04, 2016, 05:42:47 AM »
4% is way too low for a commercial building construction loan.  Re-evaluate the risk level.  You're missing something.  There is no such thing as a risk free investment.

Outside of that, I see no reason not to invest, as long as this loan is set up properly (the loan is secured by the building, proper terms, etc). 


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ender

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #4 on: May 04, 2016, 06:06:54 AM »
This sounds like a horrible idea. Mixing money and family sometimes ends fine, but often ends really poorly. You've already convinced yourself it's "guaranteed" and zero risk though so I suspect you will want to do this anyways.

What are your long term goals and normal annual spending? If your goal is FI/FIRE the safest route to get there is a pretty quick FI/FIRE on 70k pretax income per month (!).

Also, make sure you consider the tax implications associated with taking that much money out of your business. If you have other more tax efficient options than withdrawing it, you may find that your "4% bond return" (the interest of which is likely taxable too) ends up costing you quite a bit of money.

Financial.Velociraptor

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #5 on: May 04, 2016, 09:01:02 AM »
I would prefer investment grade municipals for extremely low risk 4% return.  It will be more liquid, has no family complications, and is fed tax exempt (a nice yield kicker in your tax bracket).  I play this space with closed end funds to take advantage of 30% or so leverage and ~6% returns: NIO, NEA, IIM, and IQI are tickers I own in that category.

webguy

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #6 on: May 04, 2016, 01:07:35 PM »
Thanks for the feedback so far guys.  I probably shouldn't have stated that there's no risk, but instead said that there's very little risk. Due to this family members personal situation there's no scenario I can foresee that would leave us unable to get the investment back. They have a lot of other assets (business, personal, real estate) and various other fallbacks which would protect them if a calamity occurred. Plus I trust this family member explicitly and know they have my back. They can get a loan from a bank but most commercial loans are around 7-8%. They proposed using a couple of investors instead to reduce their interest rate, reduce the time and effort involved in dealing with a bank, and also provide a decent risk-adjusted return on cash for the investor.

I appreciate the feedback that doing a deal like this with family is a bad idea, and I think I agree, which is why I'm on the fence.  I'm still considering it though. Is there an interest rate which would make you reconsider a deal like this? 5%? 6%?  Or any other terms/clauses you think I could request to make it more attractive?

Papa bear

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Guaranteed 4% return to replace bonds. Good investment?
« Reply #7 on: May 04, 2016, 01:18:24 PM »
If they have the means to protect your investment, why are they looking for "investors?"  They can build the building themselves.

Commercial real estate is risky.  Medical buildings are risky.  Physician practices aren't immune from business risks, and can have other complications, such as the changing Medicare and Medicaid billing requirements. 

I'm not saying not to do this.  Hell, I've been in real estate deals with family members with great success.  But don't kid yourself on the risk.  It's there.

I would loan the money at market rate.  There are even implications from your family members side if a loan is below market.  Loans to family are not an arms length transaction.  The IRS will look at this and they can use an implied interest rate for tax purposes.  Do some more homework here.


Edited for spelling/grammar

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« Last Edit: May 04, 2016, 01:20:08 PM by Papa bear »

ysette9

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #8 on: May 04, 2016, 01:22:00 PM »
Personally I wouldn't think the interest rate would have THAT much to do with whether you should pull the trigger on this investment or not. Since it is a good chunk of change and you are dealing with a family member, I would mentally set this into the bucket of charity, and only do it if you can make that sum of money a gift without it hurting your relationship. Any time we have lent family members money it has always been with the (private) understanding that if the person defaulted, we could afford it, no problem, and that it wouldn't cause a bunch of family drama.

As far as asset allocation goes, if you do this, I would recommend getting out of REITs and putting more money into either bonds or stock (how about international stock market index?). The reason being is that you already have money in the REIT and in your personal equity, and this would add a bunch more money into the real estate sector. Maybe your personal investment strategy is different, but I don't want that much of my net worth in real estate.

webguy

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #9 on: May 04, 2016, 10:52:06 PM »
If they have the means to protect your investment, why are they looking for "investors?"  They can build the building themselves.

The same reason someone would get a mortgage. Most people don't have $900k of liquid cash lying around to use. Most financially savvy people have money tied up in other assets or investments and may not wish to sell them if they can get a loan/mortgage at a reasonable rate.

I'd prefer not to get too hung up on the risk side of it. There are many reasons which I don't want to discuss here that this is very low risk. I am more interested in people's opinions on whether the numbers make sense. And if not, then how to negotiate the deal so that it does make sense. I feel like 4% is pretty low considering the illiquidity of the investment.

MDM

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #10 on: May 05, 2016, 12:48:33 AM »
- Is this a good investment in place of bonds in my portfolio?
This is the easy one: yes, you could reasonably consider this in place of some type of bond - preferably a bond with duration similar to the length of the loan.


Quote
- Does it seem like a good deal, or should I try to negotiate better terms?
They can get a loan from a bank but most commercial loans are around 7-8%.
I feel like 4% is pretty low considering the illiquidity of the investment.

Seems you have done a good job answering your own question: 4% is very low if their alternative is 7-8%. 

In the end, the "correct" interest rate is whatever you and the borrower can agree to.  They have proposed 4%.  You don't like that.  So you propose, say, 6% - including any (or no) adjustable rate clauses you think reasonable.  They may or may not take that.  If they don't take it, you have to be prepared to walk away.  Otherwise, you aren't negotiating, you are whining.

I could imagine this being particularly difficult if "they" are your parents or other family authority figures.  If so, you are over 21 now and can decide on your own....  Good luck!

Papa bear

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #11 on: May 05, 2016, 05:37:43 AM »
If they have the means to protect your investment, why are they looking for "investors?"  They can build the building themselves.

The same reason someone would get a mortgage. Most people don't have $900k of liquid cash lying around to use. Most financially savvy people have money tied up in other assets or investments and may not wish to sell them if they can get a loan/mortgage at a reasonable rate.

I'd prefer not to get too hung up on the risk side of it. There are many reasons which I don't want to discuss here that this is very low risk. I am more interested in people's opinions on whether the numbers make sense. And if not, then how to negotiate the deal so that it does make sense. I feel like 4% is pretty low considering the illiquidity of the investment.

You are asking people to evaluate an alternative investment which is impossible without evaluating risk.  Any advice means squat without all the information. 

Good luck with whatever you do.

Papa bear

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #12 on: May 05, 2016, 05:43:49 AM »
If they have the means to protect your investment, why are they looking for "investors?"  They can build the building themselves.

The same reason someone would get a mortgage. Most people don't have $900k of liquid cash lying around to use. Most financially savvy people have money tied up in other assets or investments and may not wish to sell them if they can get a loan/mortgage at a reasonable rate.

I'd prefer not to get too hung up on the risk side of it. There are many reasons which I don't want to discuss here that this is very low risk. I am more interested in people's opinions on whether the numbers make sense. And if not, then how to negotiate the deal so that it does make sense. I feel like 4% is pretty low considering the illiquidity of the investment.

You are asking people to evaluate an alternative investment which is impossible without evaluating risk.  Any advice means squat without all the information. 

Good luck with whatever you do.

Fishindude

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #13 on: May 05, 2016, 05:50:54 AM »
I won't get into the risk issues either, but 4% Isn't enough, you should get at least 6% for something like this.
I doubt they could get the money for 4% at a bank.



Retire-Canada

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #14 on: May 05, 2016, 07:21:35 AM »
If they can't get a loan for less than 7% - 8% given all the "low risk" factors you describe you have to ask yourself why not? Is losing $600K less of a risk to you than the bank? It would seem not.

Your post sounds just like the start to one of the many sad stories you hear from people about family related financial blow ups. They usually end with "but, I never expected X and Y to happen and then I didn't get my money back and I don't speak to them any more!" Nobody goes into these deals expecting their to be any problems at all and nobody really understands how other people will react with the loss of $1M+ of assets/value until it happens.

Let them get a commercial loan. It's not worth the potential grief to loan that sort of money to family just to save/make a few %.

Drifterrider

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #15 on: May 05, 2016, 11:23:58 AM »
I would ask myself what I can legally do to recover my money in the event they don't want to repay me.  Can I place a lean against their building and if so, I would do so at the outset (you aren't buying a bond you are making a loan (construction mortgage loan). 

If they are of means, why are they borrowing from you?  Cashflow?

It is your money but you did ask.

I'd be cautious.



Abe

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #16 on: May 05, 2016, 12:59:10 PM »
I agree with all the others that mixing family + business is probably a bad idea, and the risk on this is higher than you think (unless your family member owns / is a partner in a major medical group in the area, than I agree it is low risk). Why not ask for a fraction in the medical group partnership? That may be more palatable to them as it keeps their costs lower in the initial phase, and, if my guess is correct, more profitable for you in the long run. If they are a stand-alone practice, I'd take a look at national trends and say it is too risky and not agree to any financing at all.

MidWestLove

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Re: Guaranteed 4% return to replace bonds. Good investment?
« Reply #17 on: May 05, 2016, 05:53:36 PM »
It is unknown whether it is a "good investment", more likely no than yes.

Some thoughts
- what is the true after tax return of these "4%"? what is your tax rate (fed+ state) ?  will you be getting 1099 for this, how exactly would it work with taxes?
- how does it compare to say VWIUX or any other cheap national muni bond fund ?  such mutual funds would beat the investment above is almost every level - after tax return for high income earners, liquidity (you can write checks against it any time and get dividends monthly) , much lower risk, no family member entanglement ,etc. tax specific muni bond fund could be even more interesting if you are in the high income tax state (California, etc)

if I were go into this or any other 'hard money lending' I would charge a lot more than 4% and structure it in a way to make sure risk is compensated appropriately. I would also never do it with the family unless I am ready to call it charity from get go - no need to f4ck up life long relationships should any of dozen things in business venture go different/wrong.
 

"
I'd prefer not to get too hung up on the risk side of it. There are many reasons which I don't want to discuss here that this is very low risk. I am more interested in people's opinions on whether the numbers make sense. And if not, then how to negotiate the deal so that it does make sense. I feel like 4% is pretty low considering the illiquidity of the investment."

I think your gut is telling you something
- this is not a very low risk. this is a single issuer callable bond by a entity that has no taxing authority and with unknown rights to you as a bondholder. worse, there is no secondary market and all conditions favor the issuer , they can 'refi' at any time while you can not sell the investment at any time or at all.
-numbers make no sense for the amount of risk you are taking

if you are into single issue bonds - fidelity bond desk or any other major discount broker will give you a lot of options and potentially better deals for your money than this , plus you would get some liquidity options for security you purchased.
 
« Last Edit: May 05, 2016, 06:06:40 PM by MidWestLove »