What Is A Bridge Loan?   If you have been looking at the products available for commercial and residential real estate loans, you have probably encountered the term bridge loan before. Unless you’ve had to apply for one, though, you might not realize what bridge loans are or how they are used.  These are short-term loans designed to allow borrowers to: In the case of investing in bridge loans, the third reason is the most common. These are the loans mostly used by “house flippers”; real estate investors who purchase and rehabilitate properties before reselling them. They represent a great investment opportunity too, and if you are interested in getting into real estate lending as an investment, you need to know how investing in a bridge loan – or portfolios of bridge loans – can provide you with a great return in a relatively short amount of time.

Bridge Loan Features

Before deciding to take the plunge and starting to invest in bridge loans, it’s important to understand the pros and cons,  and exactly how these products work for the lender, and by extension, the investor who is investing in the loans.

Other Types Of Bridge Debt

If you are looking for bridge loan investment opportunities, it’s important to understand the diversity of the investment opportunities available. Residential bridge debt is one major category of these loans readily available to individual investors. However, there are other types of bridge loans. Some are used by real estate investors operating in the multifamily and commercial space, and others are used by companies buying and developing new facilities for their own use, or as a stopgap while other financing is sought. Each of these types of bridge debt brings with it unique risks and opportunities, so it is important to understand the specific types you invest in and to balance your investments.

The Future Of Bridge Debt

These loans have been powerful instruments allowing for economic development to a wide variety of businesses for many years. It’s not likely that will change anytime soon, but what is likely is that there will be fluctuation in the demand for basic residential bridge loans in various states, cities, and neighborhoods. That’s because residential property investment is its own business with its own very local cycles. By diversifying into a range of bridge debt, though, investors can reap the rewards of the high-interest rates while opening themselves up to more investment opportunities in any market. Advance your investing knowledge by understanding the tax implications around another investment avenue: real estate crowdfunding. Free eBook Download   TOP-7REAL-ESTATECROWDFUNDING-SITESFOR-INVESTORS (1) Our friend and industry colleague Joe Stampone recently put together a great eBook on his top 7 real estate crowdfunding platforms. While we were excited and honored to be included, we wanted to share Joe’s post and eBook because it’s a great 3rd party view on the industry. I’d encourage you to not only take a look at the eBook, but also follow Joe’s blog if you’re interested in learning more about real estate from a true industry insider. We’re excited to work with Joe more in the future! Blog Post: A few months ago I provided an overview of the various opportunities for real estate crowdfunding investors, however I didn’t dig into the specific platforms. In my latest eBook, I break down what I view as the top 7 real estate crowdfunding sites for investors. While there are 100’s of sites out there, the 7 I chose are established players, well-funded, operated by experienced real estate professionals, and sites I’d trust with my own money. This is by no means exhaustive, but a good starting point for any potential real estate investor. Direct investing in cash flowing real estate should be part of any investors’ portfolio. However, a millennial who is an unaccredited investor with a few thousand dollars to invest has a much different investment objective than a high-net-worth individual who recently retired and has $1mm to invest. Why I wrote this guide: 1. There are a lot of poorly run platforms funding risky deals and it’s impossible for the amateur real estate investor to identify the good ones. 2. There are several investment models and it’s challenging to determine which is right for you based on your investment objectives. 3. The space is evolving rapidly and there are new investment models that investors should be aware of. In the guide, I break down each platform outlining what I like, my concerns, fees to investors, their underwriting process, and even fun facts. There are 5 core investment models to choose from: . . . You can read the rest of Joe’s post and download his ebook HERE. Joe Stampone_Headshot Joe Stampone is the VP of Investments for Atlas Real Estate Partners. He also authors a popular blog, A Student of the Real Estate Game, a community of real estate professionals driven by a passion to be on the cutting edge and grow their careers through collaborative learning.

NYC

At any given moment there are likely multiple factors influencing the price of a particular investment asset. The fundamental driver of investment returns over the long term is growth in the asset’s ability to generate free cash flow (per unit of ownership, but this is for another day).  The generation of free cash flow enables a reinvestment in the asset with the objective of producing incremental free cash flow over the subsequent period.  To simplify, picture a business consisting of a large portfolio of rental homes. Using the free cash flow generated one year, the owner purchases a few more homes. The following year, more cash is generated, and the process is repeated.  While this obvious cycle of business investment had been a key source of asset value growth since the dawn of capitalism, it has been shown to be extremely difficult for an investor to generate returns in excess of this Return on Invested Capital (“ROIC”) of the underlying asset.

Although ROIC has many permutations, for the purpose of this post it will represent the basic unlevered free cash flow generated by a business (after taxes, but before any growth-oriented capital expenditures), divided by the total capital funding of the business:

Figure 1

It is an imperfect metric that often needs to be customized for a specific investment opportunity, but the idea is to identify how much “re-investible” cash a business is generating relative to the amount of capital the business has invested in its own cash-generating assets.

If a company generates cash that it can use to invest in its current line of business, it can simplistically be expected that this incremental cash investment will generate the same ROIC as the existing business.  Shown below in Figure 1 is the hypothetical rental-home business compounding its growth through continued reinvestment in its asset base, self-funded through its own Return on Invested Capital.  As the cash flow stream grows over time, it is intrinsically more valuable to the owner.  This growth in cash flow, over the long run, is what typically generates investment returns.

Figure 1

There are several key hurdles to the investor in generating returns equal to or greater than the compounded ROIC of the underlying asset.  Primarily: taxes.  An enormous chunk of investor value is soaked up by Uncle Sam.  Given that any crystallization of an investment gain will result in significant leakage, the investor is, by default, at a disadvantage in generating returns comparable to the after-tax ROIC realized by the business or asset.  In Figure 1 above, the realized after-tax returns for the investor are highlighted in grey.  Although the business is generating annual returns of 10%, the investor only realized 8.6%.  This difference may seem insignificant, but over long periods of time this difference in compounded annual return can have truly astonishing implications for investor value.

Two key assumptions in the table above are (1) the multiples of cash flow used to value both the initial investment and (2) the sale of the investment.  Valuation multiples come in many forms (price-to-earnings, EBITDA, revenue, cashflow…), but in most circumstances they are utilized as a shortcut for the investor to ascribe a value to an investment that renders it comparable with other investment opportunities.  The two typical drivers of valuation multiples tend to be either (1) the predictability of the denominator relative to price paid for the denominator value, or (2) the growth (real or expected) of the denominator, also relative to price.  An example may include a long dated, high quality bond or other fixed income asset, or real estate, which often includes a reliable income stream.  Cash flows from these assets, due to their predictability or contractual nature, are often ascribed high multiples in the marketplace.  Separately, a start-up enterprise that earns comparatively little cash flow today may command a high multiple relative to current earnings power due to the expectations of future cash flow growth.  Opposite characteristics of these examples, such as unpredictability in cash flows or expected earnings declines, can also be drivers of lower valuation multiples in the marketplace.

Multiples (i.e. valuation) are important as they provide the only real mechanism for an investor to outperform the underlying ROIC of the asset – buy low, sell high.  In Figure 2 below, an example is shown of an investor buying and selling the same cash flow stream as previously depicted, but with the benefit of lower purchase and higher sale multiples.

Figure 2

Just like the rental home company recycles its own investable cash in an attempt to generate additional future cash flows, the investor recycles his cash in the securities representing ownership of the underlying assets.  The natural fluctuations in the marketplace of ascribed valuation multiples give the investor the opportunity to capitalize on any deviation from what he or she ascribes as fair value.  In this example, only the successful recycling of capital at purchase multiples lower than those of the sale multiples can enable the investor to both make up for tax leakage on gains and outperform the Return on Invested Capital of the underlying assets.

Of course, the strategy of consistently churning investments at high multiples and repurchasing them at low multiples comes with many risks:  One key risk is in regards to timing of the reinvestment.  In Figure 2, the investor is assumed to remain uninvested during Year 5, and for the period makes no return on his money.  In the case of an investor sitting in cash, not only is he or she not generating investment returns, he is actually diminishing his own purchasing power through the erosion of inflation.  The time lag between appealing investments can last far longer than shown in this example, and if extended for too long can decimate investor returns relative to ROIC.  Given its natural unpredictability, the market simply cannot be expected to consistently provide timely reinvestment opportunities.

The negative impacts of taxes are also amplified in a scenario where an investor chooses to churn his or her money.  The more frequently gains are realized, the higher are the required future returns to offset the tax leakage and maintain trajectory of investor returns.  Each profitable sale ups the ante for future required performance.

But all is not lost for the investor as there are other ways to converge realized returns to that of underlying asset ROIC.  One method is simply time.  The longer the investor waits to monetize the investment and realize his or her gain (assuming the same purchase and sale multiple), the closer the realized IRR is to that of the underlying company ROIC.  Said differently, if Figure 1 above is extended to include a full individual lifetime investment horizon of 40 years, the after tax IRR for the investor would converge to 9.4% versus 8.6% after 10 years.  Again, these seemingly minimal discrepancies in return can have tremendous absolute dollar impacts for an investor over many years.

Purchase and sale multiples have a similar diminished impact over long periods of time.  Even if one pays a relatively higher multiple to acquire a high ROIC asset, and sells the asset at a lower multiple after an extended time horizon, the compounding effect of the high ROIC asset goes a long way to negate the impact of the valuation multiple mismatch.  Although you cannot close the gap on realized IRR and underlying asset ROIC through these methods, on high quality assets the investor can still realize exceptional returns over time.

Although other systems exist to structure investments such that they outperform the underlying business performance (i.e. leverage, cash flow reallocation), it is easy to see the hurdles an investor generally faces in outperforming the underlying asset class.  Time is the friend of an investor if they simply want to approximate the ROIC of the underlying asset, and if outperformance is the objective, the age-old adage will always apply:  Buy low, sell high.

About the Author:

Jacob D. ChaseJacob D. Chase is currently an investment professional at one of the world’s leading distressed debt hedge funds and is a Managing Partner of The Denver Fund, a privately held residential real estate investment vehicle.  Prior to his current roles he worked as a restructuring advisor at Lazard Frères.

Jacob is a lifelong student of investing, and has a BA in Finance from the Daniels College of Business at the University of Denver.

NYCSelf-directed IRAs (“SDIRA”) are increasing in popularity. More and more investors are getting bored with traditional investments (stocks, bonds, mutual funds, etc) and seeking out alternative investments in the search for higher returns. The SDIRA landscape is changing as a variety of investments are being introduced to the market. There is no doubt that SDIRAs are very flexible options and allow for a diverse set of investments. They can invest in almost anything, except for life insurance, S-Corp stock and certain types of collectibles. The problem is that there is often confusion about SDIRA tax rules. Compounding the issue is that the majority of CPAs don’t understand the complexity associated with them. It’s not that CPAs are naive to the issues it is just that they are not faced with them on a daily basis in their practices. But even though an SDIRA can invest in most things, certain investments can trigger immediate tax issues. This is where the complexity lies. The two main issues for SDIRAs relate to income from a trade or business that is regularly carried on (this can be directly or indirectly) or income generated from debt-financed property. These issues are identified herein as: (1) unrelated business taxable income (“UBTI”); and (2) unrelated debt-financed income (“UDFI”). Let’s take a closer look at these issues and then see how they apply to partnership syndications and real estate crowdfunding. Unrelated Business Taxable Income UBTI is generally defined as the gross income derived from any unrelated trade or business regularly conducted by the exempt organization, less any deductions associated with carrying on the trade. The business or trade itself needs to be “regularly carried on” in order to trigger UBTI. So in most situations, UBTI occurs when an SDIRA owns a portion of an operating business (retail store, service business, etc). Rents from real property are specifically excluded in computing UBTI, but may be subject to UDFI. Interest income, dividends, royalties, annuities and other investment income are also typically exempt from UBTI but can be subject to other limitations (such as UDFI). Unrelated Debt-Financed Income UDFI is another issue that is important to consider. It is generally defined as any property held to produce income for which there is acquisition indebtedness at any time during the tax year. It also includes gains from the disposition of such property. UDFI applies to corporate stock, tangible personal property, and more importantly – real estate. What this means in practice is that if your self-directed IRA acquires a rental home for $100,000 with a 25,000 down payment and obtains a $75,000 loan to finance the purchase, approximately 75% of the income generated by the property would be subject to UDFI. The UDFI calculation is actually a little more complex. It is calculated as the percentage of average acquisition indebtedness for a tax year divided by the property’s average adjusted basis for the year (average debt/average basis). Real Estate Syndications and Crowdfunding So now let’s take a look at how UBTI and UDFI would apply as we examine syndications and real estate crowdfunding. There are essentially two types of deals when it comes to real estate syndication or crowdfunding: (1) equity; and (2) debt. An equity deal is basically when an investor owns shares in a limited liability company (“LLC”) that either acquires a parcel of real estate or invests into another LLC that acquires real property. The investor holds an indirect equitable interest in the property and is taxed as a partner in a partnership. Equity investors receive a Form K-1 at the end of the tax year that will report their share of the partnership’s income or loss. In a debt deal the investor typically owns an interest in a promissory note that is issued for short-term financing on a real estate project. Investors in debt deals typically do not participate in any upside in the property and are merely acting as just investors. Accordingly, any payments they receive are typically classified as interest income. Unfortunately, UBTI and UDFI extend to partners in partnerships. If a partnership that owns rental real estate has a partner that is an SDIRA then the rules for UDFI will be extended to the partners. Accordingly, if there is debt financing at the partnership level, then any income or loss will flow through to the partners along with the UDFI issue. The partner is treated as if it had conducted the real estate activity in its own capacity and the IRS does not make any distinction between limited and general partners. In addition, it does not matter whether or not actual cash distributions have been made. So in a real estate syndication equity deal, rental income that is allocated to an SDIRA would partially be subject to tax under the UDFI rules (assuming financing was obtained for the property). In many cases though you may find that the tax consequences will be minimal due to depreciation that is passed through from the real estate held by the partnership. However, the SDIRA will often still be required to file a tax return. Even if no tax is due, it generally a good idea to file a tax return so that any capital gains from the ultimate sale of the real estate (which is also be partially taxable due to the debt financing) are offset by any carryover losses that have generated over the years. Tax Filing? So what are the tax filing requirements if you have UBTI or UDFI? First, a filing is only required if there is gross income of $1,000 or more. Gross income is defined as gross receipts minus the cost of goods sold. Assuming this criteria is met, Form 990-T, Exempt Organization Business Income Tax Return, must be filed and the tax paid accordingly. Tax rates can be high because IRAs are taxed at trust rates. For tax year 2013, any income above $11,950 is taxed at 39.6%. State taxes will also need to be considered. Conclusion So just because an SDIRA can invest is almost anything, you must consider any immediate tax consequences. UBTI and UDFI are important considerations when it comes to real estate syndication and crowdfunding. UDFI is all too often overlooked and can certainly be a problem in an equity deal. It is important to note that each deal is structured differently, so make sure that you do your own due diligence. As always, before you consummate any transaction make sure that you review the tax consequences and filing requirements with your CPA. Tax and Legal Advice Disclaimer: AlphaFlow and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction. back to top