Welcome to a new Case Study! This time, Mrs. “Wish I Could Surf” (not her real name) volunteered to open the doors to her finances. And every case study brings up something new to learn for yours truly. Today’s challenge: How would “alternative” investments factor into the Safe Withdrawal Rate exercise? Peer Street, Hard Money Lenders, Lendingclub, Prosper, etc. have gained a lot of popularity, especially in the FIRE crowd. When calculating safe withdrawal rates, I have only worked with stock/bond/cash portfolios because they are the asset classes with returns going back 100+ years. Doing the SWR exercise for a portfolio of Peer Street loans will require some “hacking” in my Safe Withdrawal Rate Google Sheet!
Further challenges come from the fact that Mrs. and Mr. Surf keep their finances separate (similar situation as in the Case Study for Rene) and Mr. Surf will still be working for a number of years, so we have to make some assumptions on how to assign the tax burden between Mr. and Mrs. Surf. Lots of work to do! So let’s get started and look at Mrs. Surf’s finances…
Mrs. Surf’s situation:
I’m 44 years old and the goal is for the money to last 50 years or so.
I also have a little bit of a unique situation in that I was divorced 9 years ago and remarried last summer. My husband/partner and I choose to run our finances separately – he still works and likely will for the next 7-10 years though (maybe less, just depends). I’ll be able to access health care through his company for my daughter and me for that time period.
Though we run our finances separately we split the cost of the mortgage and property taxes on the house I own.
Mortgage has slightly less than $260,000 outstanding. It’s a 3.279% fixed 30 year rate and I’ve paid ahead from time to time. I’m taking your advice now and will only pay the minimum… 🙂 I think I have about 14 years left until that’s paid off completely. I pay $1,670/month on the mortgage.
Social Security: the benefits are about $2,130/month at age 67 (in 23 years).
Actually, I calculated that the mortgage has about 16 years left so I will use that number. How about the current portfolio?
- Hard Money Lending Private Equity $100,000
- Checking $5,000
- Savings $7,500
- Betterment $269,177
- Betterment Preserve Capital $6,019
- 401K $224,670
- Lending Club – $933
- Vanguard Brokerage $272,892
- Vanguard Roth IRA $36,153
- Vanguard Rollover 401K $273,514
- Peer Street $415,778
- Total $1,611,636
Very impressive numbers! Mrs. Surf is also expecting a deferred compensation package in 2018 worth around $80,000. That’s a nice tax arbitrage: she was able to shift some of her 2017 income into 2018 when she’s likely going to enjoy a slightly lower marginal rate! Even more important: She can double-dip in the 401k and max out another $18,000 in pre-tax contributions for the next calendar year! Maybe even $18,500, if the IRA raises the limit in 2018. Together with an expected $16k tax refund next year her finances in early 2018 are projected to look extremely solid:
- Cash/MM $12,500
- Brokerage $591,488 (taxable accounts at Vanguard plus Betterment plus the after-tax deferred compensation package).
- 401k/Rollover401k $516,184 (existing 401k plus rollover IRA plus $18k contribution in early 2018)
- Roth $36,153
- Private Equity $100,000
- PS/LC $416,711 (I will lump together Peer Street and the tiny LendingClub balance)
- Total $1,673,036
How about expenses?
The $4,000 monthly budget is all-in for my daughter and me. Includes my half of the mortgage and my estimated tax liability. The $4,000 is honestly a higher budget than what I actually spend but if the shit hit the fan and $4,000 assumes I pay the entire mortgage and property taxes. My actual spend is closer to $2,500. I modeled my $4,000 off if something happened to my husband and we didn’t have his income and I paid the entire mortgage.
OK, we’re going to work with a $48,000 p.a. expense target. Roughly $10,000 of that is her share of the mortgage payment, which we won’t have to adjust for inflation and she has to pay that amount for only 16 more years (yay!). $38,000 is the actual long-term annual consumption target that needs to be inflation-adjusted!
The Safe Withdrawal Rate Analysis
Historically, Mrs. Surf’s Hard Money Loan has paid in excess of 10% in annual dividends. Peer Street about 8% p.a. The challenge for the SWR analysis is that we don’t have much in the way of historical returns for Peer Street investments. Certainly not going back to 1871! Of course, just because we don’t have historical returns doesn’t mean that it’s a good assumption for us to model Peer Street paying 8% returns every year going forward. It would be huge mistake to model the real-estate-backed loans as safe Treasury Bonds with an 8% coupon! If we were to have another 2008-style recession I’m sure the Peer Street and private hard money loans would take a big nosedive! So, here’s my proposal for how to “hack” the ERN Google Sheet for this situation:
- I assume, for the historical backtests, that half of the Private Equity plus Peer Street portfolio, $258,356, is set aside and will earn a 7% (nominal) yield forever, paid in the “supplemental income” column, while the other half will behave just like an S&P500 equity index portfolio. If we average over the two components we’ll get an expected real return of just about 6%, exactly the same as your current 8% nominal Peer Street yield minus 2% inflation. But we still generate a pretty substantial business cycle exposure in the alternative investments in the simulations.
- The total portfolio value that’s used to calculate the safe withdrawal amount is then $1,414,681.
- I assume that the 401k accounts are 50%/50% in stocks/bonds, all other brokerage accounts are 100% equities and the small cash allocation will earn a money market return. This would imply an allocation of 81%/18%1% in stocks/bonds/cash. Pretty ideal alloction for your situation.
- The monthly cash flow from the $258,356 is $1,507 (nominal). For the first 16 years, that number is netted against the $835 mortgage payment. We inflation-adjust these two payment streams because in the Google Sheet everything is supposed to be in real dollars. I assume a 2% annual inflation rate.
- After 23 years you will also get Social Security, worth $2,130 in today’s dollars, net of a 15% haircut, to account for potential future benefit cuts. Just to be on the safe side!
- I assume a 600 month/50 year horizon and a 50% final value target. Notice that in the Google Sheet, I set the final asset target value to 43.2%. That’s because the $258,356 set aside for the supplemental income would have depreciated after 50 years worth of inflation (2% p.a.) to about 6.8% of today’s portfolio value. We add that back to the final value.
- All other assumptions are as in my baseline Google Sheet.
Google Sheets Link to the SWR Study
Given all those parameters, the failsafe withdrawal rate is 4.12%. At a 4.33% withdrawal rate, we still keep the failure rate at 5% in historical simulations. All assuming an elevated CAPE ratio! 4.12% multiplied by the $1,414,681 portfolio value (not the entire $1.6m, that would be double-counting!) is about $58,000 in annual withdrawals (though reduced by the supplemental flows). If we budget about $15,000 in taxes, you’d still have $43,000 left over, more than enough for your $38,000 consumption target. So, even with a failsafe withdrawal rate, you’ll have a cushion of about $5,000 annual expenses!
Also, I should say it again: all we needed to fund with the Google Sheet calculations is the annual consumption in excess of the mortgage payment ($38k). That’s because we already pay for the mortgage ($835 a month) with some of the Peer Street supplemental income flow! So, from the SWR calculation, your FIRE plan seems extremely safe. Of course, this is all subject to the usual disclaimers, the limitations of historical returns and the modeling assumption of your real estate returns.
Portfolio balances up to age 70
As usual in these case studies, I like to see how the specific account balances evolve over time to avoid any cash flow problems, where the taxable accounts run out before the 401k and IRAs can be tapped. Here are the assumptions:
- Asset Location vs. Asset Allocation: I normally recommend holding bonds in tax-deferred accounts and equities in taxable accounts. In the calculations below, I assume that the taxable accounts and Roth are 100% equities, the 401k is 50% equities and 50% bonds.
- Stock and bond returns are the same as I usually assume in these case studies: 5.75%/2.00% early on, then shifting up to 7.00%/3.25% over time (nominal).
- I assume that the hard money loans and Peer Street investments keep generating 7% p.a. (nominal!) and this income is skimmed off every year to pay for expenses. They will likely pay more, but let’s be conservative.
- I ignore your small cash/money market allocation for this calculation.
- I assume marginal income taxes are 30% for ordinary income and 23% for dividends/Long-term Capital gains in 2018 because your $80k deferred compensation pushes you into a higher bracket. Then, going forward, you’ll enjoy lower marginal rates. In fact, you will likely manage to stay inside the first two tax brackets for federal taxes, so capital gains and dividends will be taxed only at an 8% marginal tax in your state. I suspect that
- I assume you keep contributing $5,500 p.a. to your Roth for as long as your husband is working (7 years minimum). Starting in the year when you turn 50 (presumably 2023), you can even contribute $6,500!
- Starting in the year 2033 (presumably, that’s the calendar year when you turn 59.5) I assume you withdraw from your 401k.
- In 2034, your consumption target falls because you have paid off the mortgage.
- I solve for the withdrawals so the income net of taxes exactly matches the consumption target.
Results:
- Despite the conservative assumptions you actually keep growing your taxable account by the time you reach age 59.5. No issue with running out of money in taxable accounts!
- At age 70, when required minimum distributions become an issue you’ll have a pretty large 401k. Under today’s tax laws, this would likely push you into the 25% tax bracket because you’ll be forced to withdraw 1/27.4=3.65% of your 401k balance that year. As I have described in these case studies before, this is a good problem to have – too much money. And there’s not much you can do about it because you likely have very limited room for Roth conversions before age 70, see below.
- But again: overall the picture looks extremely positive. Despite the withdrawals, and despite lowballing the expected returns, you will likely grow your capital even in inflation-adjusted terms!
Is Peer Street really worth it?
On the surface, it seems as though Peer Street beats equities. 8% return beats my conservative estimate of equities in the near term (5.75%) and even in the long-term (7%). But keep in mind that equities still enjoy a superior tax treatment. You can likely generate 7% returns in the long-term that will be taxed only at the state level, presumably around 8% marginal taxes, for a net return of 6.44%. However, your Peer Street returns of 8% will be taxed as ordinary income, presumably at 15% federal and 8% state. That 8% Peer Street yield is now only 6.16% after tax, less than equities.
If you are not too attached to your alternative investments you might consider scaling down your Peer Street engagement over time. I understand that the 8% yield offers a lot of peace of mind especially considering that equities seem so expensive at this point. But maybe if equities are a bit cheaper again in the future (measured by their CAPE ratio) you’ll revisit this option.
Another option would be to explore if Peer Street (or some other provider) offers IRAs. Then reinvest principal payments from Peer Street in an equity fund in the taxable account, but do the reverse transaction in your IRA (sell equity funds, invest in Real Estate loans) and thereby slowly switch the Peer Street investment to an IRA where you don’t have to tax the massive 8% yield as ordinary income every year.
Roth Conversions?
It sounds like your income combined with your husband’s will put right at the top of the 15% federal bracket. You may even slightly overshoot it. But there may be years when you stay below and then it would be crucial to max out the 15% bracket for Roth conversions. Remember, 15% is likely the lowest rate you ever pay for ordinary income on your federal return and at some point in the future, when required minimum distributions kick in you may pay 25% at the margin. So, if you haven’t done so already, check out the Case Study from a few weeks ago where I proposed how to implement Roth Conversions to max out the 15% federal bracket.
A word about Betterment
Your $277k combined investment in Betterment will cost you about $700 in annual fees. Betterment now charges 0.25% p.a.! And that’s on top of the ETF expense ratios! For that reason, I’m not a big fan of Betterment! I have written pretty scathing reviews before:
- Shifting existing asset with built-in capital gains is a bad idea. Not applicable to your situation, but still a fun read: We just saved $42,000 by not switching to Betterment.
- How to do Tax Loss Harvesting yourself without spending 0.25% p.a. on Betterment: Be Your Own DIY Zero-Cost Robo-Adviser!
- How Robo advisers inflate their estimates of how much benefit you can generate from tax loss harvesting: Why we don’t use Robo-advisers.
Especially the third post is relevant to you. In the decumulation phase, the benefit of tax loss harvesting is hugely diminished. One could even argue that a few years into your retirement when you have stopped new investments and started living off your dividends, there will be no more tax losses left to be harvested.
But it gets even worse. Even under the most optimistic assumption that Betterment keeps generating $3,000 every year in tax losses they are much less useful in retirement. If you are already liquidating long-term gains to fund your expenses in retirement, note that your tax losses from Betterment will first be netted against taxable long-term gains before you can them to lower your ordinary income. In the worst case, this may be worth only $3,000 multiplied by the 8% marginal tax rate on long-term gains. You’d pay $700 in fees for $240 worth of tax savings.
Another reason to be cautious about Betterment/Wealthfront: They could be a tax audit time bomb! It’s hard to coordinate your Betterment portfolio with your other portfolio holdings outside Betterment. Thus, some of the tax losses generated by Betterment could be disallowed by the IRS. Betterment makes sure to avoid disallowed wash sales within the Betterment account. But if you bought sufficiently similar assets (e.g. VTSAX) in your other accounts (whether through new savings or dividend reinvestments) in the 30 days before or after Betterment harvested losses in the VTI index ETF, the IRS will disallow a portion or all of the tax losses.
My recommendation: Roll over the Betterment accounts to another broker, but do so in kind, i.e., without selling the underlying ETFs. Then in their new domicile (e.g. at Vanguard), you’d sell the bond ETFs (they likely have the lowest capital gains, too!) and shift to equity ETFs. It’s more tax-efficient to keep bonds in the tax-deferred accounts. Then start living off the dividend income and (potentially) sell some of the ETFs as needed to fund expenses.
Pay off the mortgage?
There was a good discussion in the ChooseFI Facebook group the other day. Applying average expected returns to calculate the pros and cons of prepaying the mortgage is misleading. Of course, an equity portfolio will, on average, beat 3.25%. But in safe withdrawal rate studies, we are concerned about the tail events when equities underperform. My preliminary research (to be published sometime in the future in the Safe Withdrawal Rate Series) shows that not having a mortgage helps with Sequence of Return Risk in retirement and will likely sustain a higher safe withdrawal rate. Again: you lose on average if you pay off the mortgage but in the worst case scenarios it’s priceless to be mortgage-free.
I think there is no need to sweat this issue because your finances have so much safety margin built-in that you probably don’t have to be too concerned about Sequence Risk. Also, unless you both agree to pay down the mortgage and you each pump $130,000 to pay down the mortgage, the matter is further complicated by the unusual arrangement with your husband. If you were to pay down your share ($130,000) your husband would have to pay off his remaining half but he’d have to make the full payment ($1,670) rather than his current $835 payment (though, for a shorter time, of course). But that may create a cash flow problem for your husband now. Maybe think about the mortgage payoff option once more when your husband retires in 7-10 years!
Conclusion
As you might have expected, your finances are in excellent shape. Well, they better be because you already pulled the plug and retired. When using the historical simulations, your current consumption needs stay below even the fail-safe withdrawal rate. It looks like you will sail (surf?) through early retirement with enough of a cushion to last for many decades and to leave a nice bequest to your daughter. I hope you find ways to use all that extra time productively. Maybe finally learn how to surf?! Best of luck to you and your family!
I hope you enjoyed today’s case study! Please leave your comments and suggestions below and make sure you also check the other Case Studies!
- Ask Big Ern: A Safe Withdrawal Rate Case Study for “John Smith”
- Ask Big Ern: A Safe Withdrawal Rate Case Study for “Captain Ron”
- Ask Big Ern: A Safe Withdrawal Rate Case Study for “Rene”
- Ask Big Ern: A Safe Withdrawal Rate Case Study for “Mrs. Greece”
Big ERN,
Another great case, though I also admit that I’m not familiar with alternative investments unless a tiny piece of them are wrapped up in our index/mutual funds. However, shouldn’t the ‘Surfer’ try to scale back while it’s all great? I’m not sure I agree with your sentence “If you are not too attached to your alternative investments you might consider scaling down your Peer Street engagement over time.” You’re suggesting her to time the market, but what if equities slip, but Peer Street totally slides down? However, since I’m not familiar with this class of investments I will not stick my nose in and advise here :-). It depends on a person’s risk tolerance, I guess.
The pattern is clear: Nice income and low expenses lead to a great surplus balance that leads to successful retirement. Oh, and luck in life is a huge factor like health and happiness for couples (though not in this particular case).
Ms. wishicouldsurf here…. luck in life is totally a huge factor to where I am today. I won the genetic lottery that Buffett refers to as I grew up in a stable household where education was emphasized and was able to obtain first class college education. Icing on the cake is that I came out with minimal student loan debt due to some slightly above average athleticism (more luck). Since I was a commercial lender (banker) for 20 years, the alternative investments I have chosen are very comfortable to me and for the time being, I’m going to stick with my large asset allocation in the alternatives. Not that I think it’s going to pass, but just heard the “new” proposal for taxes and if that were to happen, I would have to rethink my strategy, perhaps even consider paying the mortgage off sooner. I’m hoping that my alternatives are not completely correlated with the stock market and are offering me a hedge but since there is no historical data on them, I don’t really know what will happen in the next downturn. I’ve got a lot of wiggle room built into my numbers so I’m fairly confident I can pull this off, but I am always open to criticism and suggestions because I learn a lot from it. I like the Peer Street because I’m getting a very predictable stream of income from the interest alone but also because when the loans repay, I could use the principal to meet cash flow needs without having to figure out if I’m taking a capital gain, loss, etc. I just use the principal as needed. Dividend rates on stocks alone would not meet my cash flow requirements in my opinion.
Theoretically, my Peer Street investments, because they are a debt position, are more stable than an equity position would be and because it is a secured debt position, I have a contractual right to the loan amount I have outstanding in the case of a foreclosure. Thus, I get paid sooner than anyone in an equity position. But I have no data in a downturned market to back this up yet.
Ms. wishicouldsurf here…. luck in life is totally a huge factor to where I am today. I won the genetic lottery that Buffett refers to as I grew up in a stable household where education was emphasized and was able to obtain first class college education. Icing on the cake is that I came out with minimal student loan debt due to some slightly above average athleticism (more luck). Since I was a commercial lender (banker) for 20 years, the alternative investments I have chosen are very comfortable to me and for the time being, I’m going to stick with my large asset allocation in the alternatives. Not that I think it’s going to pass, but just heard the “new” proposal for taxes and if that were to happen, I would have to rethink my strategy, perhaps even consider paying the mortgage off sooner. I’m hoping that my alternatives are not completely correlated with the stock market and are offering me a hedge but since there is no historical data on them, I don’t really know what will happen in the next downturn. I’ve got a lot of wiggle room built into my numbers so I’m fairly confident I can pull this off, but I am always open to criticism and suggestions because I learn a lot from it. I like the Peer Street because I’m getting a very predictable stream of income from the interest alone but also because when the loans repay, I could use the principal to meet cash flow needs without having to figure out if I’m taking a capital gain, loss, etc. I just use the principal as needed. Dividend rates on stocks alone would not meet my cash flow requirements.
Theoretically, my Peer Street investments, because they are a debt position, are more stable than an equity position would be and because it is a secured debt position, I have a contractual right to the loan amount I have outstanding in the case of a foreclosure. Thus, I get paid sooner than anyone in an equity position. But I have no data in a downturned market to back this up yet.
Thanks for commenting! Most definitely, I don’t argue we should time the market. If there’s a stock market crash a la 1929, 1970s or 2008/9, that Peer Street portfolio will take a beating, too. I was thinking more of a slow deflation of the CAPE ratio if earnings grow faster than the S&P500 price index (think Bogle scenario, see SWR series part 16). There is no crash, no housing market meltdown, just equities become more attractive relative to earnings. Then I would shift back into equities.
That’s my idea, ERN. Right now I’m earning a predictable stream of cash flows which is meeting all my spending needs and stock dividends don’t offer me that. If there is a slow deflation of the CAPE ratio, then I plan to shift earnings there. Yes, I’m taking a risk but as indicated, I understand this type of investment more than stocks since I’ve got 20 years of lending money experience. But I don’t have a crystal ball and know what the future holds. Just doing this early retirement thing in the way that made sense to me which is slightly different than maybe what the big FIRE bloggers are saying.
I love these case studies. Do me! Do me! Seriously, I can give you my numbers if you’re interested – I’m currently at the cusp of a interesting dilemma as to what to do next…
Haha, thanks for the compliment! If you have a simple question, maybe post it in the ChooseFI Facebook group. There are others who will also weight in who have great suggestions. For a case study request, check my contact page and email me.
Dear Big ERN,
A very interesting read and lots of food for thought and I’m not even referring to Mrs Surf!
How does one go about trying to become a case study?
Besos Sarah.
Check the contact page and send me a note!
It’s interesting to hear your thoughts on the P2P real estate trend. That seems to be getting a lot of attention in the early retirement sphere, but not many people talk about its efficiency or risks. I worry that a lot of its popularity is due to marketing and “newness.”
Any particular reason you chose to treat it as half index fund?
Thanks!
Purely rule of thumb. I have no reference data on how real estate loans like the ones on Peer Street. For the SWR study, we look at tail events like 2008/9 or 1929 to gauge the sustainability of an SWR. If the market goes down by 50% again it wouldn’t be far-fetched to assume about 25% losses to your principal.
Ms. wishicouldsurf here…. luck in life is totally a huge factor to where I am today. I won the genetic lottery that Buffett refers to as I grew up in a stable household where education was emphasized and was able to obtain first class college education. Icing on the cake is that I came out with minimal student loan debt due to some slightly above average athleticism (more luck). Since I was a commercial lender (banker) for 20 years, the alternative investments I have chosen are very comfortable to me and for the time being, I’m going to stick with my large asset allocation in the alternatives. Not that I think it’s going to pass, but just heard the “new” proposal for taxes and if that were to happen, I would have to rethink my strategy, perhaps even consider paying the mortgage off sooner. I’m hoping that my alternatives are not completely correlated with the stock market and are offering me a hedge but since there is no historical data on them, I don’t really know what will happen in the next downturn. I’ve got a lot of wiggle room built into my numbers so I’m fairly confident I can pull this off, but I am always open to criticism and suggestions because I learn a lot from it. I like the Peer Street because I’m getting a very predictable stream of income from the interest alone but also because when the loans repay, I could use the principal to meet cash flow needs without having to figure out if I’m taking a capital gain, loss, etc. I just use the principal as needed. Dividend rates on stocks alone would not meet my cash flow requirements in my opinion.
Theoretically, my Peer Street investments, because they are a debt position, are more stable than an equity position would be and because it is a secured debt position, I have a contractual right to the loan amount I have outstanding in the case of a foreclosure. Thus, I get paid sooner than anyone in an equity position. But I have no data in a downturned market to back this up yet.
Another great case study, thanks. I am a bit nervous with about a third of the portfolio in non-traditional investments. That’s a lot depending on how they’re set up! I’d love to know why Mrs. Wish I Could Surf has chosen such an allocation. Higher perceived gains? Diversification? Seems like fun? Just trying to help others?
Maybe if I were a former banker I wouldn’t consider real estate loans that exotic. 🙂
arcyallen, what ERN said. I’m a veteran 20 year banker and these investments just are not exotic to me, but you have a very valid question. I’ll try to explain myself succinctly. 1) My biggest concern in early retirement was – how do I mechanically access a predictable stream of cash flows without having to stress about whether I’m taking a capital gain or capital loss, each month to pay my expenses? 2) I like real estate as an alternative investment and would like to own my own multi-unit apartment property; however, I live in southern California and the price point of those investments is so high and I don’t have the kind of cash to put this in my portfolio. My personality as a real estate investor is one where I would like to live close to where the investment is so I could stay on top of maintenance and whatnot. I know this can be done in other ways but I owned a rental property for 11 years 400 miles away and just felt like I couldn’t stay on top of things and it was a constant source of frustration for me. 3) See if you can go with me on this one – I view Peer Street as a quasi-REIT type investment. And some of the boglehead type folks like REITs as an investment for a good chunk of their portfolio. I think Peer Street is actually a little less complicated than a REIT and all the loans are first trust deed type positions which are theoretically safer than equity in a downturn. Now that I’ve been at this over two years, I have a fairly well diversified portfolio of loans in different geographic regions, between $1,000-$3,000 and I’m currently earning around 8% per annum. I get to choose whether or not I want to stay in each investment (I do auto investing and cancel the ones I don’t like) so I get to use my banker knowledge to decide.
Just a quick add on to my previous comment – I theoretically wanted my after tax accounts to meet cash flow needs without diminishing the principal balances too much. The backdoor/roth conversion isn’t accessible to me for a long time either and I didn’t want to try and also predict the future of tax policies, so I attempted to devise a plan that met all my cash flow needs right now. And, so far, this is doing what I need it to do.
LISTEN, I said non-traditional, not exotic :).
I did some digging on the Peer Street site. I was familiar with the general idea but had never dug into the weeds. It seems very interesting, but when I see them comparing 1% bank interest rates to their “safe” 10-12% income streams I get nervous. Especially when they say they’ve never had a default! (I think Bernie Madoff had a similar sales presentation) I’d also be concerned that the loans are going to people/situations that justify the higher rate to begin with.
If I just take a step back and look at it, it smells bad. It doesn’t mean it -is- bad, because I can’t tell from where I sit. But any investment that’s based on loaning people money at a high interest rates seems by nature high risk. I’ll be eager to see what the next few years brings for them.
On a related note, what do -you- think is their downside? Possible risk of principle, or suddenly lower rates, or?
Legitimate concerns, though, respectfully, I think a comparison to Bernie Madoff is a little harsh. Hard money real estate loans are actually quite a common way to reposition real estate assets and have been around for more than a couple of decades (though I have only a couple of decades worth of experience). Because it is an asset class I’m familiar with (a portion of the loans I funded over my career were quite similar to hard money loans), it doesn’t feel weird in any way to me, though I don’t expect 10-12% rates at all. It was only a matter of time until they have a default (banks who do traditional residential mortgages also have defaults on a regular basis) and I have one position (that has $1,400 in it) that has defaulted. But I’m not too worried about it… eventually I think I will get at least 60-70% of the principal in a worst case scenario and I expect 100%. It’s just a small piece of my diversified portfolio of loans there. Just because it’s a hard money loan, it does not mean that they are lending money to folks with bad character. Many of the Guarantors on the transactions have 700, 750 and some are higher than 800 in terms of personal credit score. That’s the best proxy we have as outsiders for character in these transactions and I stay away from credit scores below 650. From a capital perspective, as in investor here you are in a first deed of trust debt position, so you are first in line to get paid in the event of a default. I think over time that rates will actually come down in this asset class as it becomes more efficient and demand increases. But I think it would be better to say rates relative to traditional mortgages. If traditional mortgage rates go up significantly, I expect this asset class will also go up though I expect long term the spread between traditional mortgages and this asset class to compress. Not sure if I’m making any sense, but hopefully I gave some information that was helpful.
Note that me expecting rates to compress over time is purely a guess based on the mechanics of supply and demand. But I figure it’s better to project returns going lower than increasing over time for conservative purposes.
Just found this site so a little late to the party. Great work Mr. ERN!
IMO, the financial industry has done a wonderful job of marketing and lobbying the public. Real estate investments are considered non traditional and risky whereas a stock (not selling options) that you have absolutely no control over is considered “ok”.
I’m not invested in PeerStreet, CrowdStreet or any of the other crowdfunding real estate markets, although I have evaluated a few deals and I prefer to DIY.
Much like Mr. ERN has tons of options and market investing knowledge, investing in real estate without knowledge is dangerous. With that said, I’ve been in hard money loans that I choose what to invest in, my local area rehabbing houses, working with small builders, etc. The returns are great and the risks are controllable. My general rates are 12% plus 2 points for a 6-9 month term with a 1 point extension. I’ve originated over 160 loans and had to foreclose on 1. The process was silly long, 3 years, but in the end I was able to sell the property for all I had in it for no loss of principal.
So why won’t banks lend to these folks and why the high rates? Risk evaluation and not taking the time to develop relationships for “small” amounts of money. When a bank lends on a property, they want it to look fantastic, no problems and marketable. When an investor (me) lends, we want to lend on ugly properties that have potential. We know the builder, personally, seen their work, know they will not scare from mold, bad roof, bad AC, bugs, wood rot. The property is purchased on the wholesale market and that is the amount I lend upfront. The builder does work to make the property worth more, sometimes the loan is setup to provide more money for work done. Hard Money Lenders (HML) fill a void in the market.
When a retail buyer walks into a property and smells cigarette or pet urine they are put off, smile and say … smells like money!
Here is an example of one of the end products. The initial property was dated, chopped floor plan and no second floor.
https://www.zillow.com/homedetails/1131-Burning-Tree-Dr-Chapel-Hill-NC-27517/50040550_zpid/
I lent $385K for a little over a year.
wishicouldsurf, There are self directed IRAs that allow real estate note transactions so you can keep the taxable income down.
Wow, that’s a substantial investment! Glad it worked out.
Great recommendation about the self-directed IRA!!!
Thanks for the reply Mr. ERN. This property was on the 13th green of a nice country club based golf course community in Chapel Hill NC. The builder had the property completed and listed at $850K for over 6 months and refused to reduce. I’m was sitting on a first position note for $385K on a property listed at $850K and eventually selling $770K. The whole time earning 1% a month and if I had to take it back, a big wide moat. Sadly, all of that was taxable while still employed at megaTechCorp.
NIce! Sorry to hear about the tax bill, though!
That’s NOT her real name? Aww, come on now.
ha, SteveK! I see your Boston Marathon badge by your name and had a Meb sighting at my daughter’s soccer game two weekends ago – our daughters play in the same recreational league. Benefits of living in San Diego. 🙂 I shut down my linked in profile a few months before I quit so I don’t really even have much of a social media footprint anymore.
Lucky, you. Meb is the best. I “watched” him win at Boston although I was some 90 minutes behind him at the time he crossed. I’m just north of you in the OC
super cool dude…. sometimes runs by where my daughter has triathlon practices and he always does a quick stop and high 5 for all the kids. 90 minutes behind Meb is impressive for that hilly Boston course. Cheers!
Great case. I agree with your sound analysis as usual but the only place we differ is your 4.12% SWR for what can be a near 50 year retirement horizon. I would’ve felt more comfortable with a 3.5% figure.
Curious on your reasoning, 10! Note that I’m following a 3% “rule of thumb” in general, at least until my house gets paid off, but I’m wondering about your logic just for edification purposes.
Surf, The basis for a very conservative SWR is here: http://tenfactorialrocks.com/hacking-the-retirement-calculators/
However, my analysis doesn’t consider any supplemental cash flows like SS or pension. So, with that in place, and your mortgage disappearing soon, I agree with ERN’s 4.12% figure, though I would still start with 3.5% for the first 5-10 years. Then have a boost to 4.12% at a time when your portfolio is nominally equal to your starting portfolio (despite the 5-10 years of withdrawals), and also when your retirement planning horizon is shorter by a decade! This is why a review each year and a detailed analysis every five years (to reset the planning cycle) is a sound way to avoid your withdrawals swinging too much on either conservative or risky sides.
Right on, thanks for the information. I’m personally relying on the 3% rule of thumb and you are correct, the key is to get through those first 10 years. If I can do that, then I’ll start to rest easier. Good advice on an annual review, though I have a feeling I’ll likely be checking things on a quarterly basis these first few years to make sure everything is playing out like I think it will.
Again, this takes into account the supplemental cash flows! For a “naked” SWR analysis in the absense of Social Security etc. and other income, 3.5% is indeed the right SWR in today’s CAPE environment.
Thanks for stopping by!
Always love these case studies and the gems of information within. Although we have never considered Betterment or other Robo’s, the notion of them being a tax audit timebomb is quite scary.
We plan to do Roth conversions but will be watching carefully the AGI relative to ACA subsidy. Will be looking at all the plans when Open Enrollment starts early November.
Look forward to your post on the concept of being mortgage free in retirement (our situation) and the impact on SoR.
Thanks, Dr. PIE! Yes, trying to coordinate your non-Bettermen investments with the Betterment tax loss harvesting is not just hard, but impossible. You can obviously avoid buying in the 30-day window after the Betterment transaction. But you’ll never be able to avoid buying int he 30 days before Betterment realizes a tax loss. Scary indeed!
Looking forward to updates on how you balance the Roth conversions with the ACA cutoffs! Best of luck!
Cheers!
The expense estimate does not include health insurance premiums in the worst case. My ACA premiums are ~$1500 per month for a mediocre plan for a family of three in California.
I’ve invested in a large variety of real estate deals. I invest with PeerStreet simply to get access to more deals. I also invest in hard money loans with a private lender that I’ve known for many years. I am more comfortable with the private lender because I know their screening process and have history with them, but their deal volume is very limited. We on the outside do not have visibility into PeerStreet screening process and accuracy of appraisals. PeerStreet insiders will make their money from capital raises, or an IPO, or a buyout, not directly from the quality of loans they offer, so their interests may not be 100% aligned with loan investors.
Both good points. I am budgeting $24k per year in health expenses for my self. Just to be on the safe side.
I’d also be a little bit concerned about potential irregularities like at lendingclub last year.
ERN, I hear you on the potential irregularities. I did a small lending club experiment and it turned out exactly as I expected. Big losses, lots of late pays, return on investment less than 1%. After 6 months, I started pulling my payments out of there. But consumer debt is fundamentally so different than real estate secured debt and I haven’t seen any of the investments look like “refinances” of already existing Peer Street loans (yet). I’m keeping my eyes open that this may happen, however. I tend to like deals that show the Borrower has injected a significant chunk of their own money (though I have no way to verify the sourcing of said cash) because we both know that one of the reasons for the 2008 real estate meltdown was that many Borrowers had no skin in the game. I have some street level/first hand knowledge of some of the California based hard money lenders and the ones with excellent reputations (not “loan to own” shops), I tend to like their deals, though I steer clear away from deals without a Guarantor and with sub 650 credit scores.
Haha, sounds like my experience with Prosper in 2008! You are right, there is a good chance that the background checks are a bit more thorough on Peer Street! Thanks!
You clearly know what you are doing. But if you are going to have 25 percent of net worth with one sponsor I would suggest you diversify out to other sponsors as the loans mature. Atleast you will eliminate sponsor risk.
I am late to this because I am just reading all the great case studies
Good point! Not a bad idea to have some more diversification across platforms!
I hear you and that’s a legitimate criticism, I currently have budgeted only $800/month in healthcare expenses for my daughter and I and I fully expect this to go up but I figured I wouldn’t put off retirement a couple more years to try and nail this down when I can access it for $260/month through my husband’s work plan and he plans on working at least 5 years if not another 10 (he works 3 days a week and likes his job). And then when my house is paid off, that frees up additional monthly cash flow to cover healthcare, if necessary. Agree also about the appraisals but I do like the comps and the other data showing the stressed downside loan to value. I don’t know what the long term strategic play for Peer Street is but all my positions are 24 months or less for this reason and a lot of others. I have several consulting type opportunities in play, and if I need to make some money to get better healthcare, I’m fairly confident I can figure something out. There is so much uncertainty in the healthcare market anyway and I was ready to quit my high stress career, so I did.
She said SHE pays $1,670 monthly on the mortgage! And since she pay she only half, it must be assumed the whole mortgage isn’t twice that amount. No? Otherwise great stuff as usual.
$1,670 is the the mortgage and she pays half of it (=$835). I don’t think the $1,670 is to be seen as a half of a $3,340 mortgage payment.
That’s not the way I read it but if you say so. Thanks.
It’s the way I remember it from the email exchange for this volunteer, which included more info, not all of which made it into the post. 🙂