In the December Issue
- Shaping Investment Goals through the Four Quadrants
- Knowing Your Risk/Reward Tolerance
- How Does a Given Deal Identify with the Quadrants?
Shaping Investment Goals through the Four QuadrantsBy now, the investment quadrants should be a familiar topic of discussion for our regular readers. As we’ve often noted, the quadrants provide an excellent framework for examining deals which gives one the ability to manage investments more efficiently. Once you’ve determined which quadrant a deal falls into, you can then assess whether the deal is a good match for your own financial goals. As a quick refresher, quadrants one and two are investment grade deals while quadrants three and four are speculative grade deals. We’ll look a bit closer at some examples of how specific deals match up with the respective quadrants, but let’s first talk about risk.
There’s No Escaping Risk but You Can Manage It!Another common theme we’ve reiterated in many of our newsletters is the fact that any deal has an element of risk attached to it, so it’s critical that an investor allocate some level of loss reserve per given investment. If, for example, you project a loss reserve of 1% on a deal that you’re predicting to bring in 10%, you’re risk adjusted ROI comes down based on the loss reserve. Bearing this important factor in mind allows us to manage our expectations in regards to projected performance returns. Risk adjusted return, therefore, is the grain of salt we all know we should take but oftentimes fail to factor in. Think of it as a reality check up front. *Investor Tip: When it comes to building a portfolio, the quadrants help us see not only what type of deal we’re considering but also where a deal falls in relation to our goals. The quadrants enable us to ascertain whether a deal is low risk, high risk, cashflow focused, or growth focused. It’s paramount that you understand your goals or you’ll never end up getting anywhere, or at least not where you hoped to go… unless you just get lucky. So, the first step every investor must take in determining their goals is to take a hard look at their own level of risk tolerance. This is the true key.
Knowing Your Risk/Reward ToleranceWhen looking through the prism of the investment quadrants, we see two types of investors: (1) those who are risk averse and (2) those who are risk tolerant. If you’re among the former then you should avoid speculative deals altogether. Conversely, if you’re among the latter, then you may well want to consider speculative grade deals.
Determining Cashflow Needs, Total Return, & Tax EfficiencyIt’s also important to determine if you need cashflow along with how much you’ll require. If, on the one hand, your current job provides a high level of income, then you may be fine in low cash flow investments; retired investors, however, are less likely to be growth focused and may need passive income from their investments. Again, it’s vitally important to make these determinations around your long and short term goals. You may also be looking to get a certain amount of cashflow from your portfolio either in terms of a percentage of the portfolio or in terms of absolute dollars. Your cashflow goals may be driven based either on new expenses or your portfolio size. Having these goals defined helps significantly in shaping the types of investments you select. In addition to cashflow, it’s also vital to look at the total return which is a combination of cashflow plus appreciation. If you’re hoping to achieve a total return of 10% with cashflow of 6%, then the remaining 4% will come in the form of appreciation. Tax efficiency is also a factor to consider in that you’re concerned about how much profit remains from your investment after taxes have been paid. Here, you’re looking for cashflow with some level of depreciation and tax efficiency. It may be that you’re investing from a self-directed IRA account and you’re not concerned about tax efficiency.
Diversification, Time Horizon, & Liquidity: The Final PiecesThe last three components every investor should consider when setting portfolio goals are diversification, the time horizon, and liquidity. When determining how much diversification you’re comfortable with, the typical questions one should ask are “What is my average investment amount?” and “What is my maximum investment amount?” Bear in mind that the more diverse your investments are, the steadier your portfolio will be. With time horizon, it’s key to have knowledge of how long you intend to invest. Is it 3 to 5 years or is it ten plus years? It might be the case that you’re investing for the short term only, say 6 to twelve months. However you shape these goals make a tremendous difference. While a portion of your portfolio may be geared towards long term growth another part of it may be aimed at short term liquidity which enables you to convert an asset into cash quickly. In other words, you should also have investments that are relatively easy to buy and sell depending on your need for cashflow. Again, having these goals is fairly straightforward, and they help you select your investment types.
How Does a Given Deal Identify with the Quadrants?While it’s not always possible to determine exactly which quadrant a deal fits into, this framework provides some guidance you can employ in assessing your deals. Let’s look at a series of examples within each quadrant to illustrate.
Quadrant 1 Deal ExamplesMany of my clients are extremely comfortable with quadrant one and would happily invest the majority of their funds in these types of deals. That’s due to the fact that it feels like a safe place to be in that it provides a degree of security and cashflow. First-lien loans fall into this category when they are written under a conservative loan to value ratio with a good borrower and a clear exit strategy. Quadrant 1 is characterized by good down-side protection, low to moderate risk, and good initial cashflow with an average ROI of 10-15% (RAR = 9-14%). In terms of how you’re capital will be allocated, let’s say that quadrant 1 requires that you have 50% of your capital spread across ten investments. Example 1: Short-Term Hard Money Loan/Fund with a Loan to Value ratio less than 70% (ideally 65%). It’s a fix and flip project in which the borrower has a proven track record. The deal has a clear value-add plan and exit strategy. The time horizon is a duration of twelve months or less with a pretty good rate of return on your money at 9%-12% plus. *Bear in mind that hard money rates have been compressing lately, and it’s very possible that you could get below 9%. Example 2: Long-term Loan on a US Property for a Foreign Borrower with a LTV less that 80% (ideally less than 75%). This five-year first-lien loan on a well-underwritten asset has a good borrower who can put down as much as 25%. The rate in this case is generally lower than the historical hard money loan rate, say 8-10%.
Value-adds in Quadrant 1:these deals will generally have light value-add early on such as cashflow starting from year one. There’s not any particular magic number, here, in terms of how much cashflow to expect, but it’s possible that it could drop below 6% during the value-add phase (if that’s the case then the deal may slip into quadrant 2). In the case where a deal is on the borderline between quadrant 1 and 2, it’s not assuming any more risk per se; rather, it’s just a matter of the cashflow being more limited in the value-add phase.
Sponsor Fees Add RiskOne scenario that might add risk is when the deal has a lot of sponsor fees. This means that the sponsor gets paid first while you get paid second. When the sponsor designates he will take fees off the table first, be sure it’s a fair deal and that it’s worth your time to participate.
Quadrant 2 Deal ExampleQuadrant 2 is often characterized by first-lien non-performing notes with limited cashflow during the first and possibly second years. There is good down-side protection and low to moderate risk. Average ROI is 12-18% with a RAR of 10-16%. Example: 1st Lien Non-performing Note (NPN) with a low LTV (less than 65%). This loan has a high default rate betwen 18-24% with quality collateral and an experienced operator and team involved when it comes to foreclosures who can take the paper through its life cycle. *Investor Tip: One of the keys here is to make sure you have a high default interest rate. Otherwise, why would you invest in a non-performing note when you can’t get a higher rate of return than performing paper? You also want to make sure that you have strong liquidity to withstand any value-add phase issues or delays.
Quadrant 3 Deal ExamplesBy nature, these deals are speculative grade with a higher level of risk involved with a cashflow focus. There is limited down-side protection and strong initial cashflow with an average ROI between 16-22%. The RAR is 10-16%. Example 1: 2nd Lien Performing Notes with a Combined Loan to Value (1st + 2nd) less than or equal to 75% There is a high interest rate between 15-24% with a high quality borrower and a clear exit strategy. Example 2: These are highly leveraged syndications with a Loan to Cost between 75-90% and a Debt Service Coverage Ratio of 1.15-1.25. The Cash-on-Cash return is 12% +.
Quadrant 4 Deal ExampleThese growth-focused deals are speculative grade with a high degree of risk. They have no down-side protection and no to limited initial cashflow. Examples: These projects include Development/Re-development, Ground up development (multi-family and self-storage), Conversions for higher and better use (Big Box retail to Self-Storage), and Land Speculation with each characterized by negative cashflow through the value-add (less 50% occupancy of multi-family and repositioning of the asset upon renovation completion).
SummarySo to recap, it’s important that you start with your investment allocation plan by looking at Quadrants 1-4 and determining how comfortable you are with risk. Establishing other key elements like what type of cashflow you need, your total return, and tax efficiency along with incorporating some degree of diversification, knowing your time horizon, and assessing your need for liquidity will enable you to determine which quadrant or quadrants, you’ll feel the highest level of comfort working in. Finally, take into account that you’ll need high quality sponsors and fund managers who operate within the quadrants that match your allocation plan. As always, if you’re interested in learning more about how you can invest in the Tempo Opportunity Fund LLC or need help with the discovery phase, please visit https://tempofunding.com/fund/ or contact me, Mike Zlotnik, at firstname.lastname@example.org or by phone (917-806-5029). I’ll be happy to forward you the PPM, term sheets, and subscription paperwork or answer any questions you might have. Please don’t miss the latest Episodes on Big Mike Fund Podcast: 048: Real Estate Funds Explained 047: Going the Extra Mile: Portfolio and Investment Goals Thanks for reading, Mike Zlotnik CEO, TF Management Group LLC This newsletter and its contents are not an attempt to sell securities, nor to sell anything at all, nor provide legal, nor tax accounting, nor any other advice. The presenter is a private lending and real estate fund management business, and the information represented herein are purely for educational purposes and represents the opinions of the presented. Prior to making any investment or legal decision you should seek professional opinions from a licensed attorney, and a financial advisor. TF Management Group LLC (TFMG) is an investment fund management company that specializes in both short-term debt financing for real estate “fix and flip” projects, and long-term “value-add” equity deals.
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