Private Lending vs Buy & Hold

[David Sims]

For the past few years I have been lending my money on SFR fix and flips and getting a 12% cash on cash return. Recently I've been looking at the tax benefits, potential appreciation, and CAP rates on a multi family or commercial property and wanted to see if anyone has a compelling argument either way on whether private lending at a 12% return or buying and building a portfolio of rentals/multifamily/commercial property is a better path for building long term wealth? Currently I am only able to find cap rates at 6-8% on either NNN commercial or multifamily properties and the market is flooded with retail buyers fighting for the bigger deals. My cash on cash return is higher doing the private lending but I am not able to realize any appreciation or tax benefits at the end of the year on my private lending. My individual goals are similar to most I would assume -- Building my net worth and increasing cash flows while avoiding as much taxes as possible. Any insight, experience or actual numbers using leverage(financing) to build wealth would be much appreciated. I'm not willing to share my financial situation online for the world to see, but for example let's assume $500K of cash at 12% private lending vs leveraging financing and buying properties over a 10 year period.

[Jered Sturm]

@David Sims You asked "which is better for building long term wealth?" The answer to that is with out a doubt building a portfolio of rental property. 

When it comes to real estate investment the two most powerful things are debt (leverage) and taxes. You receive neither of those benefits when doing hard money lending. 

You mentioned an example so lets run with that:

Hardmoney lending:

$500k lent out for 1 year at 12% interest will give you a gain of $60k. Lets assume you are in a 35% tax bracket. You will cut a check to the IRS for $21k, leaving you with $39k or a after tax cash on cash of 7.8%

Apartment building investment:

$500k down payment on a $2.5MM building. At an 8% capitalization rate that you quoted (very achievable) you are left with $200k net operating income. lets assume when you borrowed the $2MM from the bank they lent it to you at 4% interest over a 25 year term. This means your mortgage payment is $127k (rounded up) leaving you with $73k in cash flow or a pre tax cash on cash return of 14.6%. This beats your 12% from above and we haven't even started on all the other benefits of investing in real estate.      

So you cash flowed $73k do you pay tax on $73k?? NO! another beauty of real estate and leverage is the depreciation tax benefit. Even though you only put 20% of the $2.5MM in to the property you get ALL of the depreciation. Apartment buildings are depreciated over 27.5 years which means you get to depreciate $2.5MM/27.5=$91,909. What does this mean? It means you don't pay any tax on that $73k you made on the building. You actually have a paper loss of $17,909. This loss can off set other income. Again assuming a 35% tax bracket the paper loss of $17,909 would result in an additional $6,268 in tax savings.  This means your after tax return is 15.85% almost DOUBLE your after tax return from hard money lending. 

Thats all great and will make you a lot of money, but where wealth is built is in the amortization of the debt you put on the property. The 2MM in debt you put on the building will have an army of tenants paying down your mortgage month after month. In our example after 10 years you will only owe $1.4MM on the building IF the property never appreciated one cent and it was still worth 2.5MM in  10 years you would have $1.1MM in equity. You could then sell it or refinance it (again tax free). 

Now lets wrap the amortization into our example. using the loan terms I mentioned the first years of the loan will result in a $52k reduction in principle or if the value stays the same that would be seen as a $52K increase in equity. If we add that $52k into the cashflow and tax benefits we are left with a all inclusive after tax return of 26.3%. How much tax do you pay on that??? NONE.

This is just the basics. You can accelerate depreciation benefits through cost segregation, Structure loans for quicker amortization depending on your goals and many other tricks. 

if you're thinking this sounds great but those are just made up numbers and assumptions. These numbers are real in my own investing. I close on a 42 unit 8 cap apartment in 2 weeks. The loan is what I stated above and the price tag is very similar. On top of all the benefits I listed I will also be able to add $600k in value over a two year period even further boosting returns. 

I obviously enjoy talking about this stuff. Feel free to reach out to me whenever and we can talk more. 

Disclaimer: I am not an attorney or CPA. This is just examples and my own experiences.