Hedge Funds and Real Estate Investing

Hedge funds in real estate are not new to the investing game. They have been historically called Real Estate Investment Trusts (REITs).  Hedge funds have been around for at least 40 years. Their success has ebbed and waned because they are susceptible to interest rate swings.  As interest rates go higher, the hedge funds value goes down to give the newest investor a higher income.

The so-called new phenomenon is that hedge funds focus on raising capital to get a current return on their principal of from 6% to 8%. These interest rates are good by comparison to CD (Certificates of Deposit) interest income but the “sales point” is that the actual rate of return will be higher.  The Hedge Fund liquidates properties with capital appreciation. Many of the hedge funds have purchased their properties in the past few years and have seen portfolio appreciation of 20% or more. These figures are the key to selling the portfolio to the unsuspecting public in the future but may never be again reproducible.

The actual end-game for the hedge funds is to cash out their entire portfolio in a public offering and go on to the next hunt for investment schemes that can be sold to the public. The mortgage crisis is a good example where the cash-out went to the largest investors simply because the fraud was so far-reaching, but the average American ultimately paid dearly. I am not being cynical, just had enough experience to know the game with 25+ years on Wall Street.

When the larger hedge funds started buying deals they paid whatever properties were being offered at. With time and not-as-expected results from their purchases they became clever about first renegotiating during the inspection period and then again before the closing.

I remember one of my Students telling me he got hedge fund’s criteria from them and he had a property that fit their requirements. They signed the contract immediately.  Just before the inspection period was over, they came at him with their contractor’s inspection report. That report cost him $9,000.  The hedge fund came back again and made him pay for their closing costs! Needless to say he was miffed!

He recently got another property under contract for $97,000 which had an ARV of $139,000 to $159,000.  It needed less than $8,000 in repairs. The same hedge fund sent in a contract for $117,000 immediately but wouldn’t budge on a ten-day inspection period.

The hedge fund sent their contractor to do the inspection and work his magic with the repair estimate. He came back with the roof needing replacement which he estimated at $8,000. The fund decided that this cost was to be subtracted from the original offering price they had made.  This is a “Hedge Fund Haircut” prior to closing. Often they will ask for a price reduction (haircut) at the actual closing.

Following is the exact response the fund manager made to my Student:

“Unfortunately our purchases are driven by the rent not the value. What it is worth plays very little into whether or not we buy something as we never “flip” our properties. I don’t think the numbers work without the $8k reduction but I will play with them in the morning and get back to you.”

If you believe any part of that, you need to get a better understanding of how negotiations work. Their never “flipping” their properties is absolutely ludicrous as everyone they ever purchase will be flipped at some time in the future. The fund manager knows the property is worth $145,000 on a bad day but is playing the game in his own way.

We responded to the sudden request by first going to the seller and getting a $4,000 price reduction for the roof.  They would not do $8,000 which is understandable but they were motivated enough to give us ½ of what we needed.

The Student wrote a nice “I understand your position” email back to the fund manager and countered with a $4,000 reduction offer. Before doing this the Student and I decided to close on the property.  We would wholetail it (this means patch and paint it and sell it retail).  It could be sold with a little “lipstick on a pig” for $139,000 for a fast sale. Essentially we said to the fund manager, “Pay or don’t play” so we could move on with yet another life experience in dealing with a hedge fund.

When the smoke cleared, the fund manager decided not to play and we went on to the closing, fast rehabbing and retailing the property. We did complete the Wholetail repairs (minimum required to stage the property) and went on sell it for $149,000 for a net profit of nearly $44,000. Thank you Mr. Hedge Fund Manager for being so rigid in your requirements!

In summary, expect the unexpected from hedge funds and make sure your contracting is ironclad or you won’t be keeping their escrow deposits if they renege on a deal.

To your limitless success,
Dave Dinkel