10% return per year? Yes, agreed!

We have many contacts with investors interested in this asset class. And many of these investors, wealth managers and family offices are sharp to the bone! Beautiful! I love that. But many others also don’t actually understand very well what returns, costs and risk really mean in this asset class. If it only says 10% return per year as a promise, people quickly agree. This, however, without factoring the risks and costs into this rate of return. They are comparing apples to bananas.

Let’s take a closer look at this:

Efficiency

the easiest of the three. An interest rate per year of income. At most, it matters with what periodicity you receive the interest. And whether there are any one-time fees such as exit fees for early repayment. Making an IRR calculation in excel with two or three scenarios often also creates clarity in case of differences in maturity.

Risk

There are two elements of interest.

1. What is the likelihood that the borrower will run into payment problems?
2. And if it then goes into “default” what portion of the financing should I write off as an investor? Mathematically, you can approach this as follows: Suppose the probability that the borrower defaults is 2.5% (1 in 40 loans) and there is healthy collateral for 75% of the loan then you write off 25% of the loan. So 2.5% x 25% then you would have to use a risk premium of 0.625% (62.5 basis points) for this type of loans. The question is do you price in these risks as well? Both upward and downward. A zero risk is therefore a zero risk premium. And do you know how to correctly identify the risks? Do you have objective data (PD% x LGD%) and dare to adjust it up or down based on analysis / arguments?

Cost

We manage loans professionally using IT and professionalism. Some investors prefer to do it themselves in order to avoid fees. But even that takes time and therefore money. I can tile myself but whether it will be done efficiently and look neat and tidy? I dare to answer. It also makes sense that loans with a 1st mortgage at 60% Loan To Value (LTV) take less time to manage than a loan without collateral. After all, you have excellent comfort in case of payment problems.

Tabular summary:

Conclusion

10% per year return may be quite different than the “sales brochure” would have you believe. Our advice: dive in! Analyze, question, and test your own conclusions with third parties