Ep. 28 Real Estate Lending as an Alternative to Bonds
The Financial Commute

Ep. 28 Real Estate Lending as an Alternative to Bonds

Ep. 28 Real Estate Lending as an Alternative to Bonds

The Financial Commute

On this episode of THE FINANCIAL COMMUTE, host Chris Galeski welcomes Michael Klein, CEO of Freedom Financial Funds, a real estate lending fund.

Freedom Financial focuses on lending to real estate professionals who add value to real estate projects on the west coast of the United States. For example, some borrowers are professionals who flip vacant office buildings into apartment complexes. Over the past 14 years, Freedom Financial has originated over 400 loans totaling over $2 billion and prioritizes their investors.

Chris and Michael discuss how Freedom Financial has prioritized their investors during challenging times. Michael recounts March of 2020, when the government shut the economy down and people began to panic. They had $16 million of capital waiting to come into the fund that disappeared. Luckily, Freedom Financial has what are called “gate provisions” (the ability to prevent investors from leaving the fund to protect people who want to stay). Five weeks later, they lifted the gate and did not lose any investors. Michael says he is thankful they were able to minimize fear by implementing the gate because they protected investors from making emotionally reactive decisions that could have caused them to lose money.

Michael credits his experience in the banking industry for teaching him some core principles that have guided Freedom Financial Funds’ success: to focus on people, their credit, and structure loans to match business plans instead of structuring business plans around loans. Chris agrees Freedom Financial Funds has been a phenomenal partner to Morton Wealth in supporting their investors’ portfolios while generating a consistent income stream.

Click here to subscribe to our YouTube Channel.

Hello, everybody, and thank you for joining us for another episode of THE FINANCIAL COMMUTE. I'm Chris Galeski, your host joined by Michael Klein of Freedom Financial Funds, a private real estate lender with over 30 years of experience, specifically with real estate. But a little bit more in terms of banking and finance. So, Michael, thank you so much for joining us.

Well, thank you for having me. It's so exciting to be here.

Interesting things in 2023 happening with the banking crisis and some revelations of, you know, 2008, 2009. But you also mentioned that potentially it's more similar to the savings and loan crisis of 1981. Not necessarily here to talk about that. But, you know, I love what you guys do and the value that you provide for clients in terms of managing risk, getting a very reasonable rate of return.

But this environment's a little bit unique in terms of how you're protecting yourself for your investors. Tell us a little bit about what you're seeing today.

Yeah, so back in January, I was on a panel and speaking to a group of about 1500 or so finance professionals from around the country. And everybody was talking about rates rising. And I suggested that that's the shiny object. Okay? It's what's going on behind the scenes that is going to create the real problem.

So I was partially right and partially wrong. Interest rates ultimately is what caused a massive problem for the couple of banks that have recently failed. And that's because they failed to match assets and liabilities. So they were they were borrowing short and lending long. In this case, they bought long bonds. Yeah, because for some reason the federal government called them risk free.

They were mortgage backed securities, and they're considered risk free under the current rules, except that there's interest rate risk, as we've all been seeing. If you're a saver, that's good news because instead of getting nothing, you're now getting 4 and 5%. Right. But if you're. But if you're holding old bonds that were at 2%, they're not worth what they once were worth.

Right. And now and there's a fix for that because when we had the great financial crisis the banks were allowed to mark that stuff, hold to maturity and not have to mark to market. Yeah. Okay. That isn’t what did it. Yeah but what does do it is when you're paying 4% and earning 2%, you're not going to survive for very long.

Right. Right. And unfortunately, there's a lot of banks like that. And that's why I liken it to the savings and loans, because the savings and loans had a lot of mortgages, primarily on apartment buildings. Right. And they were fixed rate and long term. And they were using the demand deposit. And the key word is demand means I can demand it now.

Right. And paying very little. Well, when interest rates under Volcker started getting raised and not nearly as fast as we've been living through. Right. They found themselves upside down on earnings standpoint. Well, guess what? There's a bunch of banks. In fact, this morning I was looking at a chart that the Mortgage Bankers Association put out.

And in the small to midsize, not the small, but the kind of the lower midsize banks, they're holding about three times their capital in commercial real estate loans. Yeah. Okay. Now, if it's all variable rate, no big deal. You just keep raising the rate. But a big portion of it. For example, one of the lenders that's been in the news lately made a loan to one of our clients $30 million fixed at three and a half percent about a year ago but fixed for ten years.

So, you know, so there's many risks. You can't just focus on one. There's the risk of repayment. We focus on that. Right. Right. We spend a lot of time on that and we go into that later. But there's also the Treasury management side of the business, which is, okay, I'm putting money to work today. Okay. And I have this other money that maybe I'm borrowing.

In our case, we don't borrow. Right. But banks borrow the banks borrow $9 for every dollar of equity that they have.

Yeah. And I love that point, you know, the banks caught themselves in a situation where they're earning 2, but they're paying 4. Right. And they're forced in this situation because they borrow. Right.

And the sad thing is that, you know, that Silicon Valley Bank got a clean bill of health not that long ago from the regulators that are supposedly in the know. Sure. Okay. You know, it should tell you do your own due diligence and invest in banks carefully.

I'm not I'm not trying to come to Silicon Valley banks defense. I don't think anybody expected the 25% request for withdrawals in the 48 hour period. But at the end of the day.

Well, that's I mean, that. Okay. But that's a different issue, right? That's the issue of the run on the bank. Right. Right. And they don't have the ability to do something that private funds do, which is to gate.

Right. So and that's an important thing. And so, like you have experience in lending and finance, specifically around real estate lending. And I love what you guys do. So how do you protect investors in a situation like that, the redemption risk or the bank run?

So let's go back to April of 2020 or March and, you know, they got, you know, the government shut down the economy. Right. And people panicked. And we had a around $15 or $16 million of capital waiting to come into the fund, that one day was there and the next day was gone. Okay. And so because we're a fund and we have the provisions in our documents to gate i.e., not allow people to get out.

Right. Okay. To protect the people that want to stay in. Okay. So that we don't have, you know, fire being screamed in the theater, which is what happened with the Reddit article, to SVB. Correct. Correct. Okay. And, you know, it hit Twitter, man. It was like, you know, this is on fire. And then with online apps, you know, you know, you I mean, you can empty a bank in 24 hours.

It's amazing. I mean, that's the day that we're living in.

Right without a line, without depressionary lines that are black and white. This was like full color right now, full time. So we put a gate on the fund because we literally had all that money that was waiting to get in. Yep. Because we were worried about people trying to get out. And the thing about investing is when everybody's running away, the best time to run in is right then and there.

Okay. And so I'm not a bank speculator, but I would suspect that there's some banks that have been lumped in with all banks that are good operators, have good asset liability management, have good credit management, and are trading at, you know, $0.50 on the dollar just to use a round number that shouldn't be. Yeah, Okay. But then there's ones that are trading at $0.50 on the dollar.

That shouldn't be because they're too high. Right, right, right. So, so we gated, we funded a few loans that we had committed to fund, the when the dust cleared about five weeks later and people started to go, okay, this is livable. We can make it work. We removed the gate and we didn't lose any money.

No money was withdrawn from the fund and we kept going so. But if you can stop a panic and that's what gates do you. It's actually better for the investor because on average human beings on average have a tendency to sell high and buy, you know, sell low. Excuse me.

So sell, buy and sell low.

Buy high, sell low. You know, they want to buy when everybody else is buying, they want to sell when everybody is selling. And that's just the opposite of how to really make some, you know, money.

Yeah. Look, I think redemption risk is one of those things that, you know, causes investors to lose money because they make those emotional reactions. And by you being able to put that wall up and say, hey, we are going to honor these withdrawals that are in the system, we're going to do it in an orderly fashion, and we're going to make sure that we don't have to sell really good things at really bad prices in order to meet that.

So it might just take some time. Let's talk a little bit more about your fund in particular, what you guys do in terms of the real estate lending and how you best protect investors.

Sure. So we have a very specific plan, and that is to focus on only lending to real estate professionals that are adding value to real estate projects in the western United States. That's it. Full stop. Okay. Now, there's a couple of key words in there. Real estate, professional keywords. Okay. That means not your first project. That means people that have a fair amount of experience have been through have been through a few challenges along the way.

And they've proven that they can fix them. Yeah. And adding value is another one. Okay, we get these requests. Oh, I want to take money out of my real estate so I can go buy a farm. No, that's not what we do. Right. What we do is provide capital to people that are creating value or, you know, changing a business plan, taking, you know, in the news as of late has been the office.

Right. And there's office buildings that will unlikely ever get filled again. Okay. So what do you do with those buildings? Well, maybe the answer and again, underline maybe, but is that you convert them to some other use, like housing. Yeah. Okay.

I've even seen some articles where they might be taking malls and turning those into apartments.

We have that going on where I live in Phenix. The Paradise Valley Mall has been leveled. It's becoming towers. Here in Woodland Hills, that's going to happen with the old Westfield Mall. There will be malls. There will be very few malls. And, you know, it's great real estate. You know, the actual underlying dirt is very, very good.

So but that's a value add proposition. You know, it no longer really works as X. We have one that we've recently got repaid on, but it was a good example. It was originally built for a grocery store and a bunch of the shops that you would find you know the nail salon and the hair salon and the quick little, you know, the restaurant.

Yeah, and all that stuff. And it was old and tired and the grocery store had left and, you know, and then it was really in bad shape. Our client, because of his connections within his profession, which is retail, was able to put it in escrow and while it was in escrow before actually buying it, get a tenant for the grocery store space and a tenant to take a big chunk of the vacant inline space and then devised a plan to literally demolish about 12,000 square feet of space, create more parking for the new gym that was going in and turn it around.

So he bought it for I can't remember the exact numbers but for this discussion let's say $8 million needed to put about a million and a half in it so total nine and a half million worth $12 million all day long. Yeah. Okay. That's a value add.

And so how much would you loan on something like that?

Well, you know, in that instance we lent him approximately 65% of the 12 million. Okay. Okay. Value. Yeah. And because we were very, very confident, I think it was our 13th or 14th transaction with this developer. So we had a long track record already that we know that, that he knows how to get it done. Yeah.

So we, we felt very comfortable and as it turned out we were repaid by a long term lender even before the project was 100% complete.

And I think some of those stories are really cool. I mean, obviously making sure that you're working with real professionals, having assets where there's real value add or value being created, making sure that you're comfortable with the actual value of the property and the amount that you're willing to lend on it in this environment as rates are moving fast and there's talks about cap rate, although cap rate doesn't always work in value add because you're creating value and it's going to be a different cap rate on the exit than the purchase.

So how are you how are you valuing those assets when you're looking at lending at a fast moving interest rate hike environment?

Yeah. So yeah, so this is where commercial real estate in particular, but even the folks that are watching this, their own home. Yeah, right. Real estate is not, it's not an efficient asset, right. It's inefficient. Okay. And every little detail matters. And so there is no real estate market. There's your particular piece of real estate.

Okay? And that holds true even if you live in a a large tract of homes in which you've got the model 2 B option. Right, Right. But the next door neighbor's model 2 B option doesn't have the view that you happen to pay extra for and so it matters you know every little detail matters.

And so what we try to do is assess all those little details. We've been doing this a long time. You know, I've been 30 years, my three other partners combined is, I don't know, 135 years or something of real estate experience. So, you know, we've looked at a lot of real estate. And so what we try to do is get a sense of where it would be today as if it were done today and then add in a buffer.

Okay. The likelihood of capitalization rates going down from here is very slim. The likelihood of them going up from here is pretty real. So we're erring to the side of up. Yeah. You know, an increase of rates, capitalization rates and I think that's pretty fair. Yeah. You know, but we also it's a competitive environment so there's, you know, there is a need to be careful.

Yeah. And there's also a need to keep money working.

But then you know you bring up it's, it's a dynamic moving situation. Not every deal is the same. Some properties might have a better view or a better this or that. Also some properties might have loans that are coming due and the cost of that loan against that property is going to go up exorbitantly. Right.

So there's a lot of factors in it and the success is in the details. What are you most proud of, of what you've been able to accomplish at your time at Freedom?

Well, I started as a fund manager after being a banker for 20 almost 25 years. And I knew if I stuck to some core principles that we'd be successful and those core principles are really straightforward. It's focus on the people, their credit, ultimately the business plan and the real estate. Okay make sure that you can structure your loan to match that business plan.

Don't make the business plan match your loan and make sure you've got two ways to get paid that don't involve a lawsuit. Okay. If you do that on each and every loan, what you'll end up with is the track record that I've been able to put together. You know, with the help of my partners. I didn't do it on my own.

But we've done over 400 transactions in the 14 years that I've been a fund manager and a little over $2 billion. We've never foreclosed on a property. We've not lost a penny. Now, it's been a good 14 years, Right. And I can't promise that that's going to be, you know, the same track record over the next three, because I think we could have a bumpy road.

But we've got multiple ways of getting our money back before we have to sue somebody. And we only deal with real professionals and they have deep pockets. Yeah. I don't know what the average net worth of our borrower is, but it's probably in the neighborhood of $60 million. Okay. So we have a portfolio that I could have taken to one of the banks I worked for, you know, and we're proud of that.

But look, we're ecstatic to work with you on a consistent basis because, you know, here at Morton, we focus on preservation of capital, risk management and getting paid for the risk that we're taking. We want to make sure that we're diversified, but, you know, rewarding our investors for taking on some risk and, you know, in those years of the zero interest rate policy, people were not rewarded for taking on the risks that they were for owning government bonds or corporate bonds or munis.

But you guys have been a phenomenal partner in helping us, you know, protect the value of our clients’ dollars, but generating a very nice, consistent income stream. So thank you so much for your partnership.

Thank you. It's been fantastic. Thank you.


Information presented herein is for discussion and illustrative purposes only.

The views and opinions expressed by the speakers are as of the date of the recording and do not necessarily represent the views and opinions of Morton Wealth

These views are not intended as a recommendation to buy or sell any securities, and should not be relied on as financial, tax or legal advice.

You should consult with your financial, legal, and tax professionals before implementing any transactions and/or strategies concerning your finances.