The hard-money real-estate sinkhole

Taylor Frigon Capital Management has its headquarters in the beautiful Central Coast town of Paso Robles, California. Located in San Luis Obispo County, we are well aware that this county led the entire state of California in hard-money real estate loan losses in 2008.

According to this recent article from the San Luis Obispo Tribune, investors who gave money to two companies in return for interest payments from real estate development loans lost their entire investment, totaling almost $500 million. Another article covering the damage from the four most notorious county hard-money lending operations put the total at nearly $700 million. In private conversations, we have heard estimates that the losses are as much as $750 million.

It strikes us that this unpleasant situation provides an important lesson in the concept of "malinvestment," which can be defined as the "mis-allocation of capital, often due to an alteration of the market by government incentives or regulations."

We have argued previously that investors should think of the act of investing as the act of matching capital with innovation (see for example here and here). Imagine if that $750 million had been instead allocated to funding innovative start-up companies. Had they placed their funds in a company that invested in promising young businesses run by entrepreneurs, investors certainly couldn't have done much worse!

With $750 million, a venture capital firm could fund seventy-five young companies at $10 million apiece, or a hundred and fifty young companies at $5 million apiece. The possibility that it could find one or two out of that number that could add enough value with their business to later go public or be acquired by another firm for a sum much larger than $750 million is actually quite high.

And yet there remains an almost instinctual aversion towards venturing capital in business opportunities by those who will readily venture it out towards real estate development (even real estate development by those who are unable to get a loan from a traditional bank, and thus must resort to the higher rates offered by so-called "hard money" lenders). This goes along with a belief, very common in the current Baby Boom generation, that real estate is somehow the one investment that can "do no wrong" (this irrational belief has taken something of a hit lately, but it still persists with amazing vitality, even after the carnage of the past two years).

The foregoing observations should not be taken as meaning that we are somehow against real estate investment -- far from it! We have in fact written that families should consider allocating their capital in real diversification (as opposed to the kind of over-diversification within the financial market instruments that the representatives of Wall Street typically preach) consisting of not only financial market assets but also real estate assets and even insurance products, when appropriate. Due to the tax code, real estate is one of the most tax-advantaged investments available in the United States, and it can also experience real appreciation, particularly when businesses in the area add value and thus attract more employees and even pay more in order to compete for talent with other successful area businesses.

But these two positive aspects of real estate deserve a closer look. The very tax codes and government incentives that encourage capital to go into real estate that might otherwise go elsewhere have a very real likelihood of occasionally leading to serious malinvestment, as happened earlier in this decade. A few years back, low interest rates from what we call "Fed oversteering" led to a situation in which if you weren't urging investors to participate in the real estate boom, you were at risk of getting laughed at.

Also, the very point that real estate can appreciate significantly when local businesses do well should cause investors to understand the fact that it is the businesses which drive that train, not the real estate itself. The real estate in California's Silicon Valley experienced some of the most significant appreciation in the world over the past five decades, but that was thanks in large part to the incredible value added by firms that drove the computer revolution which were headquartered and competing for employee talent in that same area. While this may seem obvious, it is amazing how many real estate owners in that area, from the generation that experienced that price appreciation, attribute it all to the miraculous powers of "real estate" rather than to the miraculous business innovations of companies such as Intel, Apple, Google, and the rest that make their homes in the middle of all that real estate*.

Furthermore, while we are on record as saying that real estate can be an important area of capital investment and a form of diversification from investment in financial market assets, the past few years should have taught investors that real estate can have three significant drawbacks: it's not always that easy to sell, it's no longer always that easy to borrow against, and it's not even always that easy to rent out to an appropriate tenant (whether commercial or residential)!

We believe that investors should learn from the San Luis Obispo County hard-money real-estate lending sinkhole, and realize two things: that the real estate experience of the past several decades has almost certainly served to brainwash a lot of people into believing that real estate is somehow less risky than it really is, and that this same history has also served to blind many investors to the overlooked investment opportunities in private equity or direct venture investing. In all the discussion of the "one-year anniversary" of the banking panic, this is certainly a topic worth considering.

* The principals of Taylor Frigon Capital Management do not own securities issued by any of the companies mentioned in this article, including Intel (INTC), Apple (AAPL), or Google (GOOG).

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