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Leverage Funds in Your Self-Directed IRA or Solo 401K to Buy Commercial Real Estate

August 8, 2018

Traditionally owners of self-directed IRAs or Solo 401ks have invested in real estate using just the funds in their accounts (meaning, without any financing); and the type of real estate purchased by these investors has primarily been residential (meaning a 1-4 unit property:  a single-family residence, a duplex, a triplex, or a quad plex).  An alternative that should be given thoughtful consideration is investing in commercial real estate (meaning an office, warehouse, or retail building which can each be single tenant or multi-tenant, or an apartment building), and this can be done using financing, which should also be given thoughtful consideration.

 

commercial real estate

 

The main reason that more investors have not purchased commercial real estate is because the price point of such investments is so much higher than buying residential properties (say $1,000,000 for commercial real estate compared to $100,000 for residential real estate).  The way that an investor (or a group of investors) could approach doing this would be to create a Limited Liability Company (“LLC”) that will hold title to the commercial real estate that will be purchased.  This LLC could be owned by one or more self-directed IRAs or Solo 401ks.  Each investor should certainly discuss the structure with their legal/tax advisor and/or self-directed IRA or Solo 401k administrator, but the general idea is that a handful of investors pool their resources that will provide the down payment and closing costs needed for the purchase of commercial real estate and an LLC serves as the owner of the real estate and as the borrowing entity.

An investor might consider using financing because it allows the investor the ability to purchase larger assets and benefit from its growth and income, all with a comparatively small out-of-pocket capital outlay.  Another reason is because it can help an investor diversify their investment portfolio; both in product type (meaning they could invest in residential and commercial properties), and in quantity of assets (meaning that an investor could own more properties using leverage than they might be able to own using only their own funds).

The loan to finance such an investment (whether it is to buy commercial or residential real estate) must be what is called non-recourse.  This means that the loan is one in which the self-directed IRA or Solo 401k account holders are not liable for repayment of the loan. The security instruments (meaning the loan documents) allow no recourse against any individual account holders or the balances of their self-directed IRA or Solo 401k funds. Using the LLC structure outlined above, in the event of default/foreclosure the lender can only look to the borrowing entity and to the property serving as collateral as the sole source of repayment.  A non-recourse lender cannot pursue any owner of an IRA or a Solo 401k or pursue other assets owned by those account holders.  So, the only recourse the lender has is to whatever the LLC itself has (and they are typically set up as single asset entities just to own a subject property) and to the real estate that is serving as collateral for the loan, and any income that said real estate may generate (this is because the primary loan documents that will be executed for this type of loan are just a promissory note, a mortgage, and an assignment of rents and leases, and no guarantee agreements).

Non-recourse loans are not common and even less common in which the borrowing entity (the LLC) is owned in part or fully by a self-directed IRA or Solo 401k or several of them.  As such, the terms of such a loan will be more conservative (to protect the lender) than a loan that is not non-recourse (meaning that more money will have to be put down, the interest rate and fee may be higher, the interest rate lock period the term and the amortization may each be shorter).  Keep in mind that while the down payment required for a non-recourse loan may be more than for a loan that is not non-recourse that only non-recourse loans are allowed when self-directed IRAs or Solo 401ks are involved, and the down payment is a lower capital outlay than if an investor just paid all cash, without any financing.

In addition to requirement that the loan being non-recourse, another thing to consider when financing a purchase is whether a tax may be due on the profits from the leveraged real estate.  An investor should consult with their tax advisor and/or IRA or Solo 401k administrator.

 

The investor should find out from the lender several things such as:

  • What the lender’s trade area is to ensure that the location of the property being purchased is in an area in which their lender can lend in (or else the investor may need to find another lender).
    • A trade area is simply an area in which the lender does business. Typically, the larger the lender, the larger the trade area (the bigger their lending footprint).
  • What commercial real estate product types that they like to lend on. Some prefer only office buildings, some warehouses, some retail properties, some apartments, and some a combination of these or all of them.
  • How much equity (aka down payment in a purchase scenario) that will be required (as previously stated, this will be more than a typical commercial real estate loan because it must be non-recourse).
  • What the interest rate range will be, will it be variable or fixed and if fixed for what period of time.
    • The reason that a lender may provide an estimated interest rate range and not give an exact quote of what the interest rate will be is because the pricing of the interest rate is based on the risk of each loan and the only way to determine the risk of each loan is to fully underwrite it and go through the lender’s credit approval process.
  • What type of payments that they offer: interest only or principal and interest and when are they due:  monthly, quarterly, every six months, or annually (monthly payments of principal and interest is the most common).
  • What the lender’s fee will be, and an estimation of all the closing costs.
  • What, if any, the pre-payment penalty will be.
  • What, if any, the escrows are required for taxes and insurance.
  • What, if any, the reserve requirement will be (possibly for any deferred maintenance to the property).
  • What the lender’s debt service coverage ratio (“DSCR”) minimum requirement is
    • DSCR = Net Operating Income (“NOI”) divided by the debt service
      • Debt service means 12 months of principal and interest payments
  • What documents are required to apply for such a loan.
    • Is there an application and what information is needed in order to have the loan request underwritten.
    • At what point in time will money be due (at application, at commitment once the loan has been approved or at closing, or some combination of these times).
  • What the term of the loan will be and what the amortization will be.
    • Keep in mind that unlike typical conventional home loan products that are secured by people’s primary residences in which the rate lock period, the term, and the amortization usually all match (say for 30 years as an example), commercial real estate loans (especially to investors) usually have a rate lock period that is one span of time, a term (maturity) of another period of time, and an amortization that is another period of time
      • (and rarely will an investor find a 30 year amortization on a commercial real estate loan; 20 years is common; sometimes 25 years on new construction, and sometimes 15 years)
  • Other information an investor may want to find out from their lender is:
    • Is the loan assumable?
    • Can the loan be sold and what is the likelihood of this happening?

 

To recap, using an LLC is a good vehicle for investors to use to purchase commercial real estate and the funding of the LLC can come from monies in a self-directed IRA(s) and/or a Solo 401k(s).   If an investor wants to leverage their purchases, then they should find an experienced commercial real estate lender that has made non-recourse loans before that is also a good communicator and prides themselves on managing people’s expectations.

 

 

 

 

 

Authored by Tim Hendricks,

Vice President/Commercial Real Estate Lender with Citizens Bank of Florida.

Telephone:  407-622-7142

E-mail:  thendricks@mycbfl.com