Harvey Capital 2023 Annual Update
A commentary on our performance in 2023
Harvey Capital I LP investors,
Our gain in net worth during 2023 was $10,390.00, which increased our book value by 12.5% on an annualized basis. While the general partner’s split is not paid until the end of the lockup period, and only after all initial capital is returned to all limited partners, I want to show the returns as if the general partner’s portion were taken out so that this can be compared to the S&P 500 index. Our rate of return, net of the general partner’s split was 9.38%, when annualized. Keep in mind this is only from 10/13/2023 through the end of the year. 2024 will be our first full operating year.
A few things to note as well about these returns and how they were calculated; the accounting method I’ve chosen is cash as I believe this makes more sense versus accrual. Tangible increases in our net worth are the only things factored into the returns here. We are an investment company and provide liquidity for various real-estate projects, therefore writing someone an “IOU” from an account receivable is not possible (wouldn’t that be nice though!). It is also a possibility for an investment that accrues interest to end up going south where the accrued interest is not able to be paid to us, or worse, we lose principal. For these reasons, I think it makes much more sense to recognize income (or a loss) on our books when it hits our account.
A real example of this is a $60,000 loan we made in late October to someone needing funds to complete a house flip. We loaned these funds in 2nd lien position and will receive 3% of the loan amount as an origination fee, and 15% simple-interest. The catch is that the fee/interest is not collected until the property is sold and the loan is paid off. Even though none of this interest has been collected, accrual accounting would have us book $3,328.77 in income from the day the loan was made, through 2023. This makes little sense to me as I do not have that cash in my hand to invest elsewhere, therefore I don’t think it makes sense to recognize it as income until it is in our hands.
Another thing to note is that our returns will always be reported based on book value, even though book value will hopefully lag behind the intrinsic value of this partnership. For instance, if we invest $100k in a property as equity, we will always carry this asset on our books at $100k, regardless of whether the market value of the property changes. If this property doubles in value, we will only realize that change in value if/when the property is sold. Any operating distributions received from this property will be recognized and factored into the returns, but based on my experience, the lion’s share of a property’s return is typically recognized in the form of a capital gain when it is sold (assuming it isn’t a dud that loses money --- which is possible, of course).
While book value and intrinsic value always meet in the end, the book value may take a while to catch up to the intrinsic value. For the types of illiquid investments we are making, the book value will only catch up to intrinsic/market value if the asset is liquidated. Even if the property’s market value is 10x our cost basis or book value, we wouldn’t get any credit for this increase in value on our books until the property sells. Only then am I cheerfully able to report an increase in the partnership’s net worth. Until then, I will do my best to explain all pertinent information and show how I view the value of our portfolio over time.
To give a real-life example of how book value and intrinsic value can diverge greatly, there was a property I invested $25k into in 2019. It was an 84-unit multifamily property in AZ, bought at a great price relative to the market. I received about $1,300 in operating distributions over the 2-year hold period, representing only about a 3% annual return on my money invested. However, the deal ended up returning about 30% to me on a compound annualized basis once it was sold. While this is an extreme example, I use it to show how book value is not the best indicator of an illiquid asset’s value.
Compare this to marketable securities which are marked to market on a minute-by-minute basis. Book value is a much more accurate snapshot of the true intrinsic value of a portfolio of marketable securities, versus an illiquid real estate portfolio. I add all this context to show that as time goes on, the intrinsic value of our equity portfolio SHOULD be worth more than book value (hopefully by a wide margin). If it isn’t, then I should find a new occupation!
The moves we made
I have mentioned to some investors that I never intended to make any investments in 2023, although a few opportunities came across my desk that made little sense not to do. So, I sped up the timeline and contributed nearly the entirety of my $300,000 personal commitment. With this, and a small contribution from one other LP, we made 3 moves in 2023. I likely won’t get super in-depth on each investment made in subsequent updates, as most people will yawn and go do something more exciting (remember though that yawn-inducing investments are typically ones that end up successful over time, while flashy ones can lead to trouble). But for this first update I wanted to share what moves we made and why we made them so all investors can understand my thought process moving forward.
The first one was from an old co-worker of mine in the mortgage business. He called me as he had a borrower he was working with that was under contract to purchase a new construction home in a popular suburb in northern VA. He was from another country and had a difficult time showing income per Fannie/Freddie standards, although he had a lot of money, and made a lot of money. The home price was roughly $900k, he was putting down $600k, and therefore needed $300k as a loan. We loaned $225,000 in 1st lien position and my former co-worker loaned $75,000 in 2nd lien position. The terms were 3% of the loan amount paid up-front, and it is an interest-only loan at 10%.
This borrower was thrilled to have this option available as it was way cheaper than the rate he’d borrow money for in his country, and he was able to get the loan without jumping through the litany of hurdles that exist in the traditional lending world. We were thrilled because we are in 1st lien position at $225k on a home worth close to $1 million earning a great return. Whether he pays or not, we are in a great position too (although most people putting down 70%+ do not walk away from their mortgage). This took all of 30 seconds to decide it was worth doing.
The second one was the $60k loan mentioned earlier. This was a 2nd lien loan for a house flip in an area I know very well and grew up in. It is also with an experienced investor I’ve known, and worked with, for a while. The return was very high relative to the risk profile, in my opinion.
We will receive 3% of the loan amount as a fee, and it carries a 15% simple interest rate. It is likely that this loan will be paid back around the 4-month mark, which would net us a return of $4,800 in total. We will likely have a few of these opportunities per year come about, and they are a great place to park money while we wait for great equity deals to come along. $4,800 doesn’t sound like much in absolute dollar figures, however if we can recycle this same $60,000 3 times throughout the year, with loan durations around 4 months, we would generate $14,400. This amounts to a 24% annual return on our $60k deployed.
To generate $14,400 annually from U.S. T-bills with a 1-year duration, we would need to deploy $274,285.71. T-bills, of course, are about as low-risk as they get --- so I understand this is not an apples-apples comparison. However, I have a decent amount of experience with house flips, I know the operator we loaned money to very well, and I know the area intimately where the home was acquired. Based on my understanding of those factors, the risk relative to the expected return is very low and I’m very comfortable making plenty more of these kinds of investments.
The third one was a $100k equity investment in a 2-property mobile home park portfolio located in Virginia. Again, this was invested with someone I’ve known for many years who is a fellow Christ follower. There’s usually an instant connection when that is the case. His group operates with excellence in all things they do, has years of experience in the MHP world, and we are thrilled to be a part of this one!
Rents were low at both parks and have plenty of room to increase, even with minimal capital invested into the parks. This is a value-add play, but mainly in the form of installing professional ownership and management. The prior owner fell in the “mom and pop” category and was not managing these assets optimally. I’m confident that new management will not have this problem.
We also received a bonus on this one, which really showed the character of the group leading this venture. After reviewing the deal, asking questions, and confirming that we would like to invest in this one, I received the legal docs several days later for review and signature. Upon review of the operating agreement, I noticed that they changed the profit split from 50-50 to 60-40 favoring the LP’s. At first I thought they made a mistake and would correct this, but they reached out to everyone shortly after explaining that they did this to have a greater chance of investors receiving 10% + cash-on-cash returns over the life of the deal.
Based on their track record and efficiency, it is likely this would have happened anyways, but the fact that they wanted to greatly increase the likelihood of this happening by selflessly decreasing their profit split was extremely admirable and shows their long-term outlook. Let’s hope and pray they can dig up some more opportunities in 2024!
Our strategy heading into 2024
As outlined in the doc going over the thesis and strategy for this partnership (you can read it at harvey-capital.com), there are 3 logical categories our investments will fall in:
Arbitrage – these are short-term opportunities meant to generate cash, assuming they end up performing as expected. They aren’t long-term wealth generators as our equity investments should be, but they allow us to generate cash that can then be deployed into long-term equities. A house flip is a common example of this where we buy a property in the hopes of selling above our total cost-basis and realize a profit.
The loans we have made above would fall in this category as well. Arbitrage opportunities are simply a means to an end, but certainly not the end itself.
Long-term non-controls – these are equity investments made into properties where we are small minority owners and have no control. I have done very well with these kinds of investments on a personal level over the years and have a handful of operators I would gladly give control to. The mobile home park investment mentioned above would fall in this category.
The general thought process here is to determine whether I believe the property is 1) being acquired at a reasonable discount relative to market value, 2) whether the value-add plan makes sense, and 3) whether the operator leading the venture is honest, capable, and able to execute on their plan. If all those boxes can be checked, this is typically a deal worth doing as there will likely be a good outcome at some point down the road, while receiving distributions along the way.
Long-term controls – these are equity investments just like the ones mentioned above, but we would have a controlling interest. The non-controls are a fantastic way to generate cash and build wealth over time, although they are often structured in a way that incentivizes the operator to implement their plan and sell asap.
While that is great and can lead to very high returns, it may not always be the best move to sell a golden goose. I’d prefer to keep the golden goose and collect all the golden eggs over time. This is especially true for properties such as industrial or multifamily where I reasonably expect surrounding populations to continue growing, rents to keep increasing, and values to rise.
I’m a lousy operator and am much better suited allocating capital into hands of people who are fantastic operators, so it will take some time to find a situation where we can acquire a controlling position in a value-add property. But if/when a remarkable opportunity like this comes along, it should impact the partnership’s value positively. These kinds of properties are what everything else points to and is what the ultimate objective is. Rest assured that I’m diligently working to find more of these deals to look at to grow the value of the partnership over time.
Now that I’ve outlined the 3 investment categories, I want to get into the strategy moving forward, which is subject to being tweaked over time.
For idle cash sitting in our account that is ready to be deployed when an interesting opportunity comes along, we will roll 3-month U.S. T-bills to generate some kind of return on this “lazy” money. As of writing this update, yields are hovering around the 5.25% range, which is not bad for cash that we need to be completely liquid in the event that we need quickly to deploy it elsewhere.
We’ll next look to make investments that fall in the arbitrage category, and this will take precedent over any cash we have invested in T-bills. For instance, if we have $250k sitting in T-bills and we find an opportunity in the arbitrage category that I understand and feel comfortable with, then we will liquidate our treasury position and deploy into the arbitrage deal.
Non-controls and controls will take precedent over T-bills and arbitrage investments, and even though arbitrage investments are illiquid, I have a path to liquidity if we need it for a better opportunity. I have 4-5 hard money lenders who do short-term loans for flips who would be interested in purchasing a loan from us. This allows us to become liquid, should a fantastic equity opportunity come along, and it allows them to deploy cash and earn a return north of 10%.
And if there is a situation where we are using all cash for a flip, we can borrow money against this property being flipped to free up the cash to deploy elsewhere. For instance, if we buy a flip for $250k and invest $50k for an all-in cost of $300k, we could borrow $200k against this asset if I had the conviction to invest it in a non-control type of deal that should yield a much higher return over time. It would be a shame to have all our cash tied up in short-term opportunities and then have a fantastic long-term opportunity come by and miss it. This is why I’ve positioned us to be able to exit these short-term positions, if needed.
We have a few exciting opportunities on the horizon I’ll share a bit about. The first one is a 95-unit multifamily property that was built in 2023 as a build-to-rent (BTR) townhome community by a nationally known builder. I’ll share more specifics in the mid-year update, but as the deal has not officially closed, I do not want to share info I am not supposed to.
BTR is a newer concept where homes are constructed for the purpose of renting. Most BTR communities appear to be townhomes, however these are also constructed as single-family homes. If you drive by a BTR community, you will think that each home was individually owned by someone who purchased them from the builder, but this is not the case.
These homes are owned and operated by a single ownership group and are managed like an apartment community. This model became popular post-covid as people wanted the freedom of renting without getting tied to a mortgage but didn’t want to live in a typical apartment building. They like their own space, a backyard, the ability to have pets, etc. They also like the fact that they do not have to worry about maintaining the home as it is not theirs. If a pipe bursts, they simply call the management company and get a maintenance worker to come fix it.
Also, these are brand-new, class-A products at the higher end of the rental market, so we should attract a better class of tenants who treat it better than the typical tenant looking to rent a class-C workforce housing type of product. This should lead to lower maintenance and turnover costs over time.
The builder of this property is nationally known and publicly traded. They began this project when rates were low and got squeezed when rates began rising in 2022. I’ve been told they are looking to exit and get this one off their books to focus on their typical model of building homes to be sold. The price is extremely attractive in my opinion, and the group operating it is one I’ve known and invested with for many years. We’ll be putting $250k into this one as a non-controlling limited partner and it should close within a month or so.
Another attractive piece to this one is the way the homes are parceled. This property can either be sold as a 95-home community, or each of the 95 homes can sell off individually. This may come into play if the residential market significantly outpaces the commercial market, and there is a substantial premium when selling individually versus as an entire community. There is a lockout period of 6-7 years before this can take place, and there are frictional costs to consider such as the cost of handling 95 separate sales compared to just 1, should the entire community be sold. However, having this additional exit strategy in our back pocket is always good, especially since this is in a hot Northern Virginia residential market.
There are a few other short-term opportunities we are committed to and have some more long-term ones we are reviewing as well, but this investment mentioned above will be our first major equity deal for 2024 and we are thrilled to be a part of it. I’ll share more info in the mid-year update about this one.
Finally, I wanted to share my thoughts on the market and give my take on what we can expect moving forward. For starters, I never hold opinions on where I think the market will go and what rates will do. People that give market forecasts or state that because X is doing something, Y will happen are usually people I do not take too seriously. There are simply too many variables in the equation for anyone to know what will happen in the future, and making speculative investments based on shaky logic is a good way to lose money. I’m guessing there were at least some “experts” in 2019 talking about how the office sector is going to improve in the coming years and now is the time to invest…
Another thing I avoid doing is making investments based on the greater fool theory. For those unfamiliar, people who invest based on this theory are focused solely on the asset’s value and what they think someone else will pay for it. The assumption is that there will always be a fool willing to pay more than you paid, and that values will continue rising regardless of the asset’s underlying fundamentals.
This happened on a grand scale several times during the 20th century, such as the lead-up to the great depression in the 1920’s. More recently, it happened in the late ‘90’s leading up to the dot com bust, and in the 2000’s leading up to the 2008 crash. During each of these run-ups prior to values crashing down to reality, there was exuberance and optimism in the air. Lots of “investors” figured that tech stock values and home prices would continue soaring and that they were a lot better at investing than they actually were. It is very easy to look (and feel) like a genius in a bull market.
Unfortunately for them, market values can only diverge from the true intrinsic value of an asset for a finite period. Sometimes it is a short period, and sometimes it is longer --- but gravity still exists.
When I began investing in 2016 I was in the category of folks mentioned above. I was less an investor and more a speculator focused on values. Over the next couple years I began listening to Warren Buffett and reading material from Ben Graham (one of Buffett’s mentors) and I had an “ah-ha” moment where I realized that I don’t need to be good at predicting values or the future, I need to be good at analyzing an asset.
If I can analyze an asset and purchase at a fantastic price, relative to what the asset will likely produce over time, then I should do okay. Instead of making decisions based on what others are doing, or because I got some hot stock tip, I was going to focus on understanding the asset’s true worth based on what it can produce over time, and not based on what I think others will pay for it. I’m not a huge fan of gold or NFT’s, as you can imagine.
Asset values are almost always influenced by interest rates, and in real estate this is especially true as most assets are heavily backed by debt. As borrowing costs have risen, beginning with the Fed hiking rates in 2022, commercial values have dropped. Part of this is because we were in a zero-rate environment for about 2 years during covid and values skyrocketed during this time, but this is also because a lot of market participants who were focused more on asset values and less on underlying fundamentals have dropped off.
I see this as a huge opportunity for us as we should be able to get into some fantastic deals. Regardless of what values do in the short-term, I know that people will continue renting apartments and mobile homes, businesses will keep renting industrial space, and rents will continue rising for the great assets in great markets, led by outstanding operators.
Rates rising and values declining allow us to get into these kinds of deals at a great discount, and this is what I’m focused on doing. Warren Buffett talks about how optimism in the market is your enemy, and pessimism is your friend. In a high-rate environment, during an election year, there is likely to be some pessimism in the air, so we’ll be sure to have some dry powder ready for when interesting opportunities come about. Wish me luck!
The next update can be expected at some point in July, marking the mid-year point. With the exception of one investor who contributed some capital in 2023, there will be no K-1’s to issue until the end of 2024. In the 2024 update I’ll be sending this time next year, I will include info regarding issuing K-1’s and when to expect them.
If anyone has any questions please feel free to reach out to me any time. You can email me at will@harvey-capital.com or give me a call/text at 703-677-7991. Take care and God bless!
In Christ,
Will Harvey III
IMPORTANT: This communication is for informational purposes only and is intended solely for the general knowledge of the recipient. It does not constitute an offer to sell or a solicitation of an offer to buy any securities, nor shall any securities be offered or sold to any person in any jurisdiction in which such offer, solicitation, purchase, or sale would be unlawful. Any offering of securities will only be made pursuant to a confidential Private Placement Memorandum (PPM) and other definitive legal documents, which must be reviewed by the prospective investor.