Private Lending v. Rentals – What Is The Better Real Estate Investment?

I live in Costa Rica also and I read a few of your articles.  I was wondering, Instead of investing in Costa Rica real estate, Why not become private hard money lenders yourselves?  That is what I do and it is pretty much a no-lose deal if you do it right.  Any reason why you prefer Real estate?

– Dan

We actually are private lenders, but only on deals in the US. In Costa Rica, our investments are strictly in real property, both of which are used as vacation rentals. I’m not sure how Dan structures his loans, but in our case, our private lending earns 10%, plus up to two points depending on the loan-to-value ratio of the underlying collateral. A 10% return is higher than what we have earned on some of our rentals, including our Costa Rica rentals, and lending doesn’t have the ongoing headache of property and tenant management. (Even with a property management, you still have to manage that team.)

We currently have two private loans outstanding v. nine doors for rent. Why don’t we do more private lending?

The earning potential of private lending v. rentals

Private lending has solid earning potential, and that’s what attracted us to it in the first place. We got started on a loan to an experienced builder. We did two loans with them, the 2nd for their assisted living property. We liked tapping into the growing elder care space without the liability and other risks of active involvement. We liked working with an experienced partner who had a track record of paying back 100% of their loans. We put $200,000 in play and earned 10% simple interest over three years between the two loans, with nothing to do but sign some loan documents and monitor that monthly payments were being made accurately and on time.

Contrast this with rental real estate, where the earning potential is not at all guaranteed. Yes, it’s possible to earn 10% from a rental. However, there are multiple factors that contribute to the ROI of a rental. On the revenue side, you have rent and occupancy rates. On the cost side, you have the price at which you buy, how much you spend to locate and then renovate the property, ongoing maintenance, taxes, insurance, HOA fees potentially, capital expenditures and property management. Vacation rentals in particular take a beating and therefore have higher maintenance costs than buy-and-hold rentals. Vacation rentals also have seasonality in the pricing and typically very high management fees, so the revenue side is trickier than buy-and-hold.

For our rentals, even with property managers handling the day-to-day, we have been far more involved. In the US, we tried using turnkey companies to find some rental investments, which should take the work out of scouting for property, but never had the same success as doing it ourselves. Second, you have to get the property in rentable condition. Even a cosmetic paint, floor change and deep cleaning is a coordination exercise and investment of hundreds or thousands of dollars, so while property managers can oversee it, you want to ensure it’s done right and cost-effectively. Third, you have to find and screen the tenants, or manage the property managers to ensure this is done to your standards. Finally, there is ongoing tenant and property management, or managing the property managers doing the day-to-day.

That said, rentals have additional bottom line benefits that private lending does not convey. In addition to the rents, there is potential for your rental property to appreciate. For example, we bought a condo in Tamarindo in 2018 that we sold in 2021, just under 3.5 years later, for ~20% more than we paid for it. In the US, the value of real estate depreciates, and you can generally net that depreciation out of your taxable income (check with your tax advisor about your specific circumstances, but here is an overview of real estate depreciation). Finally, if you borrow to buy your rental real estate, you put in just a fraction of the total cost, but you control the total asset. Given the additional upsides of owning property outright, we have favored rentals over private lending.

The risks of private lending v. rentals

Leverage cuts both ways and is a key risk in rental real estate, if you go the rental route and borrow money to acquire it, if the property appreciates, your gains are multiplied because you put in only a fraction of the total cost, but you benefit from appreciation of the whole asset. For example, we have a rental property in Florida that has increased in value from $320k to $550k, or 70%, in four years. Since we put in just $100k, not the full $320k, our cash return is actually over 100%. Leverage has juiced up our gains, in that case. Had the property lost 70% instead, so it went from $320k to under $100k, leverage would have put us underwater, owing more than the value of the collateral ($220k in debt for less than $100k in value, in this example). Ouch!

Even if you don’t borrow to acquire the rental, there is the risk that you would overpay or buy a property that isn’t suitable for renting. We once bought a property in Florida with the intention to rent it, which we did. But then the tenant moved out, the HOA changed its rental policy and we were suddenly unable to re-rent it. (Luckily, we had bought it below market so were able to unload it and still cover our costs.) Since there are so many factors that affect your rental return, a miscalculation of any of your numbers, can throw off your return.

Private lending also has risks. The security of your loan rests on the integrity of your counterparty, the legal system backing up your agreement and the underlying collateral. You have to be able to do enough due diligence on all three of these things to know your investment will indeed return, not just the interest rate, but even the principal. (See our earlier post for how we evaluate private lending deals.)

Investing in Costa Rica v. the US

Controlling for risk is the ultimate reason why we opt for rentals over private lending in general and why we have not done private lending in Costa Rica. Sure Costa Rica is a democracy with a stable history, but we don’t know the ins and outs of their legal system. We don’t speak Spanish. We don’t have a wide network there. We don’t have the ability to do enough due diligence to vet a private loan deal.

For Costa Rica specifically, we have a real estate agent, property managers, lawyer and accountant that we trust for the much more typical buying and selling of real estate. We are more confident in our ability to control the risks of rental real estate than private lending. Risk management is our first priority.

Ultimately, investment decisions – whether private lending, rentals or something else entirely – should be personalized to your circumstances

Not just in Costa Rica but in the US as well, we enjoy the process of buy-and-hold rental real estate than private lending. Given where we are on our FIRE journey, we can prioritize the joy factor and not just the financial aspect in deciding how we spend our time and efforts. That said, we do some private lending, and we are always open-minded as to what would be the best use of our resources. Maybe our investment mix will change in the future.

How about you? Are you Team Private Lending, Team Rentals or something else?